Taking The Gloves Off On The Discussion of Rational Investment Analysis (Part 9) Absolute Investing: Not An “Accredited Investor”? Build Your Own Hedge Fund With ETFs – Part 1
Thanks for coming back after the slight delay in publishing. Part 9 of my discussion on rational investment analysis deals with how "the rest of us" can compete with sloppy bearish domestic (U.S.) equity markets and the growing yet insanely volatile emerging and established world equity markets by building one's own hedge fund. I decided the easiest and best explained example of such a strategy was written by Mark Gerstein who either is the creator of or at least a financial manager who uses the services of the Portfolio123 screener (available in both a free and a premium edition). In his Seeking Alpha article, he discusses a couple of ways to build a portfolio of exchange traded funds (ETFs) that should benefit (through rebalancing periodically) from either an upward or downward move in the markets. StockTwits, nor I, am endorsing this particular piece of software (and there are quite a few like it or add-ons to stock databases that can do similar tasks).
Read the above article, but do not let it totally geek you out as some of the concepts are mathematical, but the interpretation of the math is more important than just calculating it. Most modern portfolio software (including the software above) can calculate key ratios for you.
The concept to which I want to introduce you is the process of portfolio rebalancing that is discussed in Unexpected Returns, Understanding Stock Market Cycles, by Ed Easterling. The idea of rebalancing a portfolio periodically is part of his "rowing" techniques for navigating the investment process during volatile or downward moving markets.
Typically, a portfolio is measured against the standard deviation in market price volatility, and a portfolio's returns are gauged against a risk-free return to truly understand how well the portfolio is being managed versus just buying and index. This kind of investment analysis is, in my view, critical to determining how well a portfolio is actually doing. One measure of performance is the Sharpe Ratio. The higher the Sharpe Ratio, the better the risk adjusted performance is. If the Sharpe Ratio is greater than 1, the returns versus risk-free returns are particularly positive when it comes to portfolio performance. If the Sharpe Ratio is at or below zero, a risk-free asset (as calculated using the return of a 10-year Treasury bond) will perform better than the measured portfolio.
When it comes to hedge funds (even home-grown ones using ETFs), one has to understand that the Sharpe Ratio might not be enough to measure a portfolio's true performance. When one wants to measure the performance of upward and downward volatility (so as not to penalize a portfolio for upward volatility) one must use something called the Sortino Ratio (which was developed by Frank Sortino). Note that this ratio looks at only the downside deviation in the denominator. The Sortino ratio has its own flaws (discussed in the supporting article), but the larger the Sortino ratio, the lower the risk of large portfolio losses occurring in the given portfolio. Using both of these ratios together can give an investor a better way of measuring excess returns to index benchmarks and the amount of downside risk that might occur in the future.
The next basic concept that I will introduce (and which is discussed but not introduced in the article) is the concept of rebalancing a portfolio as a hedge fund might. Remember that if one rebalances outside of an IRA (individual retirement account) one will create a taxable event and will incur a tax (generally a short-term capital gain or loss). If one is going to rebalance often (and this one model suggests rebalancing every four weeks), then one had better use a traditional or Roth IRA for investing. It is also critical, in my view, that one uses a direct access broker that charges minimum commissions to perform these trades. If you are the one doing the work, why should you pay retail or even a discount broker to them for you? What was it I said weeks ago about the first rule of investing? If you were paying attention out there, you know that the first rule of investing is to KEEP YOUR EXPENSES LOW.
What rebalancing does in a hedge-type strategy is to adjust the amounts invested in each ETF to compensate for deviations of the current movement in price of each ETF when the original investments were made (or at the last time the amounts were rebalanced) to reflect current market conditions (which might favor one ETF over another ETF in terms of percentage of the portfolio). This technique allows the performance (if the strategy works and the fund types are properly correlated) to outperform the general market as the near-term price movements go forward.
What one would have to do to test a technique would be to back test it over time and to see how well they perform in the forward period after the back test is done. As many of you know, I use neural net techniques that do a very rigorous form of walk-forward testing on data not seen by a model. The statistics from that walk-forward analysis gives me confidence that I can continue to trade accurately and profitably from a back-tested model I have built. That is why I emphasize the baseline statistics of the model.
In the next installment I will do my best to show you one example of how this can work using ETFs. It is important that if one wants to run a do-it-yourself hedge fund that one makes certain that back testing be done prior to taking risk. That also means that one would have to calculate the ratios and returns to estimate risk.
I will discuss this in more detail next time. More educational goodness is flowing your way again soon. Thanks for supporting DieBrokeBlog!
Tickers: absolute return investing, building a hedge fund with ETFs, exchange traded funds, rebalancing portfolios, Sharpe Ratio, Sortino Ratio, volatility
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Taking The Gloves Off On The Discussion of Rational Investment Analysis (Part 8) Absolute Investing: Hedge Funds (A Quick Wrap-Up)
IRON100, August 22nd, 2010 at 12:01 am, Comments: 0What I want to do in this post is to simply wrap up the discussion on hedge funds as a means of absolute return investing, which we discussed in Parts 6 and 7. I want to respond to a couple of e-mails regarding the idea that hedge funds have not been good investments over time. In aggregate that might be true, but what good investors have to do is research to find the best investments. Let’s discuss that for a moment.
Tickers: "new normal", BarclayHedge, Barron's Hedge Fund analysis, Bill Gross, Druckenmiller, Duqesne Capital Management, fat tail returns, fees, hedge fund world, John Paulson, mutual fund world, Paulson Credit Opportunities Fund, taxation
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Taking The Gloves Off On The Discussion of Rational Investment Analysis (Part 7) Absolute Investing: Hedge Funds
IRON100, August 15th, 2010 at 6:01 am, Comments: 0Hedge funds are defined broadly as shown in Investopedia here. (Use the legal definition above for accredited investor and not Investopedia's). What hedge funds do is to go after returns (either long or short) as they appear in the market, according to their individual strategy. Though the name "hedge fund" would make it sound as if each trade or position within the fund would be hedged against loss, this is seldom if ever the case. Hedge funds could be long only (that is profiting from buying assets and selling them at a profit), short funds (which means selling assets, stocks, or futures contracts to cover them later at lower prices to gain from a decrease in price), or long-short strategies (which would combine long and short strategies for profit). Realize that, though long-short funds sound like they are hedged, they too are NOT because the balance of long and short positions may not be equal. At times, a long-short fund could be positioned 100% in longs or 100% in shorts, depending on that manager's strategy. There are quantitative strategies, funds of funds (that is, a combination of funds invested into one other fund managed by a separate manager), and about any kind of strategy one can imagine.
Tickers: absolute return investing, fund research, hedge fund, hedge fund strategy, Lipper, Lipper TASS Index, long-short fund
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Taking The Gloves Off On The Discussion of Rational Investment Analysis (Part 6) What about today’s environment? How Can One Invest Smartly?
IRON100, August 8th, 2010 at 12:01 am, Comments: 0I guess I keep delaying the discussion of traditional forms of investing (those of value investing, trend following, and growth investing) because the current environment in which we exist (one of potentially higher than historical price/earnings ratios and potentially rising interest rates (and certainly LOW interest rates by any American historical standard), does not always lead to success as it might in a traditional secular bull market. What I discussed in the current environment (according to research provided by Unexpected Returns -Understanding Secular Stock Market Cycles, a book by Ed Easterling) is the environment of a secular bear market. Historically, and certainly currently, the market is composed of either sideways or downward rotation in stocks and stock sectors and comprised of many periods of volatile price action.
Tickers: absolute return investing, bonds, corporate bonds, exchange traded funds, money market funds, owning your own business, secular bear markets, treasury bonds
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Taking The Gloves Off On The Discussion of Rational Investment Analysis (Part 5)
IRON100, August 1st, 2010 at 12:53 pm, Comments: 0Let's first understand what is typical of secular bull markets and secular bear markets, and what kind of investing might work best in these environments.
Tickers: absolute return investing, bear markets, bull markets, buy and hold investing, GDP, gross domestic product, secular bear markets, secular bull markets, taxation effects on non-tax-deferred returns, total return investing, value investing
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Taking The Gloves Off On The Discussion of Rational Investment Analysis (Part 4)
IRON100, July 25th, 2010 at 1:09 pm, Comments: 0After getting a couple of questions via e-mail, I have decided to quickly in this post discuss one more dour piece of "long-term" investment news for those with the "buy-and-hold" strategy. I do not do this just to frustrate optimists, but simply to set up the discussion of how to invest in various segments of market cycles. This kind of analysis is always helpful in navigating the often tortuous environment of equities. I find this very apropos this morning, as I just watched David Gregory quiz Treasury Secretary Timothy Geithner about the possible future "less than adequate" investment returns to be offered by stocks.
Tickers: buy and hold, deflation, earnings prospects, future price appreciation, inflation, price earnings ratios, price earnings ratios compared to historical averages
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Taking The Gloves Off On The Discussion of Rational Investment Analysis (Part 3)
IRON100, July 18th, 2010 at 12:36 am, Comments: 0I am going to continue to provide some additional shades of meaning to the dilemma of how returns in the stock market are generational in nature (that is, they go through cycles that can last a generation). I will also discuss, via the works of Ed Easterling of Crestmark Holdings, LLC, how volatility can skew compounded returns (the only way to measure real growth in equities) to numbers far lower than are reported, and how those volatility cycles can be exacerbated by, of all things, life happening to investors (college, home, expenses, etc).
Tickers: average returns versus compounded returns, dispersion of returns, life happens, long-term investing, secular bear markets, secular bull markets, stock market cycles, transaction costs
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Taking The Gloves Off On The Discussion of Rational Investment Analysis (Part 2)
IRON100, July 11th, 2010 at 12:01 am, Comments: 0On this, the 101st post for this StockTwits blog, I wanted to begin the whole discussion regarding whether a simple "buy and hold" strategy is always the best idea when investing in stock indexes (index funds or index related exchange traded funds (ETFs), or even in individual stocks.
Tickers: average lifespan of an American, definition of long-term, economic cycles, generations, investing periods, price earnings ratios, price earnings ratios versus real returns, rational investment analysis, sectular bear markets, secular bull markets, Standard and Poors 500 Stock Index, trailing price earnings ratios
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Taking The Gloves Off On The Discussion of Rational Investment Analysis (Part 1)
IRON100, July 4th, 2010 at 12:01 am, Comments: 0I want to blow the "buy and hold" orthodoxy off of its mooring by demonstrating some very basic concepts regarding longer term valuations and trends (measured in months and years), that make true common sense if one has the courage to understand them.
Tickers: AAII, Barron's, buy and hold, experts, long-term, long-term investing, rational investment analysis, technical analysis, trends
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The Coming Implications of Higher Interest Rates (How One May Adjust A Portfolio For Them)
IRON100, June 27th, 2010 at 12:01 am, Comments: 0As many retail investors abandon the stock market for what they think are "safe" returns offered by bonds, what they fail to realize the potential risk to investment principal (the amount invested) that is caused by an interest rate rise. With mounting Federal, state, and even local deficits, all bond categories (U.S. Treasury Bonds, State General Obligation Bonds, and even local municipal bonds) are facing lower tax receipts with the slowdown in the economy.
Tickers: certificates of deposit, correlation of bond yields to Federal Debt levels, desire of investor to shoulder national debt, duration, FDIC insurance, FDIC insured CDs, increase in savings rates, interest rate increases, interest rate risk
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