Asymmetric Investment Returns - Insights into portfolio management beliefs, strategies, and tactics that aim to create a positive imbalance between risk and reward

As noted in Trading vs. Investing, when I speak of "trading", please note that I am implying buying and selling something. Trading is defined as: the act or process of buying, selling, or exchanging. The term "trading" is not related to the frequency of buying and selling, but instead the act of buying and selling.

Symmetric Trading System

A symmetric trading system is one that has an entry and an exit that is the same. It's a system or strategy that sells a position with the same signal it uses to buy it. 

It may buy when the price is above its 50 day moving average and then sell when the price falls below its 50 day moving average.

If you apply symmetry to chart patterns, it may buy a Point & Figure Double Top breakout and sell a Point & Figure Double Bottom breakout.

If you apply symmetry to fundamental ratios, it may buy if the P/E is below 20 and sell if the P/E is above 20. You probably get the picture. A symmetrical trading strategy is one that assumes prices rise and fall in the same fashion, so it treats them the same with the same buy and sell signal. 

Asymmetric Trading System

An asymmetric trading system is one that treats the entry and exit differently, so it has an entry and exit that are different. For example, it may buy above the 200 day moving average, but it sells if the price falls below the 50 day moving average. Asymmetric trading systems may have an entry signal that is different from the exit signal. In fact, an asymmetric trading system may exit a position applying a totally different method than the one it uses to enter. For example, I enter with a directional price indicator and exit with an unrelated risk management system.

Why would you apply an asymmetric trading system that has a different entry signal than its exit signal? If you believe there is a difference in the uptrend than the downtrend. An asymmetric trading system treats rising markets differently than falling markets. That is, it assumes a fundamental bias between the positive movement and the negative movement. For example, U.S. stock market returns are asymmetric: they present a non-normal distribution. Stock market return data has “fat tails”: the downside tends to be much greater and occur more often than “normal”.  Stocks tend to behave differently on the upside than the downside. You can simply view an index price chart to see this. Stocks tend to have more gradual upward trends, but they collapse and cascade on the downside as investors' panic. In The truth about asymmetric market returns: fat-tails and black swans I pointed out a study that finds: 

These findings prove that risk estimates based on the normal distribution, even with volatility clustering, systematically misrepresent the true nature of the risk being taken. More sophisticated modeling techniques are necessary in order to capture widely observed phenomena such as risk asymmetry and fat tails.

In Investor Reaction to News is Asymmetric  we pointed out some evidence of why I believe investors react differently to good news than bad news. Investor reaction to good and bad news is asymmetric: bad economic news is likely to play a more significant role in shaping investors’ behavior than good economic news.

For this reason, our asymmetric trading systems handle rising markets differently than falling markets. If you believe market returns are asymmetric, it probably doesn't make sense to apply symmetry to asymmetric returns. I discovered this long ago through quantitative testing and I have experienced it in real-time portfolio management. 

Even if you believe the market you trade doesn't present an asymmetric return distribution, there are other reasons to apply an asymmetric trading system that sells positions differently than it buys them. One of those reasons is the exponential nature of losses. As I discuss in the Asymmetric and Exponential Nature of Losses: losses compound asymmetrically and exponentially. That is, losses are not linear because the compounding of losses doesn’t occur in a straight line fashion. You can probably see why those who apply mathematical equations like those used in Modern Portfolio Theory underestimate risk. Their equations and methods don’t give enough respect to the big moves at the ends. Those big moves are the factor that makes all the difference if you want to capture big gains and avoid large losses. A -50% decline needs a 100% gain to get back to even. Yet some markets, like stocks, show a history of a -50% decline occurring quickly, but that 100% gain to get back to break even seems to come much slower. The recent stock market history is a good example. The S&P 500 stock index declined over -50% in a year and three years later it remains about 20% below it's prior high. 

You may guess that I probably exit positions differently than I enter them. If investors want to pursue a positive asymmetric return profile that results in a larger total return than the downside declines it takes to get it, then they should consider that we don't want balance and symmetry in all things. Some things in natural science, including the human body, look better with symmetry, but we can’t say the same about investment returns.

An asymmetric trading system is a quantitative portfolio management system that buys and sells with the understanding that the dynamics may be different when a trend is going down than when it is going up. Investors who seek an asymmetric return profile should be sure their investment manager or strategy is one that understands and exploits asymmetries. 

Asymmetry™, Asymmetry Investment Program™, and Asymmetry Capital Partners™ are registered trademarks of Shell Capital Management, LLC

I believe investors react differently to good news than bad news. Investor reaction to good and bad news is asymmetric: bad economic news is likely to play a more significant role in shaping investors’ expectations than good economic news. 

A research paper by Abdulaziz M. Alwathainani titled "Does Bad Economic News Play a Greater Role in Shaping Investors’ Expectations than Good Economic News?" (June 17, 2010) is an example of evidence of our belief. Abdulaziz says:

Investors’ responses to consistency in good and bad news are asymmetric. Bad economic news is likely to play a more significant role in shaping investors’ expectations than good economic news.

When people hear the term "trading" they sometimes relate it to frequency.

When I speak of "trading", please note that I am necessarily imply buying and selling something. Trading is defined as: the act or process of buying, selling, or exchanging.

The term "trading" is not related to the frequency of buying and selling, but instead the act of buying and selling. Only when you add a term indicating frequency does the meaning change. For example, "long term position trading" is different than "day trading" or "high frequency trading". All of those terms included the word "trading", yet none of them are the same. 

I don't actually attempt to place a predefined time frame any any position: I probably hold a winner as long as it's winning and cut a loss short no matter how recently I entered it. The time frame, frequency, and turnover isn't a factor. 

When you "invest" in something, such as a managed investment program involved in buying and selling securities (trading), you may not have a predetermined exit point. You are invested in a managed program that you expect to do the selling and buying for you. in fact, we probably wouldn't consider a program that buys and doesn't sell a "managed" program. If it just buys and then holds, there is no management and no reason to pay a management fee or consider it a "program". 

While I define "investing" as buying or selling without necessarily having a predefined exit, I believe the best "investment" decisions probably have an expected outcome and exit. 

The exit almost always determines the outcome. So, we necessarily call it "trading" when we are dealing with buying and selling exchange traded securities or other liquid exchange traded markets. 

To "manage" is to direct and control. 

Investors' invest in our managed investment program and my role is to manage the trading: the buying and selling. We call that portfolio management, which is the process of trading. 

Nearly all relative return mutual funds took losses and underperformned their benchmarks in 2011. Trang Ho of Investor's Business Dailly writes in "Most Mutual Funds Underperformed Benchmarks In 2011":

Most mutual fund managers underperformed the market, and many very badly. Morningstar data show less than a third (29%) of the 21,000 mutual funds it tracks beat their benchmarks.

I have a few things to add to this thought-provoking article. Active mutual funds that pursue a relative return objective attempt to beat a predefined benchmark index. An index is a quantitative systematic process, making them difficult to beat. An index doesn't wake up fearing missing out or losing money. The positions in an index typically get added or deleted once a year. An index stays fully invested and doesn't fear going broke when markets cascade down. A relative return objective attempts to outperform the index, either by gaining more than the index or maybe losing less. Relative return funds define risk as tracking error - they don't want to stray too far from their benchmark, so their risk/reward profile is similar. If they stray too far with their positions, they fear underperformance. For a relative return fund that benchmarks and index, it's OK to be down -50% if the index is. When we speak of mutual funds as active managers, then, it's important to draw that disctinction. 

Trang goes on to say:

The average U.S. stock fund lost 2.90% in 2011, while the S&P 500 stock index produced a total return of 1.52%, according to Lipper Inc. Of about 8,000 funds that Lipper tracks, 92% suffered losses... Foreign fund managers performed even worse, with an average 13.90% loss, owing to the European debt crisis. U.S. Treasury fund managers took the winner's stand with a 16.04% return, as investors flocked to government securities for safety.

I believe the trip they took along the way may have been important than the ending point in 2011. I made this point in Stock Index Performance for 2011 and the Full Market Cycle. For example, stock indexes declined as much as -20% or more July - September. It was a very quick and sharp cascade: enough to shake out many investors. Once they panic, it's hard for them to re-enter. It's best to actively manage risk in hopes to avoid such a scenario. Actively managing risk is to reduce exposure to the possibility of loss by selling early in the stage of falling prices or hedging. Most mutual fund managers have a relative return objective, not an absolute return objective aiming to limit downside loss. But, even a relative return manager may have attempted to reduce the downside. If they did, they may have experienced less drawdown along the way. Even though they "underperformed" relatively for the period, they may have provided a journey along the way an investor could deal with. In that case, the risk/reward isn't reflected in a presentation that only shows the end result. This is beyond the scope of Trang's article about calendar year mutual fund performance, so I thought I would discuss it here.

As I said in 2011 Hedge Fund and Commodity Trading Advisor Performance, one calendar year is a meaningless time frame unless you were trading your way to a new car, boat, home, etc. and December 31, 2011 was your deadline. And, -2.90% isn't a large unrecoverable losss, but what I believe is the far more important issue with relative return mutual funds is their performance over a full market cycle. She included a nice table with 5, 10, and 15 year results. Clearly, the last 5 years or more has been challenging for those pursuing capital gains from mutual funds. 

Source: Investor's Business Daily

For many purposes, I'm not a fan of grouping things or people together to draw inference about the group. Such shortcuts often lead people astray. As I said in The Illusion of Asymmetric Insight, people like to form groups. They may pick a group/team/tribe and sometimes follow it blindly. Their illusion of asymmetric insight is that they believe they know more about the group than they do, or they know more than the group knows about them. So, investors group different investment programs into a category and speak of them broadly. If they like hedge funds, invest in hedge funds or manage a hedge fund, they'll probably speak of the group positively. If they don't like hedge funds, don't understand hedge funds, don't know much about hedge funds, or don't have enough money to qualify, they'll probably group them together with a negative perception. Since perception is a filtering process that selects information for conscious processing, your perception is a function of your own beliefs, wisdom, and experience. At the end of the day, I guess the best measure of your perception is your actual results. If you invest in or manage a hedge fund and have a good performance history over a meaningful period, then your perception has been useful to you. If you have earned a poor track record, then it doesn't really matter what you like or don't: you may consider that your perception may be may be off.

As an asset manager that specializes in quantitative research and trading systems, I necessarily want to quantify things. If we want to get an idea of the performance history of a group or groups, we necessarily need to put them in a basket and call them a category. In this case, we are doing it on purpose with the awareness that we are. 

In Stock Index Performance for 2011 and the Full Market Cycle we looked at the results for the broad stock indices in 2011. More importantly for 2011 we examined the path they took from January 1st to December 31st. Even more important than an arbitrary calendar year performance we looked at them over a complete market cycle of the past 5 or so years. Here, we view a snapshot of the Barclay Hedge Fund Indices. As you can see, Barclay Hedge Fund Indices include a broad index "Barclay Hedge Fund Index" that groups the performance of a broad range of hedge funds into one index. The definition from their website: 

The Barclay Hedge Fund Index is a measure of the average return of all hedge funds (excepting Funds of Funds) in the Barclay database. The index is simply the arithmetic average of the net returns of all the funds that have reported that month.

If we use the Barclay Hedge Fund Index to measure the overall performance of hedge funds in 2011, they were down -5.2%. What would be far more telling is the experience along the way, which is beyond the scope of this post about the overall 2011 results of different hedge fund groups. It is useful to glimpse at these hedge fund indices to get a general perception of the results of different forms of active management, active trading, etc. However, keep in mind one calendar year is a meaningless time frame unless you were trading your way to a new car, boat, home, etc. and December 31, 2011 was your deadline. Overall, we can probably say that hedge funds results were a little negative for 2011. 

Source: BarclayHedge.com 

The far more meaningful use of performance history is to gain an understanding about the experience one would have over a longer period of time. Specifically, a study of both the upside and the downside as discussed in The Asymmetry™ Ratio: The Asymmetric Investment Return Profile of Risk vs. Reward. And, for those investors who don't have unlimited resources, a special emphasis may be placed on the historical draw-down. 

Definitions for Selected Indices:

Barclay Equity Long Bias Index: Equity Long/Short managers are typically considered long-biased when the average net long exposure of their portfolio is greater than 30%.

Barclay Equity Long/Short Index: This directional strategy involves equity-oriented investing on both the long and short sides of the market. The objective is not to be market neutral. Managers have the ability to shift from value to growth, from small to medium to large capitalization stocks, and from a net long position to a net short position. Managers may use futures and options to hedge. The focus may be regional or sector specific.

Barclay Global Macro Index: Global Macro managers carry long and short positions in any of the world's major capital or derivative markets. These positions reflect their views on overall market direction as influenced by major economic trends and or events. The portfolios of these funds can include stocks, bonds, currencies, and commodities in the form of cash or derivatives instruments. Most funds invest globally in both developed and emerging markets.

Barclay Multi Strategy Index: Multi-Strategy funds are characterized by their ability to dynamically allocate capital among strategies falling within several traditional hedge fund disciplines. The use of many strategies, and the ability to reallocate capital between them in response to market opportunities, means that such funds are not easily assigned to any traditional category.