Friday, December 30, 2011

Mechanical Trading Strategies & Backtesting and how they Create Bias

Mechanical-based trading strategies produce unintentional style or sector bias in portfolio construction. Backtesting is not the key to generating returns.

The argument behind this article is that purely mechanical-based trading strategies have a tendency to produce unintentional style or sector biases. This is problematic because the investor will find himself manifesting a viewpoint or weighting that he may have purposefully set out to avoid.

Indeed, many favour a mechanical-based strategy because it obviates the necessity for a discretionary viewpoint. This is important because an investor might want to avoid the pitfalls of selecting sector/stock weightings. Similarly, from a behaviourial finance prospective, he might want to avoid the psychological pressures of having to adjust his positions by constantly having to make discretionary decisions. In particular, value investing is seen as being susceptible to these pitfalls.

Back Testing of Trading Strategies and Why it Doesn’t Work

There is another danger here that may prove to be more pervasive via its insidiousness. Mechanical trading strategies always involve substantial back testing and, investors try to test conditions across a range of market conditions. However, what if the strategy results in a sector/style weighting that is favourable across the period of back testing, but not likely to repeat itself going forward?

The likelihood is that he will reject the system outright, or else try to refine, or add new factors to, the system in order to incorporate the new results. If the argument of this article is correct, than this process of curve fitting is likely to break down again, and the investor will find himself disappointed again.

All that this refinement is likely to achieve, is to produce a new sector/style bias -which works as
 a ‘best fit’ solution to the updated results-that will may fail as future conditions change.

Mechanical Trading Strategies Produce Unintentional Style or Sector Bias?

In a sense this is an epistemological question. In producing a mechanical strategy, traders will be trying to define a set of universal and consistent parameters upon a series of results that is actually ever-changing and evolving. Markets don’t have memories and they are not obliged to follow rules. Similarly, there is little regard for sentiment in market based strategies. This is a pity because, many believe that sentiment- think Geenspan’s ‘irrational exuberance’ and Keynes ‘animal spirits’- is what guides markets.

Furthermore, in creating the parameters for mechanical evaluation of, say stocks, they will struggle to avoid defining a factor, that doesn’t intrinsically favour a style or sector.

The latter argument is best expressed by some examples of the type of investment ratio, or filters, that are used by traders. Namely, dividend yield, price to book, price to earnings or PE ratio, price to cash flow.

Using Fundamental Filters

This section is best expressed by a series of snapshot examples within bullet points:

*Dividend Yield. Stocks that pay dividends tend to be more mature and generating cash flow. Therefore, selecting on the basis of yield tends to result in slower growth, mature companies that have previously doing well. In other words, yield would have guided investors in buying banking and housing stocks before the crash of 2008!

Similarly, favouring stocks without a dividend, would have resulted in favouring technology and internet stocks right up until the dot com bust. Furthermore, high yield companies tend to have less free cash to invest for growth. These types of stocks maybe favoured in a recession but not in a recovery.

*Price to Book. This is a favoured measure for value investors. The problem here is that different industry sectors require different amounts of tangible assets in order to generate profits. For example, a plant hire firm must hold substantive amounts of capital machinery, whilst an intellectual property company (biotech, semiconductor design, software etc) does not.

Similarly, mechanically evaluating the assets of a company does not tell investors about the quality of those assets and, its ability to generate returns in future.

*Price to Earnings. PE ratio will tell investors little about cash flow, or the capital expenditure requirements of the firm. Furthermore, they will differ in relation to where the company is in its growth cycle. However, the most damaging aspect of solely focusing on PE ratio is that it encourages a focus on companies that already have earnings. Whilst superficially attractive, this strategy means investors will rarely expose themselves to sectors like biotech or oil exploration.

*Price to Cash Flow. Focusing on this metric has many of the pitfalls of the PE ratio. In addition, it can encourage investors into low growth companies. Similarly, the market could be pricing these sectors cheaply because, they are about to be structurally challenged. For example, large cap healthcare companies currently generates huge cash flows, but how sustainable is it with the onset of an ongoing Obama health care reform process? What threats do generics pose? What drugs are in the pipeline? None of these questions are answered by solely focusing on the mechanical approach.

Portfolio Evaluation

The examples above are just a few considerations of the complexity or even impossibility of not manifesting a sector or style bias by taking an mechanical approach. Many believe that the correct approach to portfolio construction is to understand that portfolio construction is as much an art as it is a science. Furthermore, for a rational investor, taking an outright style or sector ‘view’ is a necessity, because he will serendipitously do it via mechanical strategies investing in any case!

Keynes, John Maynard "The General Theory of Employment,Interest and Money" Palgrave, 1936

Saturday, December 17, 2011

Sanjeev Shah and Anthony Bolton with Fidelity Special Situations

Fidelity Special Situations fund manager Sanjeev Shah has come under sustained criticism for his management for Anthony Bolton’s legendary fund. Shah took over when Bolton left and the performance of the special situations fund has been less than stellar. It is no matter that Bolton’s subsequent performance with his Chinese investment fund has been poor, Shah has inherited a lot of assets under management and goodwill from investors, so his investment performance will be highly scrutinized in its own right.

The usual criticisms are that his performance has been little more than a tracker fund and that he is not really engaging in special situations investing. The argument in this blog is that investors often underestimate the role of the asset manager’s (Fidelity) interests in determining investment fund returns.

Fidelity Special Situations Performance

Firstly, looking at the returns over the last six years…

Fidelity Special Situations
IMA UK All Companies

…it does indeed start to look like a tracker fund at best!

However, Sanjeev Shah took over from Bolton at the start of 2008 and the tracker like performance predates Shah’s custody. Therefore, comparing the track record of Sanjeev Shah with Anthony Bolton is fraught with difficulty.

This is not only due to the size of the fund at £2.2bn making the generation of differentiated returns difficult, but possibly also due to the incentives of Fidelity. To understand this, it’s worth looking at Anthony Bolton’s career in fund management.

Anthony Bolton and Special Situations Investing

When Bolton first took over the management of some funds at Fidelity in the UK, they were not anywhere near the kind of household name that they are today. Therefore, they had a direct interest in allowing Bolton to try and generate some supra market returns in order to garner assets under management.

Fortunately for Fidelity, Bolton achieved these results and, spectacularly so. Indeed, his funds became the darling of every little IFA out there who was grabbing some commissions from a client, who could just as easily have invested in the fund themselves.

Now turning to the incentives at Fidelity now, the situation is different. Bolton left them with billions under management and the incentive to take a risk in going for outperformance is much less. Indeed, behavioural finance teaches that the impact of a loss is psychologically weighted at double that of a gain.

Therefore, a fund that with significant assets under management, has a built in incentive not to be significantly below its benchmark. Whilst the upside from outperforming is not large enough to justify taking on the extra risk in order to generate it.

Should Fund Investors Stay With Sanjeev Shah?

On balance, fund investors would be better advised to stay with Shah and give his special situations fund some more time. Early on in his career, Bolton had some bad periods and, inevitably, investors made redemptions. Moreover, he may well be constrained by Fidelity in being able to generate non-correlated returns. We shall see.

 However, if he has the latitude than special situations investors need to recall that this style of investing requires conviction. And sometimes it takes time for the market to wake up and realize the value in someone else’s special situation! Shah needs more time.

Tuesday, December 13, 2011

China Real Estate and Housing Statistics Indicate a Slowdown

China’s real estate market is slowing. So, whilst the world is focusing on the Euro Zone sovereign debt crisis, another threat to the Global Economy appears to be gaining momentum. Let’s look at statistics on China’s housing market garnered from the official National Bureau of Statistics of China.

China Housing Market Statistics

Firstly, house prices appear to be falling as indicated in this link here for November

“Comparing with the previous month, among 70 medium and large-sized cities, the sales prices of newly constructed residential buildings declined in 34 cities while that of 20 cities remained the same level.”

“Comparing with the previous month, the sales prices of second-hand residential buildings decreased in 38 cities, while that of 19 cities remained the same level. Number of cities with decreasing chain indices rose by 13 in October as compared with September. The month-on-month increases were less than 0.5 percent for the cities with increasing price.”
…and this is having an effect on the growth rate of investment in real estate assets…


…and inevitably upon the rate of growth in industrial production…



Perhaps, Jim Chanos is right with his bearish view of China’s housing and construction market?  Whether, it is going to be a hard or soft landing, it doesn’t look like the time to pile into commodities.
...and for existing homes... 

Tuesday, September 27, 2011

What Germany Wants From an EFSF ECB Deal

The markets are enjoying a relief rally at the moment in the expectation that the latest proposals to fix the Eurozone Sovereign Debt crisis by leveraging up the EFSF via the ECB. Besides all the legal difficulties in carrying out this plan, there are also significant political issues to overcome. Putting aside the issue of Slovakia for a moment-where according to most reports the July 21 EFSF expansion plans are not likely to be ratified- the key questions relate to the quid-pro-quo benefits to the Northern European nations. In other words, what is in it for the Germans?

Leveraging the EFSF, What's in it for Germany?

And it’s not just the Germans interest that needs to be satiated. Austria, Luxembourg, Netherlands and Finland are all believed to be closer to the German position at the ECB. Therefore, it is worth taking the time to try and see what the Germans want out of an EFSF ECB deal.

Frankly, the only way that this deal can be sold to the Germans, Dutch, Austrians and Finnish is if it comes attached with a significantly stronger legal framework that is commensurate with fiscal union. Herman Van Rompuy is due to put forward proposals on fiscal union at an EU summit on Oct 17-18 and this meeting will be crucial to the future of this kind of EFSF leverage deal.

If measures towards fiscal union are not approved and, this sort of deal is approved, than the potential for a long drawn out period of difficulties in Europe is assured. We will have low growth for many years to come and potentially tumultuous circumstances.

Moral Hazard and the Debt Crisis

The danger here is the same danger that caused the financial crisis. Moral Hazard. Unfortunately, we have not dealt with this in financial sector but that doesn't mean we have to encourage it in the Public Sector too. The Germans are right. The debt problems are structural and need to be dealt with in this way. If you keep bailing out Governments and institutions, then they will not change. It is a symbiotic process. If Governments don’t structurally reform, they will be punished by the bond markets and end up going towards unsustainable debt paths.

Jens Weidmann's Speeches

In fact, Bundesbank Chief Jens Weidmann articulated this point in a few speeches recently..

The European Council therefore agreed that financial assistance should be granted to countries with severe refinancing problems, a substantial part of which is provided by Germany. This financial support is intended to buy time for the affected countries to conduct necessary structural reforms and implement consolidation measures in order to regain market participants’ confidence in the soundness of their public finances and their competitiveness. The assistance is therefore bound to adjustment programs, which each recipient country has to fulfill.

However, the reduction of interest payments on the financial aid has weakened the incentives for countries in an adjustment programs to re-establish sound public finances via fiscal and economic reforms and return to the capital market. Furthermore, the conditionality of the support measures has been loosened by the recent decisions of July 21st. This weakens the underlying principle of European Monetary Union that each country has to bear the full consequences of its own fiscal policy.  Contrary to what is actually needed in order to overcome the sovereign debt crisis, we risk seeing the propensity for excessive deficits rise even further in the future

The last point is critical.

If this is how Governments are reacting to the limited bond buying program, than what will it be like when the EFSF is expanded to E2 trillion?? Will Berlusconi carry on making austerity measures or, will he figure that it’s all ok now because someone else is going to backstop Italy's debt?

Germany Rejects Eurobonds

As Weidmann puts it..

A communitisation of debt would be sure to result in a substantial redistribution from sound to unsound countries. In addition, Eurobonds, in and of themselves, would actually be rather counterproductive to solving the fundamental problem that led to the outbreak and spread of the sovereign debt crisis. In short, I believe that the risks associated with Eurobonds far outweigh their potential benefits.
...and in itself this is nothing more than a restatement of the principle of rejecting the notion of privatizing profits (Berlusconi et al and their political popularity) and collectivising risk (the rest of Europe pays Italy's bills) and, we know how that strategy ends up.

Hence the calls for fiscal union...

In my view, enshrining strict deficit and debt limits for national budgets in EU legislation is pivotal to achieving a stable fiscal union and reliably shielding the Euro system’s single monetary policy from unsound public finances. These limits would then apply to all levels of national government, including central, state and local government and the social security systems; the EU would need to be granted ultimate powers of intervention to ensure that the limits are effectively implemented in practice.

In a fiscal union, these powers of intervention would have to be extensive enough to ensure that national governments lose their sovereignty over fiscal policy when deficit and borrowing limits are breached, if not beforehand. Consequently, the national parliaments would no longer have ultimate decision-making authority over government budgets; their decisions would be subject to approval by a central body.

So, clearly, Germany wants moves towards fiscal union. Let's hope they are successful.

Weidmann, Jens Public Speeches

Monday, September 26, 2011

The Plan to Save the Eurozone

A multi-trillion plan to save the eurozone is being prepared according to an article in the Daily Telegraph. Such a development is long overdue, so I thought it would be interesting to analyse the key takeaways from this speculation. The article can be found linked here and I will look at it point-by-point

First, Europe’s banks would have to be recapitalised with many tens of billions of euros to reassure markets that a Greek or Portuguese default would not precipitate a systemic financial crisis. The recapitalisation plan would go much further than the €2.5bn (£2.2bn) required by regulators following the European bank stress tests in July and crucially would include the under-pressure French lenders.

This implies that the banks are indeed in need of recapitalisation, despite the protestations of many of their senior executives. Such a move will be dilutive for existing shareholders. However, before we conclude that this is a done deal, lets recall that the banks will do everything they can to avoid public money because they want to retain the independence to carry on awarding their staff with inordinate salary and bonuses.

The banks are set up in the interests of their staff not the shareholders. In fact, one of the biggest problems in 2008 was the reluctance of banks to mark to market their assets because they didn’t want public money. They exacerbated the crisis. Gordon Brown had to force RBS to take public money!

Officials are confident that some banks could raise the funds privately, but if they are unable they would either be recapitalised by the state or by the European Financial Stability Facility (EFSF) – the eurozone’s €440bn bail-out scheme.

In my humble opinion, institutions do not like making investments in assets that are about to be diluted. We can see this in the price action of stocks prior to rights issues. Whereby, the institutions that know-via inside information-that an issue is coming up, simply do not buy in. They wait until afterwards. I suspect the same thing will happen here. In addittion, many of the Sovereign Wealth Funds got burnt in 2008 with investing in the banks. They are unlikely to want to repeat the experience.

Officials are working on a way to leverage the EFSF through the European Central Bank to reach the target.
The complex deal would see the EFSF provide a loss-bearing “equity” tranche of any bail-out fund and the ECB the rest in protected “debt”. If the EFSF bore the first 20pc of any loss, the fund’s warchest would effectively be bolstered to Eu2 trillion. If the EFSF bore the first 40pc of any loss, the fund would be able to deploy Eu1 trillion.
Using leverage in this way would allow governments substantially to increase the resources available to the EFSF without having to go back to national parliaments for approval, which in a number of eurozone countries would prove highly problematic
So, let’s get this clear. On Sep 29 the Bundestag will vote on the EFSF expansion plans, which entail allowing the current E440bn EFSF to buy Government debt and to aid European banks. After which, on Nov 4, the new plan will be released which involves using the ECB to leverage up the EFSF in a way that obviates the necessity for getting national parliaments to approve.

 Whilst this Machiavellian piece of politicking is almost admirable in its sheer insidiousness, it is hardly a shining example of democracy at work. But there is a reason for this cunning plan


As quid pro quo for an enhanced bail-out, the Germans are understood to be demanding a managed default by Greece but for the country to remain within the eurozone. Under the plan, private sector creditors would bear a loss of as much as 50pc – more than double the 21pc proposal currently on the table. A new bail-out programme would then be devised for Greece

So Greece will default and remain in the Euro. Now, if you share my view that Ireland and Portugal are also insolvent than similar default programs will have to be extended to them in future. This is not such a problem as the EFSF would-under these plans-be expanded enough to deal with them. Moreover, the ECB can probably deal with losses on PIG. Italy and Spain are a different proposition, however, I am rather more positive in their debt positions, provided they continue their austerity programs.

Conclusions on the ECB and EFSF Plan

In conclusion, I would add a few more points here to these projected plans
  • The ECB’s capital (which is going to print money in order to buy debt and help banks recapitalise) is held by the Central Banks of its constituent countries. This means that the risk is simply being shuffled onto the Governments balance sheets and away from the institutions that bought Sovereign Debt in the first place. So, yet again, the principle that bond holders must-at the largesse of everyone else- never be allowed to lose money is still the guiding light of policy.

  • Moreover, the central banks are going to have to take on extra risk, which should mean that their credit ratings come under risk. Theoretically, sovereign bond yields should rise. In a sense, the Governments are now resorting to off-balance sheet leverage (via their capital in the ECB) and trying to convince investors to continue to buy their own debt. Now where have we heard this before?

  • As soon as you start guaranteeing Governments support, then moral hazard kicks in and I suspect the reforms will dry up. This is likely to create a situation with striking parallels to Japan. In other words, Governments not making reforms and, zombie banks supporting zombie industries in order to create the employment and social support in order to buy the political capital to keep the game going. This suggests continuing anaemic growth for Europe.

I suspect these plans would work to avert a crisis but they would also condemn Europe to years of low growth. Worse, the plan seems to be that European Governments should be morphing themselves towards the Southern European ‘model’ of throwing money and inflation at problems rather than the German model of fiscal discipline and inflation control.

 It should be the other way around!

Tuesday, September 20, 2011

Bank of China Halts Foreign Exchange Forwards and Swaps with French Banks

The Bank of China has stopped FX forwards and swaps trading with several large European banks, according to sources. This is a worrying development because US Money Market Funds have already helped to cause liquidity problems with European Banks by cutting European exposure to French Banks. These are all inevitable signs of negative sentiment which manifest themselves in this chart which is the extra cost of swapping euro interest payments for dollars. Essentially, it goes up as  the demand for dollar liquidity goes up...

Euro Swap Five Year Spread

One-Year Chart for EUR SWAP SPREAD     5 YR (EUSS5:IND)

'Bank of China, a big market-maker in China's onshore foreign exchange market, has stopped foreign exchange forwards and swaps trading with several European banks due to the unfolding debt crisis in Europe, three sources with direct knowledge of the matter told Reuters on Tuesday.
The European banks include French lenders Societe Generale Credit Agricole and BNP Paribas and Bank of China halted trading with them partly because of the downgrading from Moody's, the sources said'

…will only raise stress further.

It is worth pausing and reflecting that before the recent Italian Bond Auction, the Italians were keen to confirm that they had been talking to the Chinese over ‘selling debt’. This blog was vocal in being critical of this pseudo ramp in an article linked in here, and this sceptical approach has been confirmed by this latest news. China appears to be more of a danger than a solution here.

Too Big To Fail, Failed

Following the financial crash in 2008, many politicians garnered significant political goodwill by proclaiming the desire to end the moral hazard implicit in ‘Too Big To Fail’ financial institutions. For example, Obama and the UK Chancellor George Osborne both promised to end the possibility of this returning to haunt the global economy. Unfortunately, nothing has changed. The current Euro zone Sovereign Debt Crisis-with Portugal, Ireland and Greece surely headed for default- is actually a crisis for the banks that bought this debt. The necessity for them to be recapitalized and the concomitant knock-on effects to the global economy are the true worries here.

If they weren’t ‘Too Big To Fail’ then the concerns would be far less. These banks bought this rubbish debt. No one forced them too. Why not just let them face up to the consequences of their actions, in the same way that everyone else does?  However, in this ‘Scared New World’ the key principle seems to be that bond holders must never be punished and, banks must continue to be allowed to game the system whilst hiding behind the ‘greater good’ argument.

So, essentially, it’s the same issue as 2008. In other words, ‘Too Big To Fail’ is still guiding the global economy. Meanwhile, Banking pay and bonuses are going up. Go figure.

Wednesday, September 14, 2011

Italian Bond Auction

Italy has been busy with bond auctions this week and managed to get out E6.5bn in bond issuance yesterday. Equity markets rallied and many investors breathed a sigh of relief from the ongoing European Sovereign Debt Crisis.

However, lets puts this into context.

According to the FT, the ECB has bought over E143bn in bonds as part of their bond buying program. Half of this has happened in the last five weeks.  With a back-of-envelope calculation, it is not unreasonable to assume that the ECB has bought around E30bn of Italian bonds over the last month.

Therefore, the Italian auction is hardly a cause for celebration. In a previous post, the key banking stress indicators were outlined and, before being optimistic for equities these indicators must turn positive. Otherwise, there is no point in the ECB actions. Readers can find these banking stress indicators here

Furthermore, looking at how the bond markets reacted after the auction, it is clear that the bond markets were not impressed and are showing increasing signs of stress...

In fact, the bond auction saw Italy borrowing (despite ECB manipulation) at highs after the initial ECB intervention...

One-Year Chart for Italy Govt Bonds 10 Year Gross Yield (GBTPGR10:IND)

...Italian CDS are through the roof...

One-Year Chart for Republic of Italy (CITLY1U5:IND)

and the Italian-German yield spread is at an all time high...

One-Year Chart for ITALY 10 - GERMANY 10 SPREAD (.ITAGER10:IND)

It doesn't look good.

As for the speculation over China buying Italian bonds; the timing of the press speculation smacks of  a desperate attempt at 'supporting' the Italian auction. The subsequent confirmation by Italian officials on the day of the auction was wonderfully prescient. Has it really come to this? Italy now has to 'ramp' its bond auctions via the press?

Wednesday, August 24, 2011

Banking Stress Indicators Are Still Elevated

This week, most economic commentators are focusing on the prospects of QE3 and, on the positive news regarding the abating of some of the peripheral Eurozone bond yields. Indeed, equity markets have rallied somewhat and it appears that the World is feeling a little better about prospects.  However, are all the economic indicators pointing in the same direction? Is it time to buy back into equities?

The suspicion is that, right now, this isn’t a widespread ‘risk on’ trade and, the market badly needs this. Sentiment needs to turn around with regards the sustainability of Italian and Spanish bond yields or there will be further turmoil ahead. The recent statements by Merkel regarding rejecting Eurobonds as the immediate answer and in rejecting expansion of the EFSF have actually upped the ante and downside risk is considerable. What is the market telling us?

Firstly, the ECB has been successful in reducing Spanish and Italian bond yields…

 One-Year Chart for SPANISH GOVERNMENT GENERIC BONDS - 10 YR NOTE (GSPG10YR:IND)One-Year Chart for Italy Govt Bonds 10 Year Gross Yield (GBTPGR10:IND)

…but unfortunately, this is only on an absolute level. It certainly hasn’t stopped investors piling into the ‘safe havens’ of Gilts, Bunds and US Treasuries. This is important because it indicates that investor sentiment hasn’t really turned round, its just that the ECB has managed to manipulate the bonds markets for a while. For example, the spread between German and Italian bond yields hasn’t come down much after the ECB action…

 One-Year Chart for ITALY 10 - GERMANY 10 SPREAD (.ITAGER10:IND)

…moreover, other indicators of banking stress are still looking elevated. Looking at the 3 month Libor-OIS spread chart…

 One-Year Chart for 3 MO LIBOR - OIS SPREAD (.LOIS3:IND)

…and the good ol’ chart of the TED spread….

One-Year Chart for TED Spread (.TEDSP:IND)

…and what about a chart of the PIIGS CDS prices…

 One-Year Chart for PIIGS (.GIPSI:IND)

…. 3 month Euribor chart itself….

 One-Year Chart for Euribor 3 Month (EUR003M:IND)

The EUR/USD swap...
One-Year Chart for EUR BASIS SWAP      3 MO (EUBSC:IND)

5 Year Euro Swaps...

One-Year Chart for EUR SWAP SPREAD     5 YR (EUSS5:IND)

..and recourse to the ECB deposit facility

One-Year Chart for ECB Eurozone Liquidity Recourse to the Deposit Facility (ECBLDEPO:IND)

This is definitely not a ‘risk on’ marketplace yet and these indicators are showing stress.  Well worth keeping an eye on.

Tuesday, August 16, 2011

Hedge Funds Delivering Performance

Hedge Funds get a lot of criticism from a market that is still predominantly focused on long only strategies. However, one of the severest criticisms levied against them is that they are largely long only strategies, whose use of leverage, means that do not protect investors from downside equity market risk. This is an understandable worry, and indeed, 2008 saw losses across nearly all hedge fund strategies bar something like short-side biased funds. Therefore, it is worth looking more closely at performance. In particular, do hedge funds tend to make directional punts? Moreover, is it worth giving up the discipline to allow them to be discretionary as opposed to a fixed market neutral approach?

Hedge Funds Performance

In order to gauge this here is a regression analysis with the monthly hedge fund results from Dow Jones Credit Suisse Index for Equity Market Neutral and Long/Short Equity Indices. Both indices are US Dollar based and are measured against the S & P 500.

2000-June 2011
Equity Market Neutral
Long/Short Equity
Alpha (annualized)
Cumulative Return
Standard Deviation

Source: Dow Jones Credit Suisse

Firstly, it is worth noting that returns are not really correlated as both r-squared numbers are low and, as could be expected, the market neutral index has lower correlation. Secondly, both indices reveal positive alpha generation although this means little given that correlation is low. Both cumulative returns are good, with long/short equity notably outperforming. All of which suggests that the greater discretionary element implied in long/short equity does not result in investors losing money. A point which is especially relevant when it is noted that the S & P 500 lost 5.3% over this period!

Hedge Funds Investment

Hedge funds work over the long term and, investors might well be tempted to allow hedge fund managers the latitude to adopt a discretionary strategy rather than be bound by market neutral. Having said that, the dispersion of results within long/short is far larger than equity market neutral. All of which suggest a strategy of a diversified holdings of long/short equity funds is likely to be optimal. Alternatively, a few core holdings of market neutral funds surrounded by a collection of satellite holdings in long/short equity funds.

Saturday, August 13, 2011

The Short Selling Ban

A number of European countries decided to ban short selling for a period of 15 days and the light of introspection deserves to be thrown upon what these measures actually mean for the functioning of global financial markets. It is understandable that Governments should be concerned about the downward spiral in stock prices because they do have a direct effect on the economy. For example, lower equity markets affect shareholders net worth and their propensity to consume. In addition, low equity values will affect companies’ abilities to raise cash and, particularly, banks balance sheets.

Short Selling and Hedge Funds
All of the above is a concern, so stopping shorting can be seen in a positive light, particularly when long only investors are facing losses and, all manner of pejorative language is being used against the ‘evil’ short sellers. The common perception of short selling is of an art practiced in the ‘shady’ and lightly regulated world of hedge funds.
 ‘Shorters’ are seen as short term speculators who are preying on the misfortunes of others, and some are even seen as promulgators of false rumours and media speculation around their targets. This negative perception has hardly been helped by the criminal activities of Madoff and Rajaratnam. Moreover, the ludicrous amounts of money that some hedge fund managers earn is an easy target for criticism from the tabloid press.

Why Banning Short Selling is Wrong
The principle arguments against banning short selling are that it is not really efficacious (it did little to stop banking stocks sliding in the financial crisis of 2008) and, that it helps to create inefficiently priced stocks. Both of these points make perfect sense and the importance of pricing signals in a market economy should never be underestimated, but there is a deeper, more important, reason why shorting should not be banned.  Simply put, shorting creates the opportunity for myriad and diversified investment strategies which help to hedge risk away. However, this argument should not be restricted to investment strategies on a micro-economic level. Its true import is related to the global economy!

Increasing Globalisation and Correlation in the Global Economy
Essentially, the problems of the financial last few years have been created by a World that is becoming increasingly interlinked and whose asset classes and economies are synchronised to such a degree that economic cycles are creating super-positional peaks and troughs. In plain English, this means that if all the economies are dependent on one variable (ex mortgage bonds on banks’ balance sheets) then the potential for disaster is that much larger.
Moreover, these risks tend to be directional because vested interests snowball to create these scenarios. For example, banks start issuing sub-prime debt to NINJA’s (no income no job), then structuring CDO’s, other banks buy the debt, and suddenly everyone (homeowners, banks, politicians, bank debtors) becomes reliant upon the debt not collapsing. The rest is history. Unfortunately, the economic consequences are not. 

How Short Selling Helps Markets
The one caveat to the above scenario is if some economic agents are diversified in the direction of their profitability. So, for example, if there had been significant numbers of banks who had been short sub-prime mortgages or had diversified away from this directional risk then they would have able to buy up the failing banks or at least support the underlying assets. The banks were very vocal in criticising the necessity of marking their assets to market during the financial crash, but the real problem was that none of them had the financial position to buy these assets of each other. This is what happens when all the financial institutions profitability is dependent upon the same direction. Increased correlation intensifies systemic risk, whilst diversification helps to mitigate it.
If the authorities persist in trying to ban short selling all they will, de-facto, be doing is encouraging more correlation of asset classes and interests. This is likely to create more risk and stop –at source- the nascence of diversified strategies that should be seen as helping, not hindering, global growth.

Friday, August 5, 2011

ECB Buying Spanish Debt

At least according to reports in a couple of leading Spanish newspapers. For what it's worth, I think the market evidence shows their could be some credibility to these reports. For example, whilst Italian debt yields continue to rise...

One-Year Chart for Italy Govt Bonds 10 Year Gross Yield (GBTPGR10:IND)

....Spanish yields have mysteriously come down a bit...


However, I think it is really not enough to fight sentiment at this stage. Frankly, there is little that Trichet and the ECB can do with the EFSF. The EFSF has 30% of its guarantee commitments coming from Italy & Spain and the idea of the EFSF issuing debt in order to loan Italy & Spain money is too ludicrous to contemplate.

The key to understanding the market panic comes from a cursory view at the debt exposure of European banks to Italian debt...

chart's not hard to see that if Italy continues on an unsustainable debt path then the consequences could be dire for European Banks and they will have to raise capital. Taxpayers need to brace themselves although I doubt Bob Diamond will be taking a pay cut.

As to the country specific exposure to Italian and Spanish debt, I have tabulated some data here from the Bank of International Settlements (BIS). Firstly, Italy...

Claims on Italy Debt (m)FranceGermanyUKUSANon-Europe
Public Sector105,04550,98212,73414,38048,144
Non-Bank Private Sector256,10561,43446,94913,56423,391

and then Spain...

Claims on Spain Debt (m)FranceGermanyUKUSANon-Europe
Public Sector32,58129,3898,6296,06019,101
Non-Bank Private Sector77,03179,32177,19927,16239,065
Total146,085177,859100,80257,91889,102 the problem is substantial and I can't quite understand why investors are piling into bunds and French debt because Italy and/or Spain really are too big to fail. If this all ends up with the creation of a 'Eurozone bond' and a movement towards fiscal union, then German and French yields will have to rise to  price in the adoption of risk over peripheral debt. Bunds aren't as safe an option as most investors think!