Category: Investing Insight

Investing insight to make you a better investor.

Will Your Strategy Outperform?

0

Came across an interesting paper: Will My Risk Parity Strategy Outperform? Robert M. Anderson, Stephen W. Bianchi, CFA, and Lisa R. Goldberg. Even though they discuss risk parity, they make some pretty interesting points that relate to all investment strategies.

Today’s alpha is tomorrow’s beta

… the introduction of new securities can have an indirect effect; a strategy that was seemingly profitable in the past might have been less profitable if the new securities had been available and thus made the strategy accessible to a broader class of investors.

Before index ETFs, there was no cost-effective way of replicating an index. For example, NIFTYBEES was listed in 2002 and came with an expense ratio of 0.80% while retail brokerage charges were in the 0.5-1.0% range. Replicating the NIFTY index before NIFTYBEES came around was expensive. So any backtest before 2002 that that tries to argue the benefits of buying-and-holding an index ETF is likely bogus. Similarly, today’s active management strategies available to a select few hedge-fund investors are tomorrow’s “smart beta” ETFs that will be available to anybody with a demat account.

Leverage is an external source of risk

The notion that levering a low-risk portfolio might be worthwhile dates back to Black, Jensen, and Scholes (1972), who provided empirical evidence that the risk-adjusted returns of low-beta equities are higher than the CAPM would predict.

There are periods when banks pull their lines of credit based on macro factors that has nothing to do with your strategy. For example, during the 2008 financial crisis, your bank/broker would have pulled your credit lines forcing you to sell near the bottom and preventing you from buying the bounce. Any strategy that uses leverage – risk-parity, for example – should factor this risk.

Performance depends materially on the backtesting period

Even if we were reasonably confident that one strategy achieved higher expected returns than another without incurring extra risk, it would be entirely possible for the weaker strategy to outperform over periods of several decades, certainly beyond the investment horizon of most individuals…

Besides, most strategies have a rebalancing frequency – once a month, once a year, and so on. The specific day you choose to rebalance can have a material impact on your strategy. For example, rebalancing during options expiry, corporate events, etc… can meaningfully skew your risk/returns.

Borrowing and trading costs can negate outperformance

Value-weighted strategies require rebalancing only in response to a limited set of events. The risk parity and 60/40 strategies require additional rebalancing in response to price changes and thus have higher turnover rates. Leverage exacerbates turnover.

There is huge execution risk involved in strategies that requires shorting of shares. Given the regulations surrounding SLBS – lending/borrowing allowed only on those securities that are listed in F&O and that too only in increments of lot-sizes – the friction involved in shorting stocks are prohibitive.

Execution drift

There is likely going to be a big difference between model execution prices and actual execution prices. For example, when we rebalance our Themes, we use the latest available price in our database. These prices themselves could be stale by over 10 minutes. These changes then have to percolate down to investors who execute them in the market. From start to finish, there could be a price gap of over 20 minutes – a significant source of drift between the ideal P&L and actual P&L.

Conclusion

Investors should have a deployment checklist for their strategies that addresses the issues raised above. What we have found is that most strategies that look good on a simple backtest don’t look that great when costs, variable periods, drift and half-lives are factored in.

Categories , Tags

The Problem with Dynamic P/E Funds

0

Executive Summary

Dynamic P/E funds use the market Price-to-Equity ratio to decide on allocation. If the P/E ratio is deemed too high, they allocate more to bonds or arbitrage strategies and if the P/E ratio is low, they allocate more towards equities. This logic sounds good on paper. However,

  1. The market always appears expensive around turnarounds – investors miss out on the recovery trade.
  2. The market always appears cheap during downturns – investors end up being long equities when bonds tend to outperform.
  3. It doesn’t protect against volatility as a pure-play bond fund would (bad fit if you are risk-averse.)
  4. It doesn’t give you the returns of a pure-play equity fund (bad fit if you are risk-seeking.)
  5. Since it dampens volatility, it doesn’t make sense to dollar-cost-average (bad fit if your looking for an SIP.)

It is a solution looking for a problem.

Analysis

We thank Franklin Templeton for running the Dynamic PE Ratio Fund Of Funds to perform our analysis. This is probably the only fund where a true apples-to-apples comparison can be made between a pure-play equity fund, a pure-play bond fund and a dynamic PE fund.

The Dynamic PE fund invests x% in the Franklin India Short Term Income Plan and 100-x% in the Franklin India Bluechip Fund based on the P/E ratio. All we have to do is look at how a buy-and-hold strategy of the components compare to the Dynamic PE fund to gauge the effectiveness of the strategy.

Dynamic PE vs. pure-play Equity

Between 2007-01-02 and 2015-09-23, Franklin India Dynamic PE Ratio Fund of Funds-Growth’s IRR was 10.93% vs. Franklin India Bluechip Fund-Growth’s IRR of 11.53%

Franklin India Dynamic PE Ratio Fund of Funds vs. Franklin India Bluechip Fund

drawdowns dyn pe vs. bluechip

Similar returns. Lesser drawdowns. Lump-sum investors will probably be fine with these returns.

Dynamic PE vs. pure-play Bonds

First, let’s compare the Dynamic PE fund to the Short Term Income Plan.

Between 2007-01-02 and 2015-09-23, Dynamic PE Ratio had an IRR of 10.93% vs. Short-Term Income Plan’s IRR of 9.49%

drawdowns dyn pe vs. liquid fund

For investors worried about drawdowns, just investing in the liquid fund would have given similar returns with a lot less risk. A 35% drawdown is a lot for a fund that gives bond-like returns.

A bond fund like the Birla Sun Life Dynamic Bond Fund, for example, had an IRR of 9.65% over the same time period

Conclusion

Using the P/E ratio for asset allocation is a bad idea. Investors would have experienced similar returns but with smaller drawdowns if they had invested in a regular bond fund instead.

Related: Dynamic PE Funds

Categories , Tags

Profiting from PE Ratio Obsession

0

Background

We are not big fans of using the Price-to-Earnings ratio. We saw how funds that use the market PE to time the market are no better than a buy-and-hold strategy (sometimes B&H performs better,) and we followed that up with how every single “ratio” has a caveat. And PE is the dumbest of them all.

However, if a large group of market participants pay attention to single flawed metric, then there should be a profitable arbitrage strategy that exploits that anomaly?

Exploiting PE obsession

Researchers in the US figured out a way to do just that.

Active investors with limited attention and capital constraints use fundamental metrics to screen and sort potential investments. Price-earnings (P/E) ratios are extremely popular, and are typically calculated using four trailing quarters of net income. Changes in the rankings of published P/E ratios may influence investor attention and subsequent excess returns. From 1974-2013, decile long-short portfolios formed on characteristics of P/E rankings which are rebalanced monthly earn value-weighted monthly excess returns of 101 basis points with annual Sharpe ratios of 0.79. Decile long-short portfolios which are rebalanced daily earn value-weighted daily excess returns of 16.99 basis points with annual Sharpe ratios of 2.91. Excess returns are robust to size, value, profitability, investment, price momentum, earnings momentum, short-term reversals, and relative volume. Changes to a stock’s P/E ranking predicts excess returns even when the stock’s P/E ratio itself does not change. The return premium cannot be explained by fundamental risk, clustering of attention at round number P/E ratios, or autocorrelation in the regressors.

We haven’t tested this for the Indian market yet. But this is just too cool not to share!

Paper: Rankings of published price-earnings ratios and investor attention

Categories , Tags ,

Beware of Single Factor Investing

0

Factors are short-cuts

Analyzing financial statements is a cumbersome process for most retail investors. Many don’t have the time, patience or expertise to dig through balance-sheets, income and cashflow statements. Most don’t find joy in reflecting on the many footnotes that accompany such statements. Here lies the attraction of single-factor investing.

Price-to-Earnings (PE) ratio is one such factor. We recently saw how there was no great advantage in investing in mutual funds that use PE to switch between debt and equity. It is a poor market timing indicator even when practiced by professional fund managers.

The ‘E’ in PE

The ‘earnings’ line-item is an accounting driven artifact that is easily gamed and has very little relationship with the company’s value. Here’s what Michael J. Mauboussin has to say about earnings, see appendix for the full note:

… an increase or decrease in earnings does not provide a clear picture of the corresponding increase or decrease in shareholder value. This is because the earnings figure does not reflect the company’s level of risk, does not take into account the investments needed for anticipated growth, and is subject to a wide variety of accounting conventions. Such accounting conventions do not ordinarily affect cash flow and hence do not affect a company’s value.

Even Shiller’s cyclically-adjusted P/E (or “CAPE”) has little predictive value in the short term. Shiller CAPE shows its strongest correlation to nominal returns over an 8-year time horizon, and is actually most predictive of real returns over an *18* year time horizon. (Kitces)

Some investors also look at Price to Book and Return on Capital Employed. These ratios provide a convenient short-hand but are far from adequate in forecasting future earnings.

Besides what does the ratio of total assets to total liabilities measure anyway? Intangibles can’t be quantified. Are inventories adjusted to current market prices? Is the loan loss reserve adequate?

Bottom line: Assets are often overstated and liabilities understated. (Fool)

What does “capital employed” mean anyway?

  1. No general agreement exists on how capital employed should be calculated, on whether initial or average capital employed should be used or on how profit should be defined.
  2. Often, accounting profit rather than cash flow is used as the basis of evaluation.
  3. It ignores the time value of money.

Take away

Every style of investing – value, momentum or factor – depends on finding historical patterns and extending them into the future.

Every valuation metric comes with a “yes, but…”

No single factor is a predictor of future returns.

Appendix

Categories , Tags

The Treasure in Treasury Operations

0

Treasury Operations of Banks

First the Wikipedia definition: Treasury management (or treasury operations) includes management of an enterprise’s holdings, with the ultimate goal of managing the firm’s liquidity and mitigating its operational, financial and reputational risk. Treasury Management includes a firm’s collections, disbursements, concentration, investment and funding activities. In larger firms, it may also include trading in bonds, currencies, financial derivatives and the associated financial risk management.

For a bank, this means asset/liability management, hedging interest rate risk, managing reserve and capital requirements, etc. It is also something banks provide as a value added service for their clients.

Revenue from Treasury Operations

Banks break out segment revenues that include revenue derived from treasury operations. However, they don’t carve out how much of it was proprietary trading. This is the average quarterly revenue from treasury operations since June 2014 (in Rs. Cr.) of major Indian banks:

bank.treasury.revenue

In fact, for a few of them, revenue from treasury operations exceed from those from retail banking.

bank.treasury.retail.revenue

The need for more disclosure

The revenue from treasury ops is a black box. If most of that revenue is derived from prop trading, then investors need better disclosure of the risks that were taken. Recently, YESBANK got pummeled on a UBS report that raised doubts over their exposure to stressed companies. As a retail investor, we really don’t have a clue about the risks involved in holding equity in what could turn out to be a hedge fund in bank’s clothing.

Categories , Tags