Monday, 5 May 2014

What lies ahead of the curve?

My ex-boss often spurred us underlings to ‘stay ahead of the curve’.

Sometimes this got misquoted as ‘stay ahead of the curb’, which has a marginally different meaning: the curb is the edge of a street, while a curve was the crest of a statistical distribution. One leads to traffic accidents, while the other led to alleged powers of prophecy, and a period of see-I-told-you-so opportunities. 

For a time, I took the saying at face value because, hey, even if I was wrong, at least I was first. But initial naivety aside, I think the deeper question is, ‘when does on run with the herd, and when does on stand against the herd?’


From another perspective, the question becomes whether the herd right or wrong about what lies ahead.  Media headlines tend to revolve around negative news, like riots and protests. Rioters clash with police, destroy property, or break out. Generally, bad things tend to get reported when herds are involved.
However, research suggests, what gets reported in the media is only a small fraction that misrepresents what doesn’t get reported. In other words, what gets reported isn’t a fair representation of what happens when crowds congregate. This isn’t a question of journalistic quality, but rather a disconnect from reality that is likely to happen when you try to condense 24 hours into ten 3-minute segments on a daily basis.

That’s approximately 2% of a day that gets broad media attention, of which the decision of what gets into that 2% is sometimes driven more by ratings than content, according to The Newsroom. Or according to the Press Freedom Index, that 2% is driven more by restrictions rather than releases of information.

But returning to the question of whether the herd is right or wrong raises two questions in my mind: 1) who is in the herd?  and 2) what is the herd saying?

I’m generally not a fan of herds of ideologically driven zealots, which includes well-educated and intelligent zealots. However, intelligence and experience and track record do play a part in whose opinion I’d give more weight. George Soros has a longer and more notable track record than Peter Schiff for instance. And if I had to choose a herd, I’d probably face in the same direction as Soros, all else remaining equal.  Listening to the herd is a matter of understanding the argument and the implications of what that argument entails.

Both questions has problems – the first borders on ad hominem fallacies and the second has the problem of overgeneralization, because herds are not Borg-like hive minds (at least not for long anyway) and teasing out what the herd is really saying is like trying to read the comments column on Youtube.

But they seem pretty fair questions to ask of any large group of people heading in a single direction.

Tuesday, 29 April 2014

Portfolio action: Buying Russia

Over the past week, I made a switch in my portfolio. Once again, this is my attempt to document the rationale for the following decision.

I’m selling out of China, making the decision to buy into Russia.

Reason 1: Russia looks cheap
So says JP Morgan in their 2Q 2014 Guide to the Markets publication.
 Source: MSCI, FactSet, J.P. Morgan Asset Management. Data as of 3/31/14.

From the same source, Russia’s current PB ratio is 0.6x versus the 10 year average of 1.4x. As a general rule of thumb, if it’s selling at less than 1x PB, it’s cheap.

But we know what is cheap, can get cheaper, especially if it finds itself under pressure from financial shocks. 

But it’s not like Russia is in danger of a shadow banking-fuelled debt crisis.

Reason 2: Russia’s survivability looks okay
I’m not going to try to argue that Russia’s going to have a fantastic time in the next few years. People with crystal balls bigger are welcome to project as far as they want. But what I see is Russia looks sufficiently buffered to handle a fair amount of economic whoopassery before they really crumble.
Source: World Databank, World Development Indicators , last updated 9 April 2014.
Having said that, that’s pretty much all the reason I’d have for putting my money in the hands of a  Russian fund. The question now is really, which one?

Three funds, three track records
To bring the question into focus, I need to know what exactly I’m looking for, and that is the fund that is most likely to deliver outperformance over a market cycle. I haven’t much idea where in the market cycle the Russian market is (although valuations suggest it’s closer to the bottom than it is to the top) but I do have some idea that the market will still be intact once it turns up.

So I’m looking for is a fund that has the greatest likelihood of delivering outperformance over a market cycle. The way I’ve chosen to approach this question is to look at historical 3-year returns of the underlying market, and compare each fund’s corresponding return in each period.

Here’s the 3-year rolling return of the Russian market, represented by the FTSE Russia TR USD. All total return data in SGD terms unless otherwise specified.

It’s a pretty ugly picture if you bought Russia around October 2010, as 3-year returns of the market since then have been increasingly negative. If you had entered in March 2011, 3 years later in March 2014, chances are you’re looking at a negative 40% return or so.

But let’s rearrange history a little bit by sorting returns from high to low, giving us a smooth curve.

The chart above shows the historical 3-year returns every day for the past 5 years (end-March 2009 to end-March 2014). Returns have been as poor as -40% or so, to as high as 60% or more.
Here’s the fun part, taking the corresponding fund excess returns (arithmetic difference between fund returns and market returns) for each period, and throwing them against the market return to see when the fund delivers what sort of excess return. 

Three funds: H, J and P are plotted against the sorted historical returns of the FTSE Russia TR USD.

H: Could be worse. Fund tends to underperform most of the time, but keeps underperformance to around 10% to 15%. Noted outperformance in the region 15% to 30% when the market rallies strongly.

J: Looks pretty high beta. Like H, tends to underperform most of the time, but unlike H, underperformance seems worse when markets are not doing much, returning as much as -20% excess return at some points. Upside is noticeably higher when market rallies – in the range of more than 40% excess return in a strong market rally. I guess that’s what keeps investors coming back for more.

Lastly, P: Of the three, arguably the steadiest downside management. By some market voodoo hoodoo, fund has kept performance positive most of the time, across positive and negative conditions. The most the fund has underperformed over a three year period is less than -10%. Meanwhile, upside is as high as 40% in some cases.

On this basis, I’m going with fund P.

I’ll review this decision three years down the road, in March 2017.