Monthly Archives: May 2015

(Partially) Hedging a Portfolio with Futures or Options to reduce Volatility and to a lesser extent Return

After having gone short futures for a client portfolio recently, I needed to explain what effect such a tactical decision has on the portfolio in question to the clients beneficiaries.

Below is a graphical representation of what happens when you hedge part of a portfolio (in a very specific example, this would need to be calculated for each portfolio that was being considered for a hedge).

Firstly the expected volatility is reduced (in my example hedging 15% of portfolio with SMI put options would move the volatily down by around 1%).

Secondly the expected return is reduced (in my example from 4.9% to 4.8%).

While the exact numbers give a false send of certainty and detail, it does go a long way to quickly and graphically showing what happens when you hedge a portfolio.

Hedging can be very interesting to complement a long term buy and hold portfolio, in my opinion. using-options-or-futures-to-reduce-volatility-while-keeping-expected-return-nearly-unchanged

Central Banks In The Driver Seat

The Reserve Bank of Australia always has interesting comments ;

“Low interest rates are acting to support borrowing and spending, and credit is recording moderate growth overall, with stronger lending to businesses of late. Growth in lending to the housing market has been steady over recent months. Dwelling prices continue to rise strongly in Sydney, though trends have been more varied in a number of other cities. The Bank is working with other regulators to assess and contain risks that may arise from the housing market. In other asset markets, prices for equities and commercial property have been supported by lower long-term interest rates.”

– Regulators and National Bank see the housing market as potentially overheating (why mention it otherwise? The SNB here in Switzerland has exactely the same problem; housing overheating). The low long-term interest rates putting in a good bid to the market as a whole.

What could be the key for next months and years? I believe the big question is how this develops/unfolds:

“The Federal Reserve is expected to start increasing its policy rate later this year, but some other major central banks are stepping up the pace of unconventional policy measures. Hence, financial conditions remain very accommodative globally, with long-term borrowing rates for sovereigns and creditworthy private borrowers remarkably low.”

Fed slowing the US housing market. ECB heating up the EU housing market. The BoE heating up the UK housing market. The SNB heating up the Swiss housing market. Makes you wonder if the proverbial frog in the pot will realise it’s in water getting close to the boiling point, or whether there may even by a lid stopping it jumping out in time.

My feeling; at the moment there’s still much too much caution, too much money on the sidelines so that equity markets will see a good deal of M&A before the top there is seen. But there’s also a lot of fast money in the housing markets worldwide. But normally a bubble bursts AFTER an acceleration of a strong trend. To get back to my proverbial point with the frog; there’s cold water being poured into the pot regularly, still.

Looking at the SMI index, I would argue at the moment, that it should be less likely to break the 200 day moving average, than to stop and rebound. My opinion is based on the growing liquidity in Europe (a very important market for Switzerland), the high dividend yields of blue chip companies, the high liquidity held by investors, the lacking alteratives.

smi-jan-2015-may-2015

 

PS: The quotes are from Glenn Stevens, Governer of the Reserve Bank of Australia. They were published today.

Giovanni de Francisci Gets It – Wisdom coupled with good grasp of History and Psychology

That is what I thought when I watched the youtube clip (https://www.youtube.com/watch?v=r5QsIT0KjkU) of Giovanni de Francisci talking about hedge fund managers.

What he said is also just as correct for simple independent asset managers. I have just come through an education programme to become a Certified International Investment Analyst (CIIA) and the amount of modern portfolio theory (MPT) and diversification talk can make people blind to the most interesting investments. Or as Giovanni de Francisi put it in the clip linked above: A hedge fund manager he speaks to has to diversify to satisfy the clients rules so much, that he gives up close to 1/3 of the performance he achives when focussing on his favorite ideas for himself (he can bear the risk). So the hedge fund manager had to hold more positions, just to please many clients who have been indoctrinated by MPT and would not be allowed to invest.

Giovanni de Francisi also tells a great example about a hedge fund manger and his tactic regarding condos in Florida in the aftermath of the subprime crisis (towards the end of the video). Limited downside and over 100% profit opportunity.

Now of course he was talking about his favorite stories. It is therefor more anectodal than scientific. It would be interesting to see how many times he really does get better performance from his selection of fund mangers.

But in my experience the best investments have always been ones that knowledgable private investors would react to the most negative. Talk to someone about russian bonds during the most active part of the Ukraine war. Talk to someone about a condo in Florida in 2009. Psychology of the masses makes the best investments the hardest to stomach. Here’s a great graph Jack Schwager talks about in his book “Market Sense & Nonsense”.

hfr-statistic