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

Market conditions evolve over time. Circumstances evolve over time. That is, prices don't always adjust immediately and efficiently. Instead, prices drift in one direction or another as market participants decide how to respond to new ever-evolving information. Some of them under-react, others over-react as they perceive information differently and react to it based on their perception. For example, different readers of this message will perceive its meaning in different ways; based on their own knowledge and experience and "frame of reference". In fact, people often believe they know more about things than they really do. They can become overconfident in what they believe they know. When I do an interview, for example, people sometimes believe they know what I do and say "I do that too". Yet, I've never given any specifics. They really don't know. They unknowingly experience the Illusion of Asymmetric Insight. As evidenced by the vast differences in long term performance of different market operators, some are better at perception, avoiding overconfidence, understanding the issues like Illusion of Asymmetric Insight, evolving, and adapting than others. Such an understanding and skill can only be achieved by experience. The truth is, that is something few really have. 

It can be useful to look at how conditions did evolve. Not that anyone can do anything in the past, but instead to get an understanding of how things unfold. My systems adapt to these evolving conditions. Below we post some articles and comments over the past several weeks.

Investor Sentiment

Stock market risk becomes elevated with breadth indicators reaching bearish level

Managing Market Risk

Bear market cycles and Subsequent Bull Runs Q2 2012

S&P 500 Index at Inflection Points Q2 2012

Some investment managers miss out on capital gains

Standard Risk Measurement Not Enough: Eurozone Crisis Deconstructed

Spain Stock Market Cascade

World Bear Market?

Asymmetry™ Tactical ETF portfolios now available to wealth managers on Folio Institutional, Schwab Institutional, TD Ameritrade Institutional, Fidelity Institutional Wealth Services, Pershing Advisor Solutions

With one of the strongest and longest running actual track records applying systems that pursue asymmetric returns, we have had a lot of interest from independent wealth managers. We have made our programs available on the institutional platforms used by wealth managers and are in the process of hiring advisers across the country that will work with wealth managers. 

We are pleased to announce that our Asymmetry™ managed accounts are now available to wealth managers who are independent registered investment advisors and custody accounts with:

• Schwab Institutional + Schwab Advisor Services™
• Fidelity Institutional Wealth Services®
• TD Ameritrade Institutional
• Pershing Advisor Solutions®

The Asymmetry Investment Program™ global tactical rotation and systematic trend following models are offered at different objectives and risk levels. 

Asymmetry™ R15

Asymmetry™ Global Tactical Rotation GTR 10

Asymmetry™ U.S. Sector Rotation 

Asymmetry™ U.S. Equity Trend Following

Asymmetry™ International Country Tactical ETF 

Asymmetry™ Global Trend Following

All agreements and compensation arrangements are negotiated entirely between the wealth management firm and Shell Capital Management, LLC.

For more details about the Asymmetry Investment Program™ managed accounts contact us. 

The table below shows how long some of the worst cyclical bear markets since 1950 have lasted and how long it took to recover from them. Recall that losses are asymmetric: the larger the loss, the more gain it takes to recover from it. "Aggressive" investors therefore tend to feel really excited on the upside, then less so when they loose what they spend years accumulating. 

A bear market is defined as a peak-to-trough decline in the S&P 500 Index of 20% or more. The bull run data reflect the market expansion from the bear market low to the subsequent market peak. All returns in the table are S&P 500 Index returns and do not include dividends. The table assumes the current bull run from 3/9/09 through 12/31/11. It could be argued that the index had a bear market in the decline of 2011.

The good news is that cyclical bear markets haven't historically been permanent losses for this stock market index. The losses were eventually recovered in about 2.2 years. This time, however, the bear market has lasted 4 years and 4 months. It could be argued that the this index barely reached its 2000 peak in 2007, so it has actually traded in a range below the current level for more than a decade. To see what I mean, read: S&P 500 Index Inflection Points of the Current Secular Bear Market. Clearly, buy and hold may be a risky investment strategy for individual investors who don't have unlimited time horizons. You can probably understand why a tactical strategy that aims to avoid some of the loss and capture some of the gains has become very popular in recent years. As wealth managers often point out: the trouble is that few investment managers have any skill or experience actually doing it. And, many of them who have actually been doing it long enough to speak of haven't done it very well. 

Source: Standard & Poor’s, FactSet, J.P. Morgan

I came across Credit Suisse Global Investment Returns Yearbook 2012  on Abnormal Returns.

CSFB examines the dynamics and impact of inflation and currency risk and how stocks and bonds have performed in different conditions. Inflation erodes the value of most financial assets, though some assets like gold or homes may actually rise in price. After all, inflation is generally “rising prices” of things (like homes). Stocks may be negatively impacted by rising inflation, but to a lesser extent than bonds or cash. Investment salespeople often promote stocks as an inflation hedge, but stocks may actually only offer limited hedge against rising inflation and that’s due to their higher ‘expected’ return, not because they rise with inflation.

The currency section speaks of how changes in exchange rates can boost or lower the return of foreign investments, such as global or International ETFs.

The various impacts of inflation, currency, etc. is a topic that John Murphy covered very well years ago in Intermarket Analysis. It’s useful to have an understanding of how different assets typically respond to changing conditions. It’s also useful to have historical data so you actually know the probability and can develop an expectation. Therein lies the potential for trouble: when you develop an expectation of something you may create a hope for things to turn out a certain way. If your expectations are strong, you may worry about it and then be upset when it doesn't turn out the way you expected. Or, if your expecation is very strong you may bet heavy on that outcome and the more confident you are, the less adaptive you'll likely be to change when the condition changes. What we learn from past data is that, while things probably play out a certain way, it is rarely all the time. After all, that's why it's 'probablistic'. If you are positioned for a certain outcome, you may be on the wrong side of reality if you aren’t adaptive.

After reading over Credit Suisse Global Investment Returns Yearbook 2012, I find some of the data may be useful knowledge. But at the end of you day- it makes me grateful that I have a system for buying and selling that adapts to changing price trends. I don’t need to know in advance if inflation will be high or if instead the condition will be deflation. I don’t need to know if a change in currency will impact my foreign stock exposure. I don’t need an indicator to tell me if others are “risk on” or “risk off”. None of these things are known for sure in advance. Even if you know how an asset typically reacts to a certain condition, you still don’t know it will this time. No one knows in advance which condition will play out. The best anyone can do is adapt. All of these things are reflected in the direction of the price. If they aren't, then they don’t matter.  If the condition does impact the price of our positions, my system will respond to it. That, I’m sure of. It’s what it does. If we are going with what is rising in price, we may end up with those things that are responding to underlying conditions. If we do that profitability over a long time, then we increase our odds that we outpace the erosion of our buying power due to inflation. 

These are the best possible activities we can do.

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

As 2011 is in the past and the new year is here, there is always a lot of talk about the prior year as well as predictions about the year ahead. If you believe you know the outcome in advance of a time that doesn't yet exist, go ahead and make your prediction and your bets. Even talking about a calendar year in the past isn't of much use unless you were trading your way to a new car, home, or yacht and December 31, 2011 was your deadline. I believe the best time frame is a full market cycle that includes up and down periods. Those who don't understand investment results are created over complete cycles probably find themselves earning big gains that are later wiped out by large losses, over and over again. The pursuit of an asymmetric return profile necessarily requires the capture of some of the upside and then the avoidance of some of the downside. It's the capture of more of one than the other. With that said, we view the past stock market performance history using the Russell broad market indices. Nevertheless, below is a table of the typical format of presenting a performance profile. In the table we show the calendar year but also include longer periods to include the more important full market cycle (5 years or longer). The definitions for the indices are at the bottom of this post. 

Source: Rusell Return and value data utilized in this calculation tool comes from sources believed to be reliable but is neither guaranteed nor warranted and is subject to revision without notice

A picture speaks a thousand words. Below is the price chart of some of the broad stock market indices that represent the performance of stocks of companies of different sizes: small, mid, and large company stocks. Stocks broadly started 2011 in a rising price trend. The year was filled with negative headlines and fear. The stocks indices declined around -20% very quickly late summer and then recovered those losses to close the year at about the price they started. One useful thing about viewing price charts this way is we can see the visual representation of the path along the way, not just the ending point. The calendar year range for these broad indices was -9% to 1.5%. Stocks were "flat" if we look at the average, but that doesn't present the experience during the year. In the chart, we can note the highest high, the lowest low, and the distance between the high and low (the draw-down) along the way. You can probably see how stock investors probably oscillated between the fear of missing out and the fear of losing money in such a volatile period. 

Source: http://stockcharts.com/freecharts/perf.html?$RUT,$rui,$rua,$rmc, 

Looking at these stock market indices over a full market cycle (a period typically 5-6 years that includes both rising and declining price trends) we see the performance profile of stocks that include both gains and losses. Performance tables do not present "investment returns" appropriately because they only illustrate the end result for a period, but not the path or the worse draw-down along the way. In the price chart below, we get a visual representation for the most recent market cycles. Since April 2005, these stock indices gained a total 10 - 25%, or and average of only 1-4% annually.  From that starting point, they were up over 40% at one point (October 2007) and then declined over -50% by March 2009. The smallest stocks recovered their declines is the 100% gain it takes to recover from a -50% loss. The majority of the stock market, mid and large companies, are still far from their previous highs with the broadest index, the Russell 3000 (green line) gaining only about 10% over the entire period. While these price charts don't include dividends, they also don't include any costs. As we have illustrated both the risk and reward over the most recent full market cycle, you may agree that the stock market by itself has not presented the kind of asymmetric investment returns that meets most investors' objectives. In fact, applying a conventional asset allocation with annual reblancing to a broad mix of stocks and bonds doesn't create the kind of asymmetric profile many investors want. It's important to understand long term (secular) trends and Seasons and Cycles of the Stock Market.

Index Definitions (Source: Russell Investments)

The Russell 3000 Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.  The Russell 3000 Index is constructed to provide a comprehensive, unbiased, and stable barometer of the broad market and is completely reconstituted annually to ensure new and growing equities are reflected.

The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market. The Russell 1000 Index is constructed to provide a comprehensive and unbiased barometer for the large-cap segment and is completely reconstituted annually to ensure new and growing equities are reflected

The Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. The Russell Midcap is a subset of the Russell 1000® Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. The Russell Midcap represents approximately 31% of the total market capitalization of the Russell 1000 companies. The Russell Midcap Index is constructed to provide a comprehensive and unbiased barometer for the mid-cap segment. The Index is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true mid-cap opportunity set.

The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 Index is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set.

The Russell Microcap Index measures the performance of the microcap segment of the U.S. equity market. Microcap stocks make up less than 3% of the U.S. equity market (by market cap) and consist of the smallest 1,000 securities in the small-cap Russell 2000® Index, plus the next smallest eligible securities by market cap. The Russell Microcap Index is constructed to provide a comprehensive and unbiased barometer for the microcap segment trading on national exchanges, while excluding lesser-regulated OTC bulletin board securities and pink-sheet stocks due to their failure to meet national exchange listing requirements. The Russell Microcap is completely reconstituted annually to ensure larger stocks do not distort performance and characteristics of the true microcap opportunity set.

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

The Misconception: You celebrate diversity and respect others’ points of view.

The Truth: You are driven to create and form groups and then believe others are wrong just because they are others.

The Illusion of Asymmetric Insight is a very good article on the new blog for the book "You Are Not So Smart: A Celebration of Self Delusion". The illusion of asymmetric insight is that you believe you know people better than they know you. You believe you have asymmetric information about their persona, but they don't have the same about yours. You believe you can see more of the iceberg than you really can.

I like to point out asymmetries and this is an interesting one. Reading the article reminded me of a comment I hear from time to time "Yeah, we use X, too" (you can fill in the black for X with words like "tactical asset allocation", "relative strength", or "technical analysis" or "money management and position sizing". People sometimes believe they know what someone else does, or how they do it, when they really have no idea. For example, I was interviewed by Investors Business Daily about one of the basic parts of my portfolio management system and many people I spoke to afterward believed they knew far more than they do about it. Yet, after reading the article they couldn't tell me what buys and sells we executed last week. They have an illusion of asymmetric insight about how we pursue asymmetric returns. Other times I get the question "what do you use?", asking what research services, etc. we may "use". The fact is, our systems and tactics are all completely proprietary and developed into our own programs. Yet, an illusion will lead someone to say "you just be using X" or "you are probably doing Y". Their illusion is a function of their own frame of reference: the things or methods they happen to know about. You know what they say about "assume".

The illusion of asymmetric insight makes it seem as though you know everyone else far better than they know you, and not only that, but you know them better than they know themselves. You believe the same thing about groups of which you are a member. As a whole, your group understands outsiders better than outsiders understand your group, and you understand the group better than its members know the group to which they belong.

The researchers explained this is how one eventually arrives at the illusion of naive realism, or believing your thoughts and perceptions are true, accurate and correct, therefore if someone sees things differently than you or disagrees with you in some way it is the result of a bias or an influence or a shortcoming. You feel like the other person must have been tainted in some way, otherwise they would see the world the way you do – the right way. The illusion of asymmetrical insight clouds your ability to see the people you disagree with as nuanced and complex. You tend to see your self and the groups you belong to in shades of gray, but others and their groups as solid and defined primary colors lacking nuance or complexity.

That part made me think of the so-called "passive vs. active management" debate. It's really not much of a debate. Some people argue that investors should create an asset allocation policy and allocate to index funds. Others believe you should actively pursue the return profile you want. Both have difficulty making a good argument because they suffer from asymmetric insight that clouds their ability to think independently. Instead, they choose a side and spend their time focusing solely on picking on the other side. They choose a "tribe" and follow it blindly. For example, one book that claims to be about "seeking alpha" is nothing but a book about anti alpha seeking. The book is a failure because it leaves out any mention about even the most basic ways one may achieve alpha. It's a book with hundreds of references to academic research without a single mention of the useful academic research supporting alpha. My knowing the illusion of asymmetric insight has probably allowed me to gain a broader perspective. In my pursuit of asymmetric returns (what may be called "alpha" by some), I read and study the "other side" as much as anything. You see, in the literature supporting the other side of the "debate" is where we find the edge. They write a lot and they aren't achieving good results themselves, so they must be missing something. Yet, they don't believe they are. There is where we find the Alpha. If most people aren't finding it, then it must be something they aren't doing. 

So, you pick a team, and like the boys at Robber’s Cave, you spend a lot of time a lot of time talking about how dumb and uncouth the other side is. You too can become preoccupied with defining the essence of your enemies. You too need the other side to be inferior, so you define them as such. You start to believe your persona is actually your identity, and the identity of your enemy is actually their persona. You see yourself in a game of self-deluded poker and assume you are impossible to read while everyone else has obvious tells.

The truth is, you are succumbing to the illusion of asymmetric insight, and as part of a flatter, more-connected, always-on world, you will be tasked with seeing through this illusion more and more often as you are presented with more opportunities than ever to confront and define those who you feel are not in your tribe. Your ancestors rarely made any contact with people of opposing views with anything other than the end of a weapon, so your natural instinct is to assume anyone not in your group is wrong just because they are not in your group. Remember, you are not so smart, and what seems like an insight is often an illusion.

People like to form tribes. They pick a team and sometimes follow it blindly, relying solely on faith with no evidence whatsoever the tribe is the right one. In fact, I recently got an invitation to an ETF conference. It listed several speakers: some in the "passive" camp, others in the "active".  It called on of them "the world's leading technical analyst for ETFs". Yet, if you look at his companies performance you'll find an actual performance history that is far from "leading". If you have no actual evidence your tribe has an edge, you probably have to be either too ignorant to notice or accept it with blind faith. It's a shame even the "leader" probably don't know the difference. The conference go-ers won't hear from any world leader, but instead one whose persona makes someone believe he is. In fact, those who really have an edge in active portfolio management have no real incentive to speak of it beyond general concepts. When you know you have an edge and are able to exploit it, then you may also know that edge can be diminished if too many jump on board. You can probably see how we've come full circle back to another asymmetry.  

If you don't think something is possible, you may consider it's just your own illusion. You shouldn't interrupt those who are doing it - your illusion may be wrong. Instead, you may consider the pitfall of the illusion of asymmetric insight. I know that I do. In fact, I could be experiencing it now. The proof, however, is in the results.

Lance Ritchlin wrote an interesting article in the Journal of Financial Planning December 2011 titled "William Bengen on risk, Volatility, and Safe Withdrawal rates in today’s Markets".

Bengen is known for his research into “safe” withdrawals from retirement portfolios called the “4 percent rule” that has been broadly accepted by financial planners as the standard. The “4 percent rule” generally refers to the amount of your total account you may withdraw without a high probability of running out of money at some point. Bengen wrote the book on the subject in “Conserving Client Portfolios During Retirement” which was published in 2006 by FPA Press.

A financial planner sent me the article for comment. Indeed, it is a thought-provoking article. As a quantitative investment manager, we've designed, tested, and simulated thousands (maybe millions) of systematic trading systems that apply every indicator and parameters we can come up with to determine those that create the kind of results we want. We've also simulated taking withdrawals from those systems. So, what I can tell you is that your maximum withdrawal rate is a function of your total return over time, but it’s even more a function of avoiding large losses. When your account value is down, you sell more of a portion of it at lower and lower values. If your account is down -30% or -50% for a long period of time you’ll have an even harder time recovering. It’s bad enough that a -30% declined requires a 43% gain to recover the loss. If you withdraw money from it while it’s down, the compounding is amplified. So, I’m not sure a generalized rule of thumb like “the 4% rule” is useful for those who don’t allocate to an asset allocation policy and re-balance annually. If you pursue and achieve asymmetric returns the possible withdrawal rate is a function of the money management system used.

I do agree with some of the comments made by Bengen in the article:

I think that they need to find a money manager who is willing to do something other than buy and hold. I'll be quite frank about it. Buy and hold in these environments is an invitation to disaster.

I don’t know him, but we certainly agree on that statement. I also like his intentions highlighted in this comment:

You need a money manager who is willing to withdraw your funds from the market when there is high risk present -- and I believe the risk is very high now -- and be willing to then further invest you when values improve and the risk is reduced.

Now days we seem to hear more and more “financial advisers” are realizing that passive buy and hold, asset allocation, and re-balancing isn't enough to meet your objectives for total return and tolerance for loss. I congratulate them for adapting more useful beliefs that doesn't rely solely on faith that markets will go up, but I wonder how many of them held these beliefs before it was so obvious. For example, I have always believed we need to actively control risk and rotate capital between markets like cash, currency, bonds, stocks, and commodities based on a system that is derived from the firm foundation of math. It reminded me of the article “Eating Pie Will Keep You on the Treadmill” I wrote in January 2008. You have to believe and do before, not after. 

A hat tip to KK for sending me this great article for comment.

I will first say that I am not criticizing Bill Miller here. It's not because I'm taking up for him because he's an "active" manager, either. He's a "relative return manager", which is very different from my "absolute return" objective. So, our objectives are very different in our pursuit of actively getting what we want, as are our beliefs. With that said, I believe Bill Miller did exactly what he aimed to do. I believe he followed his funds objective. Which is, according the Legg Mason Value Trust website:

Our goal

Long-term capital growth

What we invest in

The Fund invests primarily in equity securities of large-capitalization companies selling significantly below their expected value due to market inefficiencies or uncertainties about the company. The Fund may invest in companies of any size and can invest up to 25% of total net asset value in debt securities.

Our approach

The Fund's manager uses a value-investment discipline to determine when a company's stock price represents a large discount to his assessment of the company's intrinsic value (the value of all the qualitative and quantitative aspects of the company's business). To determine intrinsic value, the manager focuses on a company's cash earnings, discounting projected future cash flows to see what they are worth today. The manager takes a long-term approach, generally holding securities for long periods to realize the growth potential, resulting in relatively low portfolio turnover.

If you read that, it says nothing of managing risk or controlling drawdown. The objective is "invests primarily in equity securities of large-capitalization companies selling significantly below their expected value", which says nothing about not losing 50% or more in a year. So, I will suggest that Miller probably did a good job and met his objective. The issue, then, is that some of his investors probably underestimated the risk and their tolerance for loss. As I've said before, a value investing strategy, or any counter trend method that bets against the trend, is high risk. In fact, it may be unlimited risk. You see, Bill Miller didn't have a predefined exit point in which he would exit a position if he’s wrong. In fact, he would actually buy more if a stock he entered when down more. That works, until it doesn't. All it took was a real bear market in stocks for him to take on heavy losses. Value investing, or any counter trend method that bets against the trend, is high risk, not less risk. As I said in Conventional wisdom has risk wrong: how it's defined, measured, and managed, nearly every blow-up in history was some method betting against the trend. The only way to truly direct and control risk is to decrease exposure to the possibility of a loss.

With that in mind, read Bill Miller to Step Down From Legg Mason Value Trust Fund to see my point. 

Asset allocators use the so-called Modern Portfolio Theory in attempt to measure risk. But linear equations like standard deviation try to simplify the data to the point it grossly fails to capture the true potential for loss. Equations like standard deviation, in fact, aren't very useful in understanding market data. A good way to understand the problem is the flaw of averages: a 7 foot tall guy can drown in a pond that averages only 3 feet deep. If you don't consider the maximum drawdown (historical decline), in this case the maximum depth, you will greatly underestimate the risk.

Source: http://www.flawofaverages.com/

Market trends move far higher and lower from its average to fit nicely into a bell shaped curve. The bell curve for market data is asymmetric, not a picture of symmetry. It’s people who use such an equation that have outlier losses that are much larger than they expected.

The conventional wisdom of stock picking is the “value investing” methods popularized by Ben Graham in his first edition of Security Analysis in 1934. Ben Graham actually argued against measures of risk based upon past prices (such as volatility), saying that price declines can be temporary and not reflective of a company’s true value. He argued that risk comes from paying too high a price for a security, relative to its value and that investors should maintain a “margin of safety” by buying securities for less than the true worth.

I completely disagree with this part of the Graham “margin of safety”. His margin of safety assumes that you can actually buy securities for less than they are worth. In other words, you need to know that in advance and others don’t. It assumes the outcome is determined by the point of entry. I believe just the opposite. I believe the outcome is controlled by the exit – we don’t know the outcome in advance, so the results are determined by what point you sell. Graham’s “margin of safety” assumes you are right to begin with. so your risk management is achieved from paying a price so much lower than true value that you have room (a margin for error). That may have been more possible prior to 1934. Anyone who believes they are so right at the point of entry because they are paying such a low price, then, certainly won’t exit the position if it goes a lot lower. If you have no predefined exit on the way down to protect against large losses, I guess your exit is $0, and your risk is "all of it".

That’s what’s happened in nearly every major blowup in history. If you walk into a pond that is an average of 3 feet deep and you start walking faster as it gets deeper and deeper, you are increasing the chance you may drown. Starting out deeper in the water isn't going to change that.

Long Term Capital Management, one of the biggest blowups in history, assumed the markets they traded wouldn’t trend agsinst them any further, so they kept betting against the trend buying lower and lower until they couldn’t anymore. With a few Nobel Prize winning PhD’s on staff, they certainly believed they were right and got caught tight in the loss trap. They lost billions. 

In 2008 the Wall Street Journal printed The Stock Picker's Defeat about Bill Miller. Bill Miller’s Legg Mason Value fund has been criticized much since it’s large losses during the 2008-2009 period. Miller buys stocks he considers to be undervalued. That very worked well for about 15 years, but they learned how risky buying declining stocks can be. He was simply following his objective. It said nothing about any aim to manageme risk or capital preservation. If you keep buying what is falling, betting against the trend, you have to realize the fact that you are probably risking it all. A value investor believes a lower price is simply a higher “margin of safety” and that probably works until it doesn’t. When it doesn’t, you may be whipped out.

A more recent fund example is Bruce Berkowitz and his Fairholme Fund. A few weeks ago CNN Money wrote "Fairholme Fund loses half its value and its co-manager". It's another "value" fund that buys declining stocks hoping they go back up. They may turn out to be right, but in the meantime their losses are apparently too large for their investors. According to the article, they manage billions but billions have been withdrawn from the fund in addition to the capital loss.

Conventional wisdom seems to believe that "buying low, selling high" is some form of risk management. So, when some people hear something that sounds just the opposite, like my recent interview in Investor's Business Daily, they perceive it as more risky. Yet, it's just the opposite. Buying things that are rising and selling when they decline is a tactic of managing exposure to loss that is absolute. Defining risk as the difference between the price today and the price we'll exit if to goes down is an absolute form of risk management. 

Another recent example is John Paulson, a hedge fund manager who become famous for profiting during the 2008 period crisis by betting that the strong housing market trend would reverse. It did... that time. Reuters recently wrote "Big losses for John Paulson". He apparently bet too big against the trend this time and took on huge losses. In this case, reportedly even he is losing sleep over the losses, according to "Losses mean sleepless nights for John Paulson". You can probably see how the more you believe you are right, the more that loss trap is likely to keep you awake at night. When your ego is tied to your opinions, it's hard to let it go and cut loose from the trap. 

I was reminded of these things today when I read this in IBD about MF Global. 

The brokerage bought up bonds of Italy, Portugal, Spain and Ireland last year, betting they would have bounced back by now. But the euro-zone debt crisis continued to fester, and MF Global started running out of cash.

The bold highlight is mine. You can probably see how conventional wisdom is the very tactics that lead to such blow-ups. Efficient Market Theorist point to such managers as examples of the problem with "active management", but it's really only an example of the problem of the most common approaches - the kind that get risk wrong.

If you're talented, don't go into a business in which the macro environment will determine your success

-Ray Dalio, President of Bridgewater Associates, a $90 billion hedge fund manager.

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.

A performance incentive fee is the key compensation for a hedge fund manager. Many people may not understand the concept of "alignment of interest". For example, a family office recently told me they only invest in private funds because of alignment of interest. Essentially they want the fund manager to profit when they do. For example, if a $50 million private fund earns a 10% net return, the fund manager would earn $1 million of the profit as a performance incentive. If the fund manager earned a 100% return, his compensation would be $10 million. If the fund manager has a loss he gets no performance incentive fee until the loss is fully recovered and the fund reaches a new high. You can probably see why some money managers focus on growing the fund through the process of trading rather than trying to find more and more new investor money. I know people across various sides of the money management industry - the incentives and motivations are vastly different depending on their business structure and specialization. A wealth manager that measures success by assets under management will focus on gaining new clients. An alternative portfolio manager pursuing asymmetric investment returns may have an incentive to focus more on the profits they generate. That is, if you really believe you've got some skill, you'll want to align your rewards in that direction. At least, that's what an entrepreneur who sells a business for $100 million may tell you.

This thought-provoking article "More hedge funds lured to new source of capital" written by Alistair Barr at MarketWatch takes the concept of incentive to a whole other level:

Hedge funds typically charge 2% management fees and they get about 20% of any profit each year. First-loss capital changes this in a big way.

Allocators like Topwater usually invest about $45 million as long as hedge fund managers agree to put up 10% of that from their own wallet — in this example $5 million.

Topwater pays a performance fee on the $45 million that’s more than double the industry standard of 20%. This fee is paid monthly, if the manager makes a profit in the period.

However, if the manager loses money during any month, that money comes out of their own capital and Topwater’s $45 million remains intact. In this way, the hedge fund managers put themselves in the “first-loss” position, in return for the capital.

Source: MarketWatch

The opposite of active is inactive, or passive. Some people pursue an active approach to earning investment returns. Others pursue a passive approach.

To fully understand the meaning of a word, it can be useful to study it's meaning.

The synonyms for passive are inert, unreceptive, submissive, flaccid. An antonym for passive is proactive.

I relate better to the synonyms for words like tactical: planned, calculated, deliberate, premeditated, considered, intentional. Tactical asset management is the intentional actions that are calculated, planned, and deliberate pursuit of investment objectives.

To decide between active and inactive, it may be useful to explore the words. The following are from Microsoft Word.

Which do you choose?