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

Steve Schaefer at Forbes makes a great point in Don't Forget Buffett Missed Apple And Google, State Street's Gold Guy Says. The article is actually a summary of In Gold We Trust? written by Chris Goolgasian at State Street Global Advisers. The interesting point they make is that Warren Buffett has critisized gold much like he did the technology and Internet stocks in the late 1990's when he missed out on them. 

But, I think the key take away is:

[Buffett] points out that [gold] has no earnings, yield or way to return cash to the investor,

If you consider that a Total Return is earned from capital gains + dividends + interest, then you may notice the missing part of his thinking.

He is relying on something other than himself for a "way to return cash back to the investor". That is, if you own a stock (or any other security or commodity), you get your cash by "selling the stock". 

That, ladies and gentlemen, is how you create a "capital gain". It can be a major part of your "Total Return". If you don't ever do it, you may never have any. 

I reader asked why I hadn't commented more during this "uncertain time". That's fair enough, and I like answering questions. Others have asked if I "watch it closely" when volatility rises. 

My first objective is managing the portfolio. I believe every new moment is unique as it has never happened before, so it is always uncertain. Time evolves, it never goes back to where it was. I fully embrace that reality. In fact, it seems to be a source of my happiness. A good movie is spoiled if you already know the outcome. It can be a disappointment if you believe you do and are proven wrong. When others are excited and worried, I don't "watch it closely" any more than any other time. I am always aware of changes. I already know what I'll do next, so I don't need to worry about what may happen next. I already knew at what point I would quickly exit any positions I have that are falling to manage risk. I also know at what point I will re-enter them if they reverse back up. For me, volatile market conditions are both expected and normal. It neither affects my day nor how I feel. I just go with the flow knowing every new day will be unique and I like that about life.

If we are to do something worthwhile, we necessarily have to do it before, during, and early in the stage, not after the fact. Those who have read along my short missives the past several weeks may have picked up on the overall theme- active risk management. Specifically, that active risk management is something we do all the time, not just some of the time. I don't time active risk management- it's what I do. Active risk management is the predetermination of risk. It's something I do daily. I have a predefined risk level every day. It's an amount of decline we are willing to accept as we pursue a profit. 

If you read the comments leading up to the recent decline of nearly 20% in the stock market, you may notice a theme.

June 02, 2011: The essence of investment management is the management of risks when I discussed that quote by Benjamin Graham and added some of my own thoughts.

June 08, 2011: What's going to happen next: Huge Losses? When I commented on some bearishly alarming newsletters being passed around. I suggested “ you know what you'll do if it does, but don't wait around looking for it.”

June 15, 2011: Know at what point you are wrong is quoted Dickson Watts, the author of the 1965 book “Speculation as a Fine Art and Thoughts on Life”. The quote was “Fools try to prove that they are right. Wise men try to find when they are wrong.”

 On that same day, I went on to post Active risk management: don't leave it to chance.

June 28, 2011: High Net Worth Individuals and Hedge Funds I pointed out “Their top priority is preserving capital."´

July 07, 2011: Cash is a severely underappreciated tail risk hedge pointed out that statement as an interesting quote. That is, cash is an "asset class" too.

Later that day in The S&P 500 Stock Index no new high 44.9 months later I pointed out the wide swings in the stock market and my belief that “Clearly, the objective of avoiding such a waterfall event through active risk management may be considered valuable to some.´

July 16, 2011: High Net Worth Investors Want to Preserve Capital and Demand Effective Portfolio Management said “"capital preservation" doesn't mean parking money in low rate fixed income but instead actively managing risk to avoid much of the downside.

July 22, 2011: If you're talented, don't let the market determine your results points out a quote well known hedge fund manager. Not everyone is talented or skilled, but I believe those who are should use it, rather than taking what the market dishes out.

August 01, 2011: Directional price trends and volatility are not random, they cluster together I pointed out how price drifts unfold into price trends. That is, market prices tend to cluster together and evolve into directional price trends. Most of the volatility occurs in a negative trend, when prices are making lower lows and lower highs or trading below moving averages.

If you've read through these, you can probably see how there isn't much more to do when we are prepared. If you would like to get the updates via email, click HERE. 

I just received one of those alarming emails telling me of the coming Collapse of the U.S. Dollar and a stock market crash unlike ever seen before. It's a fine example of charlatan marketers using their knowledge of investor behavior to get our attention. You know, the ones that include statements intended to get us excited, like:

HUGE LOSSES!

It may be true that some people may once again take on heavy losses, should some of the alarming newsletter writers predictions come to pass. It doesn't seem to be working well so far, because the last one of these I got said to buy silver just days before its 30% decline. But, I can tell you I don't worry about things that haven't happened. A wise man once told me that people spend much of their lives worrying about things that don't ever occur. Because they worry, they experience those things over and over, even though it never happened. That is, you experience the things you fear the most over and over again by worrying about it.

Instead, I suggest you know what you'll do if it does, but don't wait around looking for it. For me, I'll just rotate out of those things that are falling into something that isn't. It's what I do. Predefine your risk by knowing at what exact point you'll exit if it's moving against you. Then, don't worry, be happy!

I take the active management of downside risk seriously as evidenced by my investment performance, and I'm telling you: that's exactly how I do it.

The topic of selecting an investment manager is an important one. Many investors, including professional financial planners and advisors admit they have little skill at selecting asset managers. In fact, some admit they do such a poor job at it they don't even try. But if you understand the value in alternative investment strategies from private equity to absolute return focused investment programs, then you need to know what to look for in an investment manager. These alternative investment strategies are most often offered privately in a private hedge fund format and sometimes offered as a separate managed account (SMA). Whether you are a private individual investor, an allocator for a family office or institution, or a portfolio manager, the video below is an outstanding example of how a sophisticated investor analyzes a money manager. It’s an interview with the Chief Investment Officer of a family office. He explains why a family who sold a large business may be interested in alternative investments or alternative investment strategies rather than conventional public investments and investment programs like mutual funds.  His family office has allocated 80% to alternative investment managers (like hedge funds and the Asymmetry Investment Program™). He offers some insight about:

• Why family offices (and other wealthy investors) are attracted to alternative investment strategies commonly offered as a private hedge fund.
• What they specifically look for in selecting a portfolio manager.
• How allocators filter managers post crisis:  What exactly did you do in 2008?
• Are they looking at younger emerging hedge fund/money managers?

Click below to view:

On how they select hedge funds:  (begins around 4:07/9:57)

We are looking for opportunities with managers were we can get comfortable as to their strategy and what will generate returns for them and what the risks might be? We haven’t been very active with emerging or start-up managers. I think a lot of that has to do with where we are in terms of time.

2008 was an awesome and an awful market experience it's helpful to look at managers who actually were in existence during that period of time to gain some understanding of how they manage their portfolios are the most difficult. Someone doesn't have a 08 track record is much harder to get a sense of how they're going to do a difficult markets. 09 was a pretty easy market to make money if you were long.

How are you evaluating the 2008 period what are you looking at specifically, the drawdown?

We obviously start with performance but  I also want to see exposure in the portfolio. How did the manager navigate those markets? Did he keep his portfolio fully invested in a market environment for his strategy was not allowing it to make money was actually causing losses? Did he trim exposure? When did he put exposure back into the market place?  is something that we look at it. It's really it's a number of different factors we try and I can understand how the manager managed during that period of time and try to gain some insight on his style. Conviction doesn't automatically mean that you stay fully invested at all times. Although we certainly saw a number of managers who waited FAR too long to trim their exposure. So,  it's a combination of all those factors we try and consider. But I would say one of the things that are most important to me is trying to follow a managers gross and net exposures during that period trying to understand. That leads to conversations of what the manager was thinking at the time.

He goes on to say: 

I like analogies. And one of the analogies in 2008 brings to me it’s like a sailor setting his course on a sea. He’s got a great sonar system, he’s got great maps and charts and he’s perhaps got a great GPS so he knows exactly where he is. He knows what's ahead of him in the ocean but his heads down and he’s not seeing these awesomely black storm clouds building up on the horizon are about to come over top of him. Some of those managers we did not stay with. Managers who saw that, who changed course, trimmed their exposure, or sailed to safer territory. One, they survived; they truly preserved capital in difficult times and my benchmark for preserving capital is you had less than a double-digit loss in 08, you get to claim you preserved capital. I've heard people who've lost as much is 25% of investor capital argue that they preserved capital… but I don't believe you can claim that. Understanding how a manager managed and was nimble during a period of time it gives me great comfort, a higher level of comfort, on what a manager may do in the next difficult period. So again it's a it's a very qualitative sort of trying to come to an understanding of what happened… and then make our best guess what we anticipate may happen next time.

As a portfolio manager of an alternative investment program I can tell you he's spot on. Those whose jobs are that of the asset allocator, who allocates capital to investment programs, often rely too much on Modern Portfolio Theory statistics and not enough on looking very closely under the hood. As a quantitative trading system developer and operator, we are focusing on far different things and I can tell you: it's the things that matter. It's critical that the investor or allocator take a close look at the downside: how was their drawdown from peak to trough? What were the actual holdings during that time? Like he said: do they stay in the market even when it's not working for them? Or, do they reduce their exposure to the possibility of loss (risk management) by selling positions or dynamic hedging?

I also agree with his comments about experience. After such a radical waterfall occurred in 2008 - 2009, more investors and professionals have now figured out the state of the market. In a secular bear market, such waterfalls occur and it can happen again. After the fact, many investment professionals have scrambled to come up with solutions and naturally they'll be attracted to what actually worked in the past: like some forms of Global Tactical Asset Allocation, Trend Following, and other so-called "alternative" investment strategies like we run. We now have new people interested in active portfolio management that seek an absolute return, rather than a relative return. But like he said: they lack the actual experience. You really don't know how they'll react in the heat of the battle. But you can be assured of this: back-testing a system is one thing, executing is another.