Big-Risk = Big-Return is true for individual securities. But not for a portfolio. A common misconception for investors (and traders).
Risk-Reward has a positive correlation, but it’s not perfect.
Risky securities are diversifiable by lower correlated/negative correlated securities. By buying low correlated securities to hedge your risky security, are you lowering your upside? No. You’re lowering your downside.
For investors, capital preservation is more important than the growth of capital. The bigger the investment loss, the greater the gain required to break even. A 20% investment loss requires a 25% gain to get back to the initial investment value. Whereas a 40% loss requires 67% and 70% loss requires 233%. The best offense is a good defense.
If you invest $10,000 in S&P 500 ETF and a recession causes the market to drop 30%, the $7,000 value would need to gain 43% to get back to $10,000.
Let’s look at the following 3 portfolios, each with a different strategy:
Portfolio 1 is invested 100% in S&P 500 (SPY).
SPY’s annualized standard deviation is 15%.
Portfolio 2 is invested 60 and 40 in S&P 500 (SPY) and Investment Grade Bond Fund (FBNDX).
Both are 0.31 correlated, based on annual returns.
FBNDX’s stdev is 4%.
Portfolio 3 is invested 33.34%, 33.33% and 33.33% in S&P 500 (SPY), Investment Grade Bond Fund (FBNDX) and U.S Real Estate ETF (IYR), respectively.
IYR is 0.69 correlated to SPY. 0.63 correlated to FBNDX. Correlation is based on annual returns.
IYR’s stdev is 21%.
* I initially wanted to backtest them for 30 years, but since IYR was the only real estate ETF I could find with the earliest fund inception date (June 2000), the backtest is from Jan 2001 to Dec 2016.
Downside protection strategies may help prevent investors from their bad habits of overreacting to downside volatility and incorrectly timing the market, missing the boat of high returns. Over the past year, S&P gained 18.10% while an average investor gained half of the growth.
If you are a passive investor, consider downside protection strategies to limit volatility and build wealth over the long-term.
Diversify portfolio with:
Bonds (Finance 101) such as Treasuries, high-yield bonds, TIPS, etc.
International equities (different geographies, different returns/risks), such as, emerging and frontier market equities, etc.
I endorse the idea of employing a multi-asset strategies that lower the downside potential while increasing the upside potential or even decreasing the upside potential less than the decrease in the downside potential.
I am not saying you should allocate your portfolio to every asset there is. It depends on your goals, lifestyle, risk preferences, your responsibilities, the investment % of your overall capital, etc etc etc.
How you allocate each security is up to you (or your financial advisor), or me me me me.
No portfolio is risk-free, but minimizing the downside can help mitigate the pain inflicted by market “fire and fury” and a changing risk landscape in globalization era.
If you have any questions/comments/suggestions, feel free to contact me personally and/or leave a comment below.
PS: Maybe make Bitcoin/Ethereum/Litecoin 5% of your portfolio.
PS: Active traders should also minimize the downside risk, especially if you work, have school, etc.
PS: Never mind. Thank you for reading. Don’t forget to subscribe.
As you may know, I met legendary investor Bill Ackman (Short Herbalife) in the first half of this year. He was taller and bulkier than I expected. Ackman speaks in a soft voice (to strangers of course) and has a firm handshake. My tiny hands were nothing compared to the strong hands of Mr. Bill Ackman.
In case you don’t know, Ackman is one of the world’s most famous hedge fund managers and activist investors. Pershing Square Capital Management net return was 40.4% in 2014, the highest among its peers. Since inception in 2004, Pershing Square posted net gains of 567.1% versus 135.3% return for the S&P 500. The hedge fund’s 1.5% base fee and 16% performance fee is low relative to industry standards.
Last Tuesday (September 13th), another legendary investor Carl Icahn (Long Herbalife) was right next to me at the Delivering Alpha and I didn’t even see him.
Yes, I know!!! Oh my god.
In case you don’t know, Icahn is one of the world’s most famous hedge fund managers and activist investors. As the chairman of Icahn Enterprises LP, Icahn says “Some people get rich studying artificial intelligence. Me, I make money studying natural stupidity” according to his Twitter bio. I love that quote.
How did this happen? During a coffee break before Stephen Schwarzman – Chairman, CEO, and Co-Founder of Blackstone (another legend) – was due to speak in front of investors, press, students (me unfortunately), etc…I lost my focus.
How did I lose my focus? I wanted to be on the cover of Institutional Investor magazine. Well, not the real magazine. There was a photo booth at the conference.
Why was the fake magazine cover so important? Besides being in love with finance, I wanted to get a picture of my handsomeness. Someone who works for NBC even told me I was handsome when I was leaving the event. My response was “I always look handsome” which is a fact.
…So here I am, stepping on the booth while Icahn is just passin’ by!
I was 5-10ft away from the man I admire and I didn’t even see him. I didn’t even notice the cameraman with a strong lighting. I noticed nothing. I was thinking about how I made it to the cover of Institutional Investors magazine and Forbes is next.
Here is the video of me on CNBC for the first time and Carl Icahn on the same screen.
CARL ICAHN: I really think he’s [BILL ACKMAN] a smart guy.
CARL ICAHN: I sort of like him [BILL ACKMAN]. I think he’s smart.
CARL ICAHN: I really believe Ackman being smart
I also think/believe Ackman is smart and so is Icahn.
I didn’t know Icahn was right next to me until I came home. At around 8:40 P.M, I come home. Until 10:24 P.M, I eat my dinner and some snacks, while checking emails and twitter, and reading news.
At 10:24 P.M, I’m scrolling through @CNBCnow twitter and that’s when I saw the video. My reaction was too graphic to describe it here.
The rest is history.
Delivering Alpha 2016 is one of the moments I will forever remember. I really enjoyed the conference and meeting people from the media and hedge fund world.
Although I came late to the conference, at around 1:40 P.M, and missed Ray Dalio, the experience was still amazing. Not just amazing, but also incredible, stunning, astonishing, etc.
Delivering alpha as a concept is all about beating the market. Over the past six years, the investment conference has brought many great investors who got a track record of actually delivering alpha to speak in front of audience.
CNBC and Institutional Investor hosted the annual Delivering Alpha conference at NYC’s Piere Hotel.
I will forever remember this day, September 13, 2016.
So far I met Ben Bernanke, Marcus Lemonis, Chamath Palihapitiyaa (CEO of Social Capital), Bill Ackman, and Carl Icahn. Who’s the next high-profile person I will meet? Janet Yellen? Mario Draghi? Warren Buffett? Stay tuned.
So far I made it to Bloomberg (for real) and Institutional Investors (literally), what’s next? Forbes? WSJ? Time Person of the Year? Stay tuned.
It’s only matter of time before I’m on stage at the Delivering Alpha and media asks me questions. Stay tuned.
Yes, I know markets have been rallying and S&P 500 has been hitting all-time highs. But, remember Brexit?
In case you forgot, the people of United Kingdom voted to leave European Union on June 23rd. Markets then destroyed more than $3 trillion in paper wealth in the next 2 days (Friday and Monday).
After that, market just shook it off. As Taylor Swift says, “Shake It Off.” “It’s gonna be alright.”
The actual businesses and people in the UK just cannot shake, shake, shake, shake, shake,….it off.
The UK job market went into “freefall” as the number of people appointed to full-time roles plunged for a second successive month in July, according to a survey. An index of permanent positions dropped to 45.4 from 49.3 the previous month, the lowest level since May 2009. A number below 50 indicates a decline in placements (contraction). Employers in the survey cited Brexit-related uncertainty.
The same uncertainty that scared away some investors and sit on cash, including me. 91% of investors made money in July as US markets kept hitting record highs, according to Openfolio, an app that allows you to connect and compare your portfolio to 60,000 other investors. Average cash holdings of these investors grew 25% over the past three months leading up to July.
75% of investors lost money in June as Brexit uncertainly weighted in. The portfolio of the majority of investors are tracked with S&P 500. The problem here can be described by Ron Chernow,
As a bull market continues, almost anything you buy goes up. It makes you feel that investing in stocks is a very easy and safe and that you’re a financial genius.
93% of investors lost money in January as the energy prices plunged and uncertainty in China scared investors.
Here’s another quote by Robert Kiyosaki (Rich Dad),
As a bull market turns into a bear market, the new pros turn into optimists, hoping and praying the bear market will become a bull and save them. But as the market remains bearish, the optimists become pessimists, quit the profession, and return to their day jobs. This is when the real professional investors re-enter the market.
I’m naturally contrarian like Bill Ackman. I love going against the crowd. I love Bill Ackman. When I met him, I had no problem keeping my cool after learning my lesson from the Ben Bernanke experience.
Being contrarian has made me money. It has also got me into “value trap” like buying $TWTR around $34.
On Thursday (August 4th), Bank of England (BoE) cut rates by 25bps (0.25%) to 0.25%, the lowest since the central bank was founded in 1694 (322 years) and the first cut since March 2009.
The central bank signaled further cut to the interest rate if the economy deteriorates further, “If the incoming data prove broadly consistent with the August Inflation Report forecast, a majority of members expect to support a further cut in Bank Rate to its effective lower bound at one of the MPC’s forthcoming meetings during the course of the year.” (I’ll address the recent economic reports and BoE’s forecasts later in this article)
During the press conference, Mark Carney (The Governor of BoE), stated he is not a fan of negative interest rates. He clearly stated that MPC (Monetary Policy Committee) is very clear lower bound is above zero. Options other than NIRP (Negative Interest Rate Policy) are available, “we have other options to provide stimulus if more stimulus were needed.”
Carney told banks they have “no excuse” not to pass on the rate cut in full to customers. In other words, he’s telling them not to mess with him.
“With businesses and households, anyone watching, if you have a viable business idea, if you qualify for a mortgage, you should be able to get access to credit.”
With 6-3 vote, they will provide an extra 60 billion pounds ($78 billion) of newly created money by buying government bonds over six months, extending the existing quantitative easing (QE) to 435 billion ($569 billion).
To cushion the blow to banks’ profitability, BoE will provide up to 100 billion pounds ($130 billion) of loans to banks close the base rate of 0.25% under the Term Funding Scheme (TFS). The scheme will charge a penalty rate if banks do not lend.
“The TFS is a monetary policy instrument. It reinforces the transmission of Bank Rate cuts and reduces the effective lower bound toward zero, it charges a penalty rate if banks reduce net lending, it covers all types of lending, and it is funded by central bank reserves.” (Page 6)
With 8-1 vote, BoE will also buy as much as 10 billion pounds ($13 billion) of corporate bonds in the next 18 months, starting in September. For that, BoE is targeting non-financial investment-grade corporate bonds, issued by “firms making a material contribution to the UK economy” (Page 3)
I did not expect that much of stimulus.
I expect .25% rate-cut by Bank of England. But, not more QE. There's a little chance I think QE will be less than £20bn. $GBPUSD#BoE
Activity among UK manufacturers contracted at its fastest pace at the start of third quarter. UK manufacturing PMI (Purchasing Mangers’ Index) fell to 48.2 in July, down from 52.4 in June, the lowest levels since February 2013.
Manufacturing sector accounts for 11% of the UK economy.
“UK manufacturing employment decreased for the seventh straight month in July, the rate of job loss was the second-sharpest for almost three-and-a-half years” the PMI report said.
It also stated “Weaker inflows of new work and declining volumes of outstanding business also suggest that employment may fall further in coming months.”
Contributes to 10% of GVA (Gross Value Added), which measures how much money is generated through goods and services produced. In 2014, GVA per head on average in the UK was 24,616 pounds ($32,113), growing 3.6% Y/Y.
Accounts for 44% of total exports. Exports alone account for 27.4% of the UK’s GDP (Gross Domestic Product).
Export orders rose for the second successive month in response to the weaker pound. On July 6th, sterling plunged to $1.2788, the lowest since 1985.
Represents 69% of business research and development (R&D), which accounts for mini 1.67% of the UK’s GDP.
What is also interesting in the PMI report is the input price. Input price inflation rose to a five-year high in July, “reflecting a sterling-induced rise import costs.” Some part of the increase in costs “was passed through to clients.”
UK construction industry, accounting for 6.5% (Parliament.uk – PDF download) of the economic output, suffered its sharpest downturn since June 2009 as the sector came under pressure from the uncertainty. UK construction PMI inched down 0.1 to 45.9 last month.
Clients of the construction firms had adopted “wait-and-see” approach to projects rather than curtailing and canceling the projects. The same “wait-and-see” that has caused investors like me to sit on cash (Cash on sidelines).
“Insufficient new work to replace completed projects resulted in a decline in employment numbers for the first time since May 2013” the PMI report stated. The construction industry accounts for 2.1 million jobs, 6.62% of the working population. The industry contributes to 6.5% of GVA.
And services too. UK services PMI plunged to 47.4 in July from 52.3 in June, the first contraction since December 2012 and the fastest rate of decline since March 2009 and the steepest M/M decline (-4.9) since PMIs began in July 1996.
The sector accounts for 78.4% of the UK economic output.
Not surprisingly, the sentiment of businesses dropped to the lowest since February 2009.
Bank of England slashed its growth and increased its inflation forecasts. The central bank slashed its growth forecast for 2017 to 0.8% from initial estimate of 2.3%, making it the biggest downgrade in growth from one inflation report to the next. They now expect inflation to hit 1.9% in 2017, from previous estimate of 1.5%.
For 2018, the economy is expected to grow at 1.8% from previous estimate of 2.3%, and CPI is expected to hit 2.4% from previous estimate of 2.1.
Unemployment is expected to reach 5.4% next year from initial estimate of 4.9%, that is more than 250,000 people losing their job….even after the stimulus.
The bank’s outlook also includes lower income and housing prices to decline a “little” over the next year.
UK house prices fell 1% in July, according to a survey by Halifax, Britain’s biggest mortgage lender. The reports for the next few months will sure be interesting.
Confidence will continue to fall in the coming months as uncertainty will continue to exist and businesses will be extremely cautious with regard to spending, investment and hiring decisions, and people will be cautious with regard to spending.
All these survey conducted shortly after Brexit reflects an initial reaction. What matters now, especially after the new wave of stimulus, is the level of uncertainty and the magnitude of contractions. The three PMIs – manufacturing, construction, and services – accounting for almost 96% of the economic output, does not cover the whole economy as the retail, government and energy sectors (Oh energy), are excluded. However, it is clear the UK economy is slowing and is likely to slow in the coming quarters. Until clouds stop blocking the sun from shining, we won’t have a clear picture of the economy.
Will there be a recession or not? I’m not calling for any recession at the time. I will get a better idea of where the UK economy is heading as we get more data.
In two weeks:
Consumer Price Index (CPI) – With data reflected in the PMIs and the amount of stimulus announced by BoE, inflation overshoot is possible. This report in two weeks will only reflect July. We should get better of where inflation is going in September and October.
In four weeks:
Another manufacturing and construction PMIs. The services PMI comes the week later.
I should make a call on whatever the will be recession after the data and some by mid-September.
Without fiscal stimulus, monetary stimulus alone cannot offset most of the Brexit ills. Philip Hammond, the chancellor, signaled loosening of fiscal policy in October. By then, it just might be too late.
Extra: Bad Karma
Since Brexit (voted for by pensioners) UK 10y yield has plunged from 1.40% to record low 0.65%…decimating pensions pic.twitter.com/CtVUoufWuF
Liquidity is the investor’s ability to buy and sell a security without significantly impacting its price. Lack of liquidity in a security can have its consequences. Post financial crisis regulations, such as Volcker Rule (Dodd-Frank), and Basel 3, has made it more expensive and more difficult for banks to store bonds in their inventories and facilitate trades for investors. Regulations designed to make the system more safer have depressed the trading activity.
Lack of supply is one cause for diminishing liquidity. Banks, the dealers of corporate bonds, have reduced their inventories. According to Bank for International Settlements (BIS), “Market participants have raised concerns that regulatory reforms, by raising the costs of warehousing assets, have contributed to reducing market liquidity and could be keeping banks from acting as shock absorbers during periods of market stress.”
According to BIS, “US primary dealers…have continued to reduce their corporate bond inventories over the past years. Since the beginning of the year 2013, they have cut back their net positions in U.S. Treasuries by nearly 80%.
Another big cause of decreasing in liquidity is technology. A technology that has changed the structure of markets, high-frequency trading (HFT), an algorithm computer trading in seconds and in fractions of seconds, account for much larger share of the trading transactions and it leads to low liquidity. Majority of HFTs, if not all, reduces liquidity by pairing selected (self-interest), leaving out others. According to BIS, 70% of U.S. Treasury trading is done electronically, up from 60% in 2012. For both high-yield bonds (not highly liquid asset), it accounts for more than 20%. About 90% of transactions on bond futures take place electronically. I have no doubt electronic trading will continue to increase.
“Greater use of electronic trading and enhanced transparency in fixed income markets typically comes at the cost of greater price impact from large trades.”, BIS said in the report. Bonds now trade in smaller transaction sizes than they did before, “… large trades seem less suitable for trading on electronic platforms because prices move quickly against participants who enter large orders due to the transparency of the market infrastructure.” “It “discourages market-makers from accommodating large trades if they fear that they cannot unwind their positions without risking a sizeable impact on prices.”
BIS in its quarterly review report (March 2015) stated (source: FINRA’s TRACE data), the average transaction size of large trades of U.S. investment grade corporate bonds (so-called “block trades”) declined from more than $25 million in 2006 to about $15 million in 2013.
This is a sign of illiquidity since “trading large amounts of corporate bonds has become more difficult.” Trades facing constrained liquidity puts investors, especially large investors, to a disadvantage.
Capacity to buy/sell without too much influence on the market prices are deteriorating. Lack of liquidity can causes wild swings in the bond prices, which then can affect the rest of the financial markets. Today’s financial markets are so connected just like the economic domino effects.
They are connected, but let me tell you why they are so important. The U.S Treasury securities market is the largest, the most liquid, and the most active debt market in the world. They are used to finance the government, and used by the Federal Reserve in implementing its monetary policy. I repeat, in implementing its monetary policy. Having a liquid market – in which having no problem buying and selling securities without affecting the market price – is very important to the market participants and policymakers alike.
Examples of high volatility in a low liquidity:
Flash Crash (May 2010)
In a matter of 30 minutes, major U.S. stock indices fell 10%, only to recover most of the losses before the end of the trading day. Some blue-chip shares briefly traded at pennies. WHAT A SALE! According to a U.S. Securities and Exchange Commission (SEC) report, before 2:32 p.m., volatility was unusually high and liquidity was thinning, a mutual-fund group entered a large sell order (valued at approximately $4.1 billion) in “E-mini” futures on the S&P 500 Index. The large trade was made by an algorithm. The “algo” was programmed to take account of trading volume, with little regard, or no regard at all, to the price nor time. Since the volatility was already high during that time and volume was increasing, this sell trade was executed in just 20 minutes, instead of several hours that would be typical for such an order, 75,000 E-mini contracts (again, valued at approximately $4.1 billion).
According to the report, this sell pressure was initially absorbed by HFTs, buying E-mini contracts. However, minutes after the execution of the sell order, HFTs “aggressively” reduced their long positions. The increase in the volume again led the mutual-fund group “algo” to increase “the rate at which it was feeding the orders into the markets”, creating what’s known as a negative feedback loop. That’s the power of HFTs.
This was nearly 6 years ago. Today, there’s no doubt the power of the secretive section of the financial markets, HFTs, are much stronger and powerful and can destroy the markets with “one finger”.
With low liquidity in the bond market and increasing HFT transactions in it, the threat is real. Automated trades can trigger extreme price swings and the communication in these automated trades can quickly erode liquidity before you even know it, even though there is a very high volume. While liquidity in the U.S. bond market is high, it’s not high enough to battle the power of the technological progress.
Let’s not forget. Fixed-income assets such as, corporate bonds, are often traded over the counter in illiquid markets, not in more liquid exchanges, as stocks are.
It’s all about profits. Some, if not all HFTs, act the way they do, to make profit. There’s nothing wrong with that. But, the creators of the algorithms have to be ethical and responsible. It’s not likely to happen anytime soon since profits are the main goal (mine too) in the financial markets. So why should HFT “be fair” to others? I know I wouldn’t.
Taper Tantrum (2013 Summer)
In the summer of 2013, the former Federal Reserve chairman, Ben Bernanke, hinted an end to the Fed’s monthly purchases of long-term securities (taper off, or slow down its Quantitative Easing), which sent the financial markets, including the bond market into a tailspin.
On June 19, 2013, Ben Bernanke during a press conference said, “the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year.” That sentence alone started the financial market roller coaster.
Yields skyrocketed. The gravity took down the value of greenback (U.S. Dollar). U.S. long-term interest rates shot up by 100 basis points (1%). Even short-term interest rate markets saw the rate-hike to come sooner than the Fed policymakers suggested. Borrowings costs increased so much, as the markets was expecting tightening of the monetary policy, it “locked up” the Fed from cutting the pace of bond buying that year.
This raises (or raised) whatever the market prices can handle orders that are executed in milliseconds. It points to a lack of supply (dealer inventories), A.K.A illiquidity. I feel bad for funds that have a lot of corporate-bonds in their portfolio. The struggle is real.
An open-ended funds that allow investors to exit overnight are more likely to experience a run, as market volatility increases. A run on funds will force the funds to sell illiquid assets, which can push down the prices lower and lower. Recently example of that is the Third Avenue (“investors’ money are being held hostage”).
Brace for a fire sale. Coming soon in your area.
Market makers, where are you? Come back. I need to sell the investments at a current price, before it goes much lower.
October 15, 2014
The financial markets experienced – as the U.S. Department of the Treasury puts it – “an unusually high level of volatility and a very rapid round-trip in prices. Although trading volumes were high and the market continued to function, liquidity conditions became significantly strained.”
On October 15, 2014, the markets went into a tailspin again. The Dow plummeted 460 points, only to recover most of the losses. The Nasdaq briefly fell into a correction territory, only to rebound sharply. The 10-year Treasury yield “experienced a 37-basis-point trading range, only to close 6 basis points below its opening level”, according the U.S. Treasury Department report.
According to Nanex, a firm that offers real-time streaming data on the markets, between 9:33 A.M and 9:45 A.M, “liquidity evaporated in Treasury futures and prices skyrocketed (causing yields to plummet). Five minutes later, prices returned to 9:33 levels.” “Treasury futures were so active, they pushed overall trade counts on the CME to a new record high.”, said the report.
“Note how liquidity just plummets.”
Again, as I said, “Today’s financial markets are so connected just like the economic domino effects.” The mayhem in in the bond market can spread to the foreign exchange (forex) market.
These types of occurrences are becoming common, or the “new normal”. As the Fed raises rates, the market participants will be adjusting their portfolio and/or will adjust them ahead of it (expectations), these adjustments will force another market volatility. But this time, I believe it will be much worse, as liquidity continues to dry up and technology progresses.
Recent market crashes and volatility, including the August 2015 ETF blackout, is just another example of increasing illiquidity in the markets. Hiccups in the markets will get bigger and will become common. Illiquidity is the New Normal.
Hello HFTs, how are you doing? Making $$$? Cool.
With interest rates around 0 (well, before the rate-hike in December), U.S. companies have rushed to issue debt. With the recent rate-hike by the Fed, U.S. corporate bond market will experience more volatility. Lower and diminishing liquidity will “manufacture” a volatility to a record levels that the financial markets and the economy won’t be able to cope with it. As said, “Today’s financial markets are so connected just like the economic domino effects.”, the corporate bond market volatility will spread to the rest of the financial markets.