Designing better futures

575 Bps of alpha with a political contribution weighted bank index

The new opensecrets.org site is out and it is fun.  You can see which industries and participants contribute politically and to whom.  So the question these days is where to get a good return on your money or more importantly the return of your money.

Here are the contributions of a handful of banks in the 2008 political cycle.

Does this pay?  I constructed a Naive index of equally weighted banks and investment bank and compared it with a political contribution weighted index starting in Jan 1 2007.

It turns out the political contribution weighted index yields an extra 575 Bps of extra Alpha over the 2.4 years.  Of course -70% versus -75% isn't exactly a one way to ticket to super happy bonus land.  This is far from a rigorous analysis for a whole host of reasons.

I hope some snappy grad student out there does some work on this across sectors and companies.  After all this is America and if you are paying for influence, shouldn't you get it? ;)

Not a big deal, but maybe if Lehman and Bear would have been a little looser with the ole pocket change in DC....

Here is the spreadsheet Download PoliticalPortfolio

Negative options lead to Black Swans

The original Black Swan story was interesting because it correctly used an ecological model and behavorial shift to show a "surprise", ie. the discovery of a Black Swan.   The ecology was the new environments which allowed for the discovery of the black swan and the behavioral shift was the exponential rate of increase in exploration of those new ecologies.  The swan metaphor is more apt than first appears.

Europeans had only seen white swans up until the 18th Century and could have created a White Swan Swap, if they possessed our contemporary financial nous. 

Imagine our smart 18th  century Dutch banker, Don Dutchman betting with Bob Blackswan that there are no black swans and never will be.  Don wagers with Bob Blackswan, that they will never capture evidence of such a creature. 

Don and Bob agree to an ongoing wager, that for every year, there are no known Black Swans Bob will pay Don 1,000 guilders, a princely sum. If a Black swan is ever spotted Bob gets 1 million Guilders a 1:1000 payoff.  The wager is drawn up and copies of the contract exchanged.  A bilateral black swan default discovery swap has just been created with a notional value of 1 million guilders.

Bob Blackswan believes in Black swans and Don Dutchman doesn't.  Bob and Don have just created a sort of Black Swan default swap. 

Before the arrangement was settled Don had his accountants and experts comb the evidence and historical record of white swans just to be sure.  Don had astronomers and mathematicians calculate the "odds of a Black Swan" using the hot new Bayesian approach that all the 18th century quants were trying. 

Don has created the perfect bet, no black swan has ever existed and the statisticians (quants) tell him the probability of finding such a creature approximates zero.  Don Dutchman believes he is in for free money and may even set up a Black Swan insurance company or bank selling these black swan swaps if he can find enough Bob Blackswans to pay 1,000 guilders a year for the privilege.

Negative Optionality lies out of the box.

Bob has a different opinion and is betting on negative optionality.  Positive optionality is found in companies or bets in which there is an internally perceived "option" or bet embedded within the company that allows for extra upside. 

For example people purchase bio-tech companies not on cash flows per se, but rather the optionality of some new wonder compound eventually becoming a cash stream via the FDA process.  People probably buy shares in apple computer based on the next hot " i-something" being released.

Negative optionality is the inverse of this, it is looking at something of current value and pricing the potential for the loss of that value based on an external event.  This even might remove market share, eliminate the market with a substitute or in some other way diminish the economic value of the investment.  Value investors see moats as negative option protection.

Don Dutchman looks at his pile of historical white swan data, finds a few off-white colored swans, but assesses his risks as low.  To be sure of his bets, he back tests 150 years of historical swan birth records using millions of swan samples.  All the samples come up white swan. 

Don even creates a "whiteness" measure for swans tracking the variance of the whiteness.  The greyest newborn swan eventually turns white.  Variance in Don's sample is so low that when he plots his swan variance relative to the risk of "blackness" he perceives it as negligible. 

The variance among swans or Don's VaR (value at risk) is incredibly small.  Don calculates his risk as so small that he takes Bob's Blackswan's bet and runs around town with it looking for other takers.  Each year Don is going to rake in 1,000 guilders from each bet holder.  The low variance in white swan samples means that seeing a Black Swan is a 25th standard deviation event greater than 1:1 trillion odds against.  Don is betting 1:1000 against, a sure thing.

Bob thinks outside of the box and outside the swan environmental data set, which is limited to Europe (the center of the 18th century universe).  Negative optionality manifesting itself as a black swan event rarely comes from within a historical data set.  Black Swan size impact negative options are environmental / contextual.  Things operate in multiple shifting environments, or frameworks: political, geographic, technical, scientific and human behavioral.

Bob is aware of 2 factors in his favor.  He knows that he just needs a single black swan sample to win his bet.  Bob also knows things are changing in in the "known" world.  It is 18th century Holland and the world is opening up due to travel and trade. Everyday, new creatures and exotic lands are being discovered, the swan environment is growing exponentially. 

The negative optionality is increasing exponentially with each new exotic environment. Every exploring ship or expedition that comes in from a new environment is a negative option that might help Bob win.  The number of exotic species discovered is increasing exponentially and each new find is a negative option that might let Bob win his bet. 

Eventually Bob wins the bet due to understanding the environmental drivers of negative optionality. 

Negative optionality sits outside of historical price and is therefore not measurable by historical data.  The only way to "price" the risk of negative optionality is to measure the "drivers" of price or value properly.  Don looked at today's swans and the historical sample, Bob thought in terms of environment, evolution and geography as drivers of negative optionality allowing him to win the bet. 

Consider the simple pundit quoting this and that fact about the US stock or housing markets or the economy.  A sample size of one isn't a serious analysis, certainly not worth betting the farm on.

The drivers of a value are important.  Unfortunately few risk managers are polymaths or interested in drivers, they are hired for their math skills or PHDs more than their imaginations, so they molest the data they have with ever greater finesses until it tells them what they wish to hear.

Behaviorally the brilliant PHd risk manager is being asked to fit the data to the need. 

The New risk manager is always wrong, because the group says so.

Consider that on the first day of the job a young risk manager walks into his boss' office, presented data from 30 housing markets globally and said, I think there is a 1:10 chance our bank will fail.  We should cease mortgage securitizations operations immediately.  It probably happened.  Collective myopia isn't all encompossing, just strong enough to facilitate belief systems that reject challenges to the group needs and beliefs.

There will be more bubbles and people who see them for that, but group behaviour will ignore them at their peril.  Read Kindelberger's mania's panics and crashes. We aren't that special, we like every other culture alive, just needs to believe so.

The bank above couldn't accept or internalize a 1:10 failure rate and so listens selectively to those who deliver the most complex and obtuse narrative backed by "rigoruous" equations about why the bank would succeed and CDS and CDO's were money machines.  Group's select for belief support and re-inforcement especially if it re-inforces a recently successful narrative. 

In many cultures, high priests or astronomers and mathematicians promised a good harvest or success in battle.  Not much has changed, we are still social animals who need a sufficiently complex narrative delivered by an "expert" to further the group.

Group behavior and need is one of the things a a good risk manager should assess and report on.  If everyone in the group needs real-estate or oil to go up, there is a risk that no one is looking out for the other side of the bet.  If that group's need has been wish fulfilled a few times, it becomes an unchallengeable belief. 

If a risk manager is any good, most people won't like them, because they challenge fundamentally held personal and group beliefs that may be highly successful.  Positive result deviance can be more dangerous and telling than small negative deviance, for it can re-inforce dangerous behaviour.  If you want to find trouble before it happens, watch a group who just made a bunch of money and is scaling up to really "go for it", without understanding what "it" is or what makes "it" viable.  If possible ask, "how high is up and why".  Everything has an upper bound limit.

I am not against PHd's, I managed 70 of them in an advanced research institute.  Like any group of people about 10% of them were deeply interesting and creative in addition to being scientists.  Others were plodders, bright but plodders.  Cross field thinking imaginative polymaths are where the "good" stuff gets discovered.  Feynman came up with his electron spin equations by watching a plate on the floor.  He knew how to see and how to think critically. Watch this video to learn a bit about that.

Where do negative optionalities that lead to Black Swans come from?

Negative options are everywhere. Luckily, we have to worry most about the fast moving ones, i.e. the cases where these "extreme" options start being created exponentially.  Some types of negative optionality impact what I call "oxygen risk", the risk that something  ubiquitous and taken for granted is removed, like oxygen. 

Consider cheap plentiful memory chips mostly produced from Taiwan.  The probability of something happening, earthquake, typhoon, china etc. is not negligible, the follow on impacts would be huge.  The probability in any given year of such an event is probably >1%, the same goes for earthquakes on the West Coast of the US and yet everyone will be shocked.  Hint: a 1% annual risk has a roughly 1:3 chance of occuring over a 33 year investment horizon.

Technological innovation due to its' exponential growth curve is one of the greatest current negative option creators. Technological innovation for many firms is the Black Swan gun pointed at them.  Technological innovation is also Schumpeter's growth engine. 

To really understand the power of technological change in society read The Singularity is Near, the best book on the future out there and something the average MBA/PHd risk manager can't/won't think about.

Example:Pharmaceutical companies are under a negative option Barrage

I used to manage what was to be the world's largest gene sample gathering project. Gene Sequencing is an example of technology negative option. The cost to sequence a gene is declining on an exponential curve.  Each decline in costs makes sequencing cheaper, what cost $3 billion in 1999 will cost $1,000 in 2011. 

As the cost to sequence drops, the number of experiments for drug efficacy or adverse affects increases.  Each study done with a SNP type analysis is a potential bullet "negative option" cleaving off the addressable market of a current drug.   The cheapening sequencing curve is creating a huge environmental shift in drug markets that you can't see, yet.  The number of gene studies will grow exponentially and with each one, current potential market size could shrink. Drugs will be safer for patients, but big pharma is under an incredible negative option attack, that will show up as a black swan. 

Knowing how to see negative options growing exponentially is a powerful thing.  When everyone believes or more importantly needs to believe the same thing, negative options abound.  Today's ridiculous conjecture, could be tomorrow's, "whocouldanodeit?".

Technology advances along exponential curves and throws negative options up all the time.   Technology and behavior represent environmental shifts similar to the "un-discovered" lands of Australia.  Think about the behavioural shift about "home ownership".  From home to part ATM, part get rich quick lifestyle.  Culturally this is a big glowing warning sign.  Everyone needed and believed home prices would increase.

It is important to recognize ethnocentric biases and beliefs.  To the Aborgine, Black Swans weren't that rare.  He who writes the history books defines the black swan. The black swan created by a negative option could be someone elses gain and good fortune.

Many technology firms trade at market premiums as "growth" companies all the while being directly under attack as their environments shift.   Consider the telcos,cable firms and networks with their walled gardens.  Every year they inch closer to being commodity bit pipes and being valued as utilities delivering an ever cheapening commodity.  The negative options of cheaper faster pipes grow exponentially making a controlled digital experience seem all the less relevant.  AT&T 2011= AOL 2007, discount accordingly.  What got you here in technology won't get you there going forward. 

I just finished Michael Covels' book, Trend Following.  An interesting statistic on page 335.  The average lifespan of a "winning" stock is 9.35 years.  If true an 8% dividend yield is required for breakeven.  Choose wisely.

If you want to hire a risk manager, hire a ploymath generalist with imagination.  Going deeper with the same data, isn't helping, thinking outside of the box and about the drivers that make a portfolio or exposure work is important. 

Scenario planning at Shell was a great revolution and yet math people don't like narratives so much and story telling isn't viewed as serious enough for a bank.  Bringing a biologist, social scientist, historian, organizational psychologist or other type onto the risk management team and then don't let the math geeks bully them. Read the living company to understand how difficult it is to change organizational beliefs.

Scenario simulations, historical narratives, scenarios with a "b" team taking the other side of the bet might tell you a lot.  Just remember, the guys who made money and its usually guys last year didn't just gain 50 IQ points, they were most likely in the right place at the right time.

Luck and intelligence are often confused in Finance.  From an anthropologist's perspective chest thumping males celebrating a bonus are just showing a standard primate victory display, but not necessarily possessing greater prowess in predicting the next quarter or year.  

After all who could have imagined that house prices across the US would go down simultaneously, didn't seem to be the quant looking inside the shiller index.  Even a bad historian could have had a bit to say about it, but the group probably wouldn't have listened as it would have been, "just a historian".  Economic's current heavy reliance on math is really just a way of denying the fact that it is just one of the social sciences with serious physics envy.

P.S. for those of you who scoff at the Black swans analogy as simplistic, how about a glow in the dark rabbit? Biotech is going to change everything it means to be human, que the swan machine.

Deep play: Math, coral & crochet.

For those of you who get it, you will realize this video is a lot deeper in terms of symbolic meaning, linkage, learning and evolutionary creation of symbolic and applied knowledge.  For the rest, enjoy the pretty coral.

Margaret Wertheim leads a project to re-create the creatures of the coral reefs using a crochet technique invented by a mathematician -- celebrating the amazements of the reef, and deep-diving into the hyperbolic geometry underlying coral creation.   

I would be interested in hearing comments about this as most of the really deep math people I know will understand immediately why "play" is important.  pushing symbols about isn't interesting, but synthesizing new relationships or constructs within a bounded environment is very cool. 

For the fairly limited maths used in "advanced" finance and risk, just curious what kind of "wooly" form would pop out of a good CMBS or CDO model.  My guess is a CDO would look something like a teratoma and be immediately recognized as unstable or unfunctional due to flawed form.

A visit to the Kingdom Hedge fund contemporenae c. 2009 with Deutsche Bank

Talking about hedge funds collectively is like talking about living things in aggregate.  To use a biological metaphor equivelant to the Linnaean system: Asset classes are equivalent to Kingdoms in the Taxonomic world. 
One hedge fund is like an "animal" to a degree, unfortunately most commentators on "hedge funds" neglect to see or understand the subtle distinctions between say, a great whale and  the common garden slug.  As a reader of this blog you of course appreciate such hard to notice subtleties and appreciate that Convertible arbitrage, high frequency forex algo and private equity investments may have subtle distinctions and nuances not quite appreciated by the general media when they utter the term, hedge fund.

With those caveats in mind, let us consider the scope of the Kingdom Hedge fund contemporenae as reported in in the 2009 Alternative asset report courtesy of the Teutonically cheerful Deutsche Bank.

Firstly we notice the purchasers of hedge funds are looking for diversification before absolute returns.  As an anthropologist, I would suggest considering, not only the responses in this survey but also the context and time in which they were asked.

Few managers receive a bonus based on a correlation co-efficient, thus stated intention and actual motivations or actions may differ when viewing these survey results.  The survey was conducted with over 1,000 professional hedge fund investors, family offices, Fund of funds, pension offices and other sordid types charged with protecting nest eggs, outperforming benchmarks and capturing the bonus brass ring at the end of the year.

The collective hedge fund investors anticipate money flows out of the Kingdom over $100billion, but who knows about the collective actions of the group:

Should you be running a hedge fund or considering it, the size requirements are growing.  The allocators like to see $100m or more $100m these days, which is probably a function of wishing to get a feeling of fund operational and platform stability.  A surprising number of funds close due to back-office and operational errors, so run a tight ship, there is more to it than buy low and sell high.

This is no time as a manager to be bashful, the  fashion these days is transparency, open the kimono.

Allocators buy a long term process, the more they understand the process and what drives it, the more comfort they have.  The allocator doesn't have a CYA position if a black box bounces.  The allocator needs the CYA for his/her risk committee, give it to them, explain or show what the process they are buying is.  The more it is a process and less a person or some abtruse mathematical arcana the better (Rennaissance excepted of course).

Post Madoff a surprising number of people like to see their money, managed accounts are coming into vogue and probably a few more peaks at the books for the PE and CLO funds.

Bets are being made on Global macro. and commodities.  That says something about faith or lack thereof in the Dollar and the desire for thinking globally and flexibly. The interest in credit and distressed credit is an interesting countercyclical bet on things turning about soon, a bit too early for my taste, but every dog has his day.

It was a rough year for the Kingdom Hedge fund as most were down, not as down as the equity benchmarks, but down enough to make that 2% management fee a bit awkward to justify. Expect to hear a lot of harumphing and blather about non-correlation and relative return from the 2/20 crowd.  

And now for a happy chart to make everyone feel more intelligent and deserving.  Performance over the MSCI was promising over the last 10 years. It is probably best not to bring up the bond market returns at this point in the discussion as it could be a bit awkward.

Most are expecting good things in the Kingdom Hedge fundus next year with returns of 10-15%, with a 2:20 structure and the 2008 -18% average return, funds should be back to break even by 2010-11 assuming it all works out.  Ah you can practically smell the return of the performance bonus in the air, please don't discuss siegels paradox for those funds 25% below the high water mark, the date of return to performance bonus can starts to feel Jetsons like.

If you manage a merger arb or event drived fund look out, the shrink ray is pointed directly at you.

On the political front, if the money flows are correct and Eastern Europe and Russia are challenged it could get rough.  If you live in Germany stock up on Natural gas and jaegermeister to keep warm next winter, everyone knows how Russia has "technical difficulties" with the gas lines when it comes time to renegotiate the gas prices.  Eastern Europe's fondness for Swiss Franc denominated mortgages isn't working out so well and the political situation is sadly deteriorating, being filled by an angry far right looking to the past for answers.  This is not good for anyone.

If you are an allocator who got stuck with a lock up and want out, a surprising number of fund of funds will take your position off of your hands.  You were nice to your fellow allocators weren't you?  Humility, ethics & civil behavior are some of the great long term investments one can make in life.

Of course the price for fund liquidity may leave a mild burning sensation in your wallet, funny how those things like "liquidity" never show up in mean-variance and allocation models.  It is always important to identify the "oxygen" in a business process, ie. what are we taking for granted but that we will miss a lot if it disappears.  Most forms of Oxygen are hidden risk in plain site and fall outside most math models.

Most of the allocators have only been at this game for 7-9 years, that is a youngish industry that was "hot" in the last 5-6 years.  Expect the "cool kids" to move on to the next big thing.  I started building trading models and studying hedge funds in 1990 in central Iowa, tough to get less cool than that.

I look forward to being surrounded by people who appreciate the responsibility of acting as stewards of other people's funds and trust rather than just banging out the bonus for themselves.  Alternative Asset allocation has an important social function, the bonuses should be an externality of that function, not the other way around.

In human behavior and society the optimal size of human relationships and organization is roughly 150 members and referred to as the Dunbar number. 

In allocator land the equivalent is 50 relationships which is too high in my mind as the trade off of knowing something about a thing and knowing nothing about many things appears in action at this level.  Purely mathematically and even from a regime change perspective one would assume diminishing returns after 15 allocations, but c'est la vie' de l'allocator.

If you are starting out a fund, expect the initial allocation or toe in the water to be $3-5million.

If you are in the business of replication such as an alphaclone type service or someone using a Principal Component Analysis approach, the hedge fund replicator space is big enough to be interesting at 7% which at a $1.5 trillion industry estimate equates to $105Billion.

Given the drive for transparency and desire for non-correlation, this sector should grow albeit with lower fees.  Having developed transparent active indexes for Forex and commodity strategies in the past, I find this an interesting space, if you work with an institution interested in collaboration lets talk.

The industry perceives its challenges as monitoring and managing risk.  An index product with a managed account structure could provide a useful solution for allocators looking to buy exposure to a process and not just a "manager" lottery ticket.

Transparency probably speeds the sales cycle for a fund manager.  The due diligence process is 3-6 months, but the sales cycle from first contact to close is probably closer to 12-18 months. 

When I had hair and was a runner in the 10 year t-bond options pit, a friend asked which commodity was the most valuable on the floor.  I immediately replied, it wasn't traded on the floor., it was trust.  Trust, is a commodity behavior and relationship that takes time and patience to establish.  It is consistency of behavior and actions matching promises.  The fund game isn't a get rich quick overnight business and it shouldn't be, it is too important.

In regards to trust, the following chart shows 5-10 full fund redemptions from allocators.  With roughly 50 allocations on average per allocator this equates to 10-20% annual turnover, not exactly a high trust business.  Allocators under perform the hedge funds they invest in just like retail mutual fund investors. Investor "sophistication" isn't a subset of human behavioral traits.

Allocators invest in a process and need to believe and understand that process in order to weather the storm, transparency increases trust and ultimately fund sustainability.  It should be noted that few hedge funds survive the retirement or demise of their founder.  It is early in the industry, but as a young industry many of these vehicles aren't built to last a process based index or replicator factory could be.

For all the media hype about Madoff and the perceived evils of hedge funds, they didn't get to too leveraged as an industry (the LTCM boneheads being an exception).   Heavily regulated and rated industries such as banks and mortgage monopolies like Fanny and Freddie are another story. 

By the way didn't Fanny and Freddie by definition crowd out the local lending green shoots in your hometown years ago, not sure more govt monopolies and regulation make things better.  Regulation often provides the appearance of safety allowing the dim or lazy to suspend suspicion and proper due diligence.  Regulations get gamed. Behaviorally, long term I would trust a lightly regulated system with nervous diligent actors, than buffoons substituting a regulator or rater's stamp of approval for common sense and wariness.

The average lock-up is 1-3 years which works for some members of the Kingdom Hedge fundus, but not all of them.  Hopefully those on the buying and selling end of illiquid assets like PE, CLO's etc. will look into the listed funds business and hopefully the US will offer a sensible regulatory environment for it similar to various European regimes. 

If you are managing a group and looking for allocations the magic number is still between $50-100m.  A good transparent index might be able to make a go of this or structure itself as an ETF.  This cheap alpha if you will may not be at at the top of the Hedge fund Kingdom food chain in terms of performance, but an allocator gets transparency, liquidity and comfort in the process they are buying. 

The duration of these processes should also outlast their creators, just like good index funds.  Consider the S&P index as such a treatment for what was once considered exotic, namely equities in the 50's. Don't make me bring up the mean monkeys again :)

Now here is something interesting, many allocators indicate they don't need a track record, otherwise it is 1-2 years, not sure what to make of that.

And finally my favorite issue risk.  Years ago I testified before the US senate in conjunction with the CIA, World Bank and State Dept. about international banking settlement risk, it has always been a favorite topic of mine.  Most allocators indicate risk aversion above a 20% drawdown mark which probably again depends heavily on the fund type. 

Buffet has 50% drawdowns, but it worked out OK.  Drawdown has a high correlation with Vol, so consider your leverage or exposures accordingly.  Swinging for the fences may give you an 80% year, but that 40-50% drawdown might keep the AUM at $50m and volatility plays to Siegels paradox in many types of systematic "non-value" type investments making it very tough to recover.

 I would like to mention an "oxygen" type risk that many managers and allocators should be aware of, namely inflation.  I wrote about it here. Last night, I sat at the Harvard Field club in Greenwich listening to a presentation to the Connecticut Hedge Fund assocation.  The mood was anxious and a thick choking fog of inflation fear was in the air and the Fed acronym machine is redlining, with each new iteration of alphabet soup bailout program tacked to another multi hundred billion dollar figure.

To paraphrase Casablanca, Maybe not today and maybe not tomorrow, but sometime and someday inflation will loom... If you run a fund or FoF's and can think beyond the next quarter, run some regressions on your allocations and approaches with respect to an inflation proxy, don't just rely on the flaky CPI, that thing has been massaged more than Eliot Spitzer. 

Low inflation is the oxygen we have all been taking for granted.  Today's hot selling Non-correlated 15% returns could rapidly fall out of favor if they don't have a positive correlation with inflation.  Remember your game as an allocator and steward of people's money is delivering a long term absolute wealth maximization process.

creative environments for designers and scientists

Some of the most interesting creative work is done in groups of collaborators.  As a former chief analyst for a European Science incubator and having lived with a designer/architect couple in Sweden, I find the creative spirit and human ingenuity endlessly fascinating.  Here is a video from a collective based in an old church in the Netherlands.

The Ivy portfolio may be for those who no longer buy, "buy & hold"

Meb Faber has written an interesting book, The Ivy Portfolio about asset allocation,Endowment approaches and asset class risk. 

Mentioning asset allocation in polite conversation is akin to discussing plumbing.  Everyone has an idea of what it is, they understand its importance, but it is a topic best avoided in polite conversation at all cost.

Like plumbing, asset allocation becomes "interesting" only when things get stopped up.  Many investors believe their portfolio flow isn't quite working properly and are looking for a way to fix it.  Plumbers are over-priced, dreary and generally smell like carnies.  Luckily Meb  knows a thing or two about asset allocation, isn't a dreary fellow at all and puts on a good read.  He is sharp and has written a focused book on thinking about an interesting method of Asset allocation. 

One of the most important papers in asset allocation is the seminal work of Brinson, Hood and Beebower determinants of portfolio performance which I read in the Jardin du Luxembourg while temporarily taking up smoking as a grad student in Paris.  It describes the principal determinants driving portfolio returns.  Surprisingly, at the portfolio level, security selection becomes far less important in most instances. (Hint: most managers are bad at security selection so the expected or derived positive contribution variance is de-minimus at the portfolio level) 

The general gist of looking at asset allocation is that in the long run it matters more at the portfolio level which is driving terminal wealth maximization, the end goal.  The dispersion and drivers of portfolio returns are driven more at the asset allocation level, than the security level in the vast majority of portfolios, with the exception of Buffet and a few people who know what they are doing.

Long term Asset allocation involves thinking outside of one's own time and geography.  Looking solely at the US equity market even back to 1871 for a doctored S&P index has come into vogue in the last year. This is bad research and sloppy thinking.  It is akin to looking at a whale and saying it represents all the animals in the ocean. 

Many equity markets have not only declined  greater than 80%, but died all together, the same with bond markets.  History is not kind in the long run to paper assets unless they are still growing in the form of timber.  Be wary of the prognosticator with an imperious tone, sense of history and a sample size of one.

Meb's simple solution to this asset allocation exposure "buy and hold" dilemma is to get out of an asset class when it looks iffy.  The trick of course is defining iffy.  In this case it is a moving average of 200 days.  I am usually against advocating the use of a single moving average or any "technical" as most people don't understand what they do, how they work or most importantly why.  Meb has some good counter arguments for why one could consider this 200 day variable a nearly "naive" or non-optimized approach. 

This 200 day number still an area for further research, which will hopefully be taken up by an econometrician as the drivers of any allocation process should be understood.  It would be interesting to see how the approach fared against the multitudes of examples of bubbles in assets ranging from farmland to tulips over hundreds of years and markets mentioned in Kindleberger's excellent work mania's, panics and crashes.  The inherent question being; is there something in the Hobbesian leviathan of human bubble behaviour that has a shared time element or profile, Karl Popper would of course argue yes.

The Ivy Portfolio shows that across many periods of time and asset classes the risk using this 200 day long/cash approach is reduced and the returns increased for a portfolio using the respective asset classes.  As an allocation exercise Meb provides multiple examples and potential justifiers for why this approach may work. The approach is always long the asset class as indicated by an index (ETF) or flat cash.  More importantly at the portfolio level the allocation is modeled equally across asset classes.  This is important as discussed here,as a priori optimization can be sub-optimal post fact.

The examples in The Ivy Portfolio are shown with Index and suggested ETFs. A website is available showing highlights to the approach.  The Ivy Portfolio is a lot cheaper from a cost perspective than managed mutual funds and provides higher levels of diversification.

There are a few nice additions to the traditional Stock, Bond, Equity assets classes.  One of these is a proxy for managed futures, ie. commodity exposure.  As a former participant in the Chicago pits and teenage futures trader I appreciate these market's efficiencies.  I wrote my master thesis on quant approaches to hedge funds and found the low-correlated positive skew in commodities whether trend following with an MLM type index or passive like the GSCI to be a useful complement to many portfolios.   The passive commodity indeces are over oil weighted, Dollar denominated etc. and did horribly in 2008.  I have exchanged a few e-mails with Jim Rogers about this, he of course recommends the Rogers commodity index.

The naive approach to weighted asset classes and adding commodities was good in The Ivy Portfolio's approach. Most people will realize this in 2-4 years post priori when the current stimulus works its magic on the purchasing power of the US dollar.

Another nice asset class addition mentioned on page 116 is currencies.  Having lived in 8 countries and worked in 6, and sat on a quant currency prop desk in London building index strategies, I am a big fan.  For those interested, Here is a crude Forex product I put together based on some work by Pierre Lequex and Emmanual Accar when I worked on unsuccessfully launching a money market forex product in 1997.  Go figure, everybody wanted the +100% returns of pets.com and co., they weren't interested in 15% returns or a nice cash proxy yielding 200bps over t-bills and no leverage.

Timing counts in fund marketing just like comedy and juggling.  The product had low correlations to traditional assets, it is similar to some Deutsche Bank momentum products available today.

The Ivy Portfolio if nothing else will get you thinking at the portfolio level.  The returns show a risk reward ratio (sharpe) of roughly 2X the S&P 500. And yes the approach was out of equities in most of 2008.  So take a look at Meb's book, as Bill Cosby used to say on Fat Albert, "...If your not careful  you might learn something before its done."

If you really want to get deep into alternatives study for the CAIA(Chartered Alternative Investment Analyst) certification and pick up a copy of Anson's Handbook of Alternative Investments or read Gibson's book on allocation, just don't bring it up at cocktail parties or first dates.

Why mean ignorant monkeys beat median jumping clowns in the investment circus.

Occasionally a bored business publication, goes to the zoo, rents a monkey and pits him or her against a mutual fund manager.  Lo and behold the monkey who doesn't know a beta from a bunghole beats a significant majority of the active managers.  Barron's should probably create a yearly Monkey Roundtable

These Journalists must be pretty good monkey pickers and should probably start a MFoF (Monkey Fund of Funds) charging 2% and 20%.  We are the Third Chimpanzee and it seems as if evolution must have robbed us of our stock picking skills, but boy can we pick monkeys.

So what is going on?  Charlie Munger and Warren Buffett both hint at it in various writings and books, my favorite is Charlie's Poor Charlie's Almanack.  Warren calls it de-worsification, or the fact that many portfolios get worse as more components are added to them.  The theory which he pretty well proves via his actions is that the more holdings you have the less likely you are to know a lot about any of them.   He doesn't say it, but most managers also jump the median, the investment equivalent of jumping the shark.  Buffet and Munger both hint at investing being similar to paremutuel betting.

The reason mean monkeys beat median jumping clowns is that most fund managers really don't understand the sustainable economic value drivers behind the businesses they invest in and therefore can't allocate well at the individual equity level.

Mean Monkey's picked by journalists have one of the key behavioral principals in investing; ignorance.  They don't know or even pretend to know anything. 

Stock returns as exhibited on page 73 of Meb Faber's great new book, The Ivy Portfolio shows the problem.  Stock returns are log normally distributed having fat tails. 
The charts are sourced from Blackstar funds and reflect data from 1983-2007.

The Mean Ignorant Monkeys. 

I tell my wife that ignorance and apathy are key investment traits, she just rolls her eyes.  Put another way, know what you don't know and be patient, activity kills in this game. Ignorant Mean Monkeys beat funds because they allocate naively, ie equally in their portfolios. God forbid the monkey's start running mean variance optimizers or the game is over.  Mean variance portfolio allocation is probably one of the most costly rear view mirrors of all time.

Suppose, that out of the Universe of 8,000 equities above Mr. Mean Monkey takes on Mr. or Ms. Median jumping manager by throwing his darts.  Most of the these competitions stop right there.  Rarely do the journalists ask the monkey about next quarters earnings projections or where the Dow will be next week. The Monkey's bets are spread equally across the selected equities and the race with the clowns is on. The clowns performance is usually measured by their funds returns. 

The Monkeys should perform roughly the same as a naive (unweighted) index with a small cap bias.  Why?  The monkeys are simply taking a random sample of the markets, so the returns should be roughly equivalent to the chart above.  The smaller cap bias will reflect the greater number of smaller cap firms present in any sampled universe of investable firms.

Imagine that from the 8,000 stocks the monkey selects 8.  One could think of the chart above broken into 8 bins.  That is what the monkey's return will equate to.  The monkey is an approximate unbiased sample of the market.

Send in the median jumping Clowns.

The active fund manager "median jumper" clown does the same thing with his or her 8 picks, ideas, gambles, allocations or whatever glossy euphemism he or she, uses in their marketing literature.  But the clown is at a disadvantage because they don't know what they don't know, so they decide to weight the portfolio according to the "best" picks.  Uh oh, here is where the trouble starts, they just jumped the median and probably picked something closer to the mode, the most commonly occurring sample.

The median is not the mean.

The statistical mean is what most people consider the average of returns.  More importantly is the median and mode, the most likely sample to be chosen and the number separating the higher and lower half of the sample.  It works like this.  You and 7 of your friends find yourself in a room playing bridge with Bill Gates and Warren Buffet.  The mean (average) net worth of the individuals in the room is measured in the billions, but you don't feel any richer because most likely you are one of the 8 representing the mode or most common sample in the room which is below the median and the mean.

The median and mode for share's returns is actually well below the cap weighted index which is closer to the mean.  The charts above indicate 64% of shares under perform the index.  This means that managers who "tilt" or weight their portfolio to their best idea are statistically taking a random sample and doing bad things, increasing the odds of picking a sub-index performer and in so doing also diminishing the allocations to the potentially significantly positive outliers that help deliver the mean performance. 

This is classic behavior flaw 101, people with more information believe they know more about something.  So the fund manager takes the useless sell side research reports, technical analysis and other hocus pocus that they haven't back tested or thought and parks a few more chips on red. 

Few managers really understand businesses.  Not many money managers have actually run a competitive business and understand the dynamics of a "market for goods and services".  When it comes to fund management and equity selection, I will bet on a humble person who has run a successful small business over somebody who can tell me what they think the Fed is doing. 

Stock "business" selection skills are different from macro economic analysis and best learned by doing.  People straight from school and fed into the investment banking world are put into an environment that demand answers even when there any.  Smart people who don't have answers or admit ignorance get weeded out.  This is an environment rarely interested in posing interesting new questions which is a far more interesting and important skill requiring imagination.  Even Buffet ran a gas station into the ground and probably learned as much from it as his Columbia MBA.

Transaction and operational costs etc. also injure manager returns.  This is the case of apathy/ patience proving things out.  Fund managers are like trapped animals.  They get caught, then get nervous and waste energy trading and allocating instead of sitting quietly and thinking about what the dynamics of the game they play truly are.  My suggestion shut off the screen and blackberry and go fishing etc. for awhile and reflect, maybe a few answers will pop into your head, if you are truly lucky a profound question will arise.

The well known reality is that most fund managers underperform a passive representative index.  Managers don't know what they don't know.  They are often in the giving answers business as they rise from analysts to portfolio managers, some are just great salesman stock brokers.  Cramer is the worst public example of an analyst gone wild.  He is a bottomless pit of useless answers filling the airwaves to pimp cars, cereal and pills for CNBC.  Felix Salmon has his own equivalent answer hole in Ben Stein. 

An answer hole (my term) is a bottomless pit where questions are thrown in and answers are always on offer.  The only thing not found in the answer hole is an honest phrase such as "I don't know."

Most Mutual Fund Managers could significantly increase their long term performance with an equivalent naive asset allocation across the board and less activity, assuming they have a random sample.  They could at least aspire to mean monkey performance and still get the fun of throwing darts while causing less harm. 

$6.24 Trillion dollars of clown self delusion

For fun take a look at your funds top few holdings ideally representing 80% of the portfolio, and allocate them equally.  You might find that a Mean Monkey portfolio approach beat your managers median jumping. 

Calling mutual fund managers clowns may be rough, but if a $26 trillion industry under performs the Naive approach by 1.0% and the average fund has expenses of 1.4% that means you or your pension fund loses $26 trillion x 2.4%= $624 billion a year playing the fund game.  The label clown doesn't seem to harsh and is more fun and light hearted than the anger going around these days.  Over 10 years that lost clown value would equate to $6.24 trillion, not including opportunity costs and compounding.  Send in the Monkeys! Figures like that sound almost stimulating don't they? (groan inducing macro pun intended :) 

Hedgies lost 18% on average in 2008 which beat most indexes by 20% and blew away most mutual fund managers.  Please note the even with the Madoff's etc. in aggregate the Hedgies who have light regulation outperformed the highly regulated mutual fund industry scam. If I wrote the pension laws.  I would limit the allocations to active mutual fund managers significantly.

I have a crude outline for a book called Circus economics & investing, it is all about how economics and investing works.  It will have stories about monkey's, clowns, 3 ringed circuses, yield totters, horse races, magic tax tricks and leveraged tight ropes describing how life works under the lights in the big tent we call capitalism.  I have also developed some nice "naive" parameterless algorithms for swap spreads,rates, volatilty etc. with +3.0 sharpe ratios if there are any interested hedgies out there. 

If you have a large equity portfolio, I offer a portfolio risk elimination service which makes a recommendation on which of your top 10 holding to eliminate in order to boost returns.

More power = more questions

Everyday we progress exponentially along the knowledge curve implementing improved technology to manifest greater power.  That power comes in the form of energy, information and control as manifested through individual and group behaviors. 

As a former chief analyst for one of Europe's most advanced research labs and an anthropologist I pose this question. 

More power to ever smaller groups can mean more risk to everyone, what should we do at the group social level? 

I don't have answers, but these are profound and looming questions.  Here is a video or War power.  I have posited since 1990 that applied biological technology will pose as many profound challenges as anything we have yet encountered.  Yes this is Bob Merton, he the maker of small fortunes from large one who blew up LTCM.  He has led some of the most expensive lessons in convexity exposure and Gamma risk ever.  Please god, for the sake of the children keep him away from systemically large amounts of leverage :).

Bob Merton video explains risk, economic situation and an awkward future.

Merton really gets it.  Merton covers a lot of ground in this video.

This video is worth the 1.5 hours. It contains explanations of:

• Convex function of a convex function leading to extreme non-linear outcomes
• Infrastructure problems
• Why it is not necessarily all about "bad" people
• Pension plan risks are looming
•  Hints of the nature of asymmetric outcomes and behavioral responses

One of the concepts Merton hints at in his talk is the trade off in an economy, having to operate a less "efficient" economy for a safer one. Classic case of a locally sub-optimal solution being globally optimal in this case stable.

Merton covers a lot of ground in very easy to understand language.   Ideally this video would be a book and expanded with more examples and visuals.

I wish he would use the language of normal accidents and asymmetry in behavioral responses to "put" like incentives and the need for CDS regulation, but he gets it by and large.

His conjecture at the end is that govt. may not want the "complex" derivatives to be valued.  I would tend to agree, the convexity of the functions inherent in a lot of CDS and correlation type products is almost too scary to consider, but considering and acknowledging these things is something we must do.  He also re-iterates Andrew Lo's correct calls for an NTSB equivelant for financial markets.

Architecture for Humanity celebrates 10 years. Very cool!

Architecture for humanity is one of the more interesting charities in the world as it uses design, information and longer term thinking to help.  It works for the designer, anthropologist skeptic in me.

I would recommend buying and reading the book Design like You Give a Damn, that shows great design in situ and process around the world.  It all started with 2 people and a few cups of cofee in New York.

UK & US Govt 5 Year CDS spreads still in extreme territory

I have been using a trial of a nifty credit service called Advantage Data to look at credit spreads and risks.  Here is a look at the last 3 months of the CDS prices for US and UK 5 years.
Looking back over the last 3 months, it looks like things are getting better.  This chart shows  a CDS bid price in bps, referencing the likelihood of default of the UK and US government debt over the next 5 years. 

Below is the chart with a time horizon going back a year or so ago. The message is that the credit crisis while apparently getting better is still posing extreme systemic risk according to CDS spreads.  I posted this data help people think about what is going on in the credit world's view of things. 

The equity markets are important to peoples perception of wealth and confidence etc. in the near term. It is the perception of risk and liquidity in conjunction with demand that actually determines how we get through this.  The current plans have been greeted optimistically, but are not priced in as a full resolution to these national crises.  Let hope spreads keep tightening.  The Q1 US GDP could be an eye opener.

As indicators of perceived risk, the equity markets don't tell a person a lot.  The CDS spreads offer a lot more information and are exhibiting strong signals that appear directionally promising, but still chronically high.  Tarp V 3.5 anyone?

Here is a the same information for the G-10 from Bloomberg. The fat lady isn't singing quite yet.