Author: shyam

Book Review: Crashed

In Crashed: How a Decade of Financial Crises Changed the World (Amazon,) Adam Tooze gives us a chronological, blow-by-blow account of the 2008 Global Financial Crisis (GFC) and its after-effects.

As a financial history buff, I found the book fascinating, albeit a tad tedious with the details. It also reinforced my belief that you cannot take the politics out of the political-economy – i.e., the study of economics cannot be divorced from politics.

With prices accelerating toward annual increases of 14 percent in 1979, Volcker and the Fed decided that it was time to apply the brakes.

In June 1981 the prime lending rate touched 21 percent.

The result was to send a shuddering shock through both the American and the global economies. The dollar surged, as did unemployment. Inflation collapsed from 14.8 percent in March 1980 to 3 percent by 1983. In Britain this was the crisis with which the Thatcher government began. In Germany it would contribute to Schmidt’s unseating and his replacement by the conservative government of Helmut Kohl. France’s Socialist government under President François Mitterrand would be forced into line in 1983.

Crashed

The Chinese model gets a fair amount of ink and it helped fill some of the gaps I had in my understanding of how the Party, Policy and Politics are intertwined, local vs. central political power, etc.

The book also highlights the all too familiar role of bumbling researchers with errors in the models that unleash large social movements that lasts years after the corrigendum is published. Reinhart and Rogoff’s “Growth in a Time of Debt” lead to painful austerity in England, debt brakes in Germany and birthed the Tea Party in the US. No one wanted to hear later that the analysis was riddled with errors.

Recommendation: Skim.

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Volatility and Allocation

Think in terms of volatility buckets, not assets

This post is part of our series on diversification and asset allocation. Previously:

  1. Diversification and its Malcontents

  2. The Permanent Portfolio

  3. Sequence Risk and Asset Allocation

  4. Static vs. Tactical Allocation

  5. Tactical Allocation

The thrust of our previous posts on allocation was that Indian investors shouldn’t blindly copy strategies that worked well in the US. There are a lot of qualitative arguments to be made to support a India-dominant view for allocation strategies. In this post, we introduce a quantitative aspect to the discussion.

It is Volatility, Stupid!

In finance, more than any other field, it is very easy to get correlation and causation mixed up.

A man goes to the doctor and says, “Doctor, wherever I touch, it hurts.”
The doctor asks, “What do you mean?”
The man says, “When I touch my shoulder, it really hurts. When I touch my knee – OUCH! When I touch my forehead, it really, really hurts.”
The doctor says, “I know what’s wrong with you. You’ve broken your finger!”

There are no universal laws for an asset class that holds across geographies and economic systems. The reason why a 60/40 Portfolio “works” in the US has more to with the quantitative aspects of the assets being mixed than what they are called. US bonds have benefitted greatly from a 30 year slide in yields, benign inflation and a flight-to-safety bid. None of these hold true for Indian bonds. So, expecting a 60/40 Indian portfolio to behave like a 60/40 US portfolio just because you mixed the same assets together is idiotic.

The most import aspect while considering assets for diversification are their volatilities. Specifically, the correlation of their volatilities at their left tails.

To keep things simple, consider a 2 asset portfolio: Eq and X. Eq has some average return that will be held constant during this analysis. What changes is its standard deviation (aka, volatility.) X is a stable asset with zero volatility (think of it as a fixed deposit.) How does different allocations to Eq change portfolio returns and volatility?

  1. Low volatility is supportive of higher allocations

  2. Higher allocations to the higher volatility asset progressively reduces the predictability of portfolio returns

Volatility is Volatile

Asset return volatility is itself volatile.

The past performance of a diversified portfolio is based on the realized volatility of its components. However, volatility itself is unpredictable over long periods of time.

Take-away

While considering assets to diversify into, look at the volatility of the asset rather than what it is called.

Don’t expect the quantitative aspect of an asset class to transcend economic systems – different markets need different treatments.

All investing is forecasting. And all allocation is forecasting volatilities.

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The Permanent Portfolio

Pain is eternal

This post is part of our series on diversification and asset allocation. Previously:

  1. Diversification and its Malcontents

  2. Sequence Risk and Asset Allocation

  3. Static vs. Tactical Allocation

  4. Tactical Allocation

The Permanent Portfolio – an equal weighted allocation to stocks, bonds, gold, and cash – was devised by free-market investment analyst, Harry Browne, in the 1980s. The basic idea is that no matter what the macro environment, the portfolio will not totally crash and burn.

The American Experience

Turns out, the theory largely worked for US investors.

If you look at the rolling 3-year annualized returns of the Permanent Portfolio, never has it given negative returns. In sharp contrast to equities and gold, US bonds have been spectacularly stable. So naturally, an equal weighted allocation to all for assets delivered decent returns with low drawdowns.

Did it work for Indian Investors?

Indian investors need to be careful with their bond allocations.

The Permanent Portfolio allocates 50% towards fixed income. This is a problem for Indian investors because unlike US bonds, Indian bonds do not have a “flight to safety” bid – they tank along with stocks during market panics.

A density plot of annualized 3-year rolling returns highlights the left-tail problem with the Indian Permanent Portfolio:

Take-away

Beware of people preaching simple solutions to complex problems. If the answer was easy someone more intelligent would have thought of it a long time ago – complex problems invariably require complex and difficult solutions. – Steve Herbert

This is another instance of a “copy-paste” solution disappointing Indian investors.

The common thread connecting the misfiring of the 60/40 and the Permanent portfolios is the vastly different paths taken by Indian bonds. Is there a better way to crack this nut? Stay tuned.

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Euclidean Distance for Pattern Matching

Most of us have learnt how to calculate the distance between 2 points on a plane in high school. The simplest one is called the Euclidean Distance – a pretty basic application of the Pythagorean Theorem. The concept can be extended to calculate the distance between to vectors. This is where it gets interesting.

Suppose you want to match a price series with another, ranking a rolling window by its Euclidean Distance is the fastest and simplest way of pattern matching.

For example, take the most recent 20-day VIX time-series and “match” it with a rolling window of historical 20-day VIX segments and sort it by its Euclidean Distance (ED.)

Here, the ED has dug up a segment from November-2010 as one of the top 5 matches. Take a closer look:

While not a perfect match, it “sort of” comes close.

Sometimes, a simple tool is good enough to get you 80% of the way. This is one of them.

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Decoding the 60/40 Portfolio

Get onboard with the embedded assumptions before diving head-first.

The 60/40 allocation – 60% in equities, 40% in bonds – is the bedrock on which most portfolios in the US are built. Jack Bogle was its biggest proponent and it serves as a benchmark in most portfolio discussions.

This post is part of our series on diversification and asset allocation. Previously:

  1. Diversification and its Malcontents

  2. Sequence Risk and Asset Allocation

  3. Static vs. Tactical Allocation

  4. Tactical Allocation

Historical Performance

From a cumulative performance point of view, it is easy to see why it is attractive.

Even with an annual rebalance, the 60/40 delivered. How did it achieve this remarkable feat? Should investors expect similar magic with the same allocation to Indian equities/bonds?

The biggest difference: Volatility

Ever since Volcker got done slaying inflation in the 80’s, US bond yields have been on a secular decline with declining volatility and increasingly occupying the place of a “flight-to-safety” asset.

Indian bonds, however, are in no way comparable to US bonds when it comes to volatility.

Volatility of US Bond returns (3-year, rolling) with those of Indian Gilts:

On a cumulative basis, Indian bond investors have taken a lot of pain for a 50bps out-performance.

Indian bonds haven’t exactly acted as a safe-haven in times of stress for Indian investors. Adding equities into the mix brings out the extreme volatility of Indian stocks:

However, the silver-lining is that Indian asset volatility have been moderating since 2015.

The 60/40

Over a long enough timeline, it looks like the 60/40 should work in India as well.

But, what if, most of the long-term returns that can be seen since 2000 was front-loaded? Rolling-returns over different windows should give us an idea:

The 5-year window shows returns stabilizing around an average of 5% (in USD.)

Embedded forecasts

All investing is forecasting. As much as one would want to follow a 60/40 allocation for its popularity, it behooves to ask: what are the embedded forecasts about Indian equities and bonds in such a strategy?

  1. Bond volatility will continue to go down.

    • The market will continue to deepen.

    • Inflation will be range-bound.

  2. Equities will be loosely efficient.

    • The gap between growth assumptions and equity valuations will be within a gradually tightening band.

  3. Ease of doing business:

    • Contract enforcement

    • Flexible labor laws

    • Infrastructure

    • Bankruptcy protection and resolution

    • Policy stability

Basically, India will move towards an environment with a predictable tax regime, a rules-based fiscal policy, and regulations that are fair and strictly enforced.

Take-away

There are millions of permutations and combinations of securities for investors to allocate. The question that every investor should ask themselves is how much time, effort and money they are willing to spend chasing returns that beats low-cost, set-it-and-forget-it strategies like the 60/40.

If you are in investor who craves simplicity & low-cost and your beliefs about the future is mostly in line with the assumptions presented above, then this is the strategy for you.

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