A LONG-RUN VIEW ON EXPECTED RETURNS

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1 A LONG-RUN VIEW ON EXPECTED RETURNS Dr. Thomas Maier, CFA 1 Mehr erkennen. Mehr erreichen.

2 CONTENT I. Avoidance of Potential Losses II. III. IV. Trend Following Low Beta Quality Factors V. Hedge Funds VI. Summary 2

3 AVOIDANCE OF LOSSES Claim: For decent long-term returns, large losses on the way must be avoided. Example: Consider an uncorrelated pharma stock currently trading at a price of 100 and two investment periods. In each period, the stock returns either -30% or +40% with equal probability. A loss in the first period cannot be outweighed by a gain in the second period: = 98. 3

4 LOSSES AND EXPECTED RETURNS Claim: For decent long-term returns, large losses on the way must be avoided The compounding effect comes into play only with a probabilistic point of view. The expected return is +5% in one period and % over two periods. 4

5 DO POTENTIAL LOSSES MATTER FOR EXPECTED RETURNS? Claim: For decent long-term returns, large losses on the way must be avoided. The assertion is true from an ex-post point of view. From a portfolio management point of view, the ex-ante point of view matters. The assertion neglects the probabilistic view of expected returns. For expected long-run returns, the size of potential losses on the way does not matter. 5

6 CONTENT I. Avoidance of Potential Losses II. III. IV. Trend Following Low Beta Quality Factors V. Hedge Funds VI. Summary 6

7 THE TREND IS YOUR FRIEND Claim: In the long run, trend following provides market-independent returns. To examine this assertion, we should define what trend following is. The trend following strategy can be specified as follows: 1. The underlying market (e.g., the equity market) 2. Lookback period (e.g., six months) 3. Holding period (e.g., two months) 7

8 TREND FOLLOWING UNIVERSE: THE LOOKBACK PERIOD Claim: In the long run, trend following provides market-independent returns. Trend Followers Lookback Period 10% 70% 20% Focus on short term (up to one week) Focus on mid term (one week up to 6 months) Focus on long term (at least 6 months) Sources: Pertrac, FERI, own calculations and estimates 8

9 TREND FOLLOWING UNIVERSE: THE HOLDING PERIOD Claim: In the long run, trend following provides market-independent returns. 2% Trend Followers Holding Period 25% Focus on short term (up to one month) Focus on mid term (one month up to 6 months) 73% Focus on long term (at least 6 months) Sources: Pertrac, FERI, own calculations and estimates 9

10 TREND FOLLOWING: SKEW OF UNDERLYING MARKETS Claim: In the long run, trend following provides market-independent returns. Number of return observations Return realization Equity markets, credit markets, and many other asset classes tend to exhibit a left-skewed return distribution. Source: Wikipedia 10

11 TREND FOLLOWING: POSITIVE DELTA IN AVERAGE Claim: In the long run, trend following provides market-independent returns δ Positve δ Negative DAX Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Lookback period of twelve months. Sources: FERI, Pertrac 11

12 THE TREND IS YOUR FRIEND Claim: In the long run, trend following provides market-independent returns. If trend followers are delta-positive on average, can the same long-run returns be generated with random delta-positve exposure (i. e., without any trend following)? Take three simple indices: World Government Bond Index in local currency MSCI World Bloomberg Commodity Index In each period, set asset class exposure randomly between -100% and +100% with a positive bias of +50% 12

13 THE TREND IS YOUR FRIEND Claim: In the long run, trend following provides market-independent returns. HFRX Risk Table Month Quarter Annualized Compound Return 0.33% 1.00% 4.04% Standard Deviation 2.76% 4.90% 9.54% Semi Deviation 2.51% 4.00% 8.69% Gain Deviation 2.01% 4.05% 6.96% Loss Deviation 1.34% 1.99% 4.64% Downside Dev. (10%) 2.07% 3.82% 7.16% Downside Dev. (0.5%) 1.61% 2.38% 5.57% Downside Dev. (0%) 1.59% 2.31% 5.49% Sharpe (0.5%) Sortino (10%) Sortino (0.5%) Sortino (0%) Skewness Kurtosis Jarque-Bera Omega (1%) Blend of exposure to each class Risk Table Month Quarter Annualized Compound Return 0.34% 1.02% 4.15% Standard Deviation 3.86% 7.33% 13.37% Semi Deviation 4.58% 8.45% 15.86% Gain Deviation 1.95% 3.88% 6.74% Loss Deviation 3.17% 6.53% 10.98% Downside Dev. (10%) 3.20% 6.35% 11.10% Downside Dev. (0.5%) 2.84% 5.31% 9.84% Downside Dev. (0%) 2.82% 5.25% 9.78% Sharpe (0.5%) Sortino (10%) Sortino (0.5%) Sortino (0%) Skewness Kurtosis Jarque-Bera Omega (1%) Sources: HFR, Pertrac, FERI. Data from January 2005 to April

14 TREND FOLLOWING Claim: In the long run, trend following provides market-independent returns. It is true that trend following provides positive uncorrelated returns over the long run. However, the same expected returns can be generated by being randomly long and short the major asset classes with a positive delta on average. Over the long run, trend following works if 1. the underlying asset classes bear a positive risk premium and 2. the long-term average delta is positive. Over the long run, it is the average positive market exposure that determines expected returns. 14

15 CONTENT I. Avoidance of Potential Losses II. III. IV. Trend Following Low Beta Quality Factors V. Hedge Funds VI. Summary 15

16 THE LOW BETA ANOMALY Claim: Investing in low-beta stocks provides better returns than the market. To test the hypothesis, we have to define what low beta means and what better returns are: Beta is usually defined as historical beta over the last twelve months. Typically, better returns means better Sharpe Ratio. So, the claim becomes: stocks with low historical beta will have better Sharpe Ratios than the average stock. 16

17 THE LOW BETA ANOMALY Claim: Investing in low-beta stocks provides better returns than the market Fresenius Volkswagen vz DAX Deutsche Bank Commerzbank Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Sources: FERI, Bloomberg 17

18 THE CONNECTION BETWEEN BETA AND VOL Claim: Investing in low-beta stocks provides better returns than the market. β i = ρ im σ i σ M Beta can be considered directly proportional to both volatility and market correlation. On average, the low beta stocks are those with low volatility. 18

19 EXPECTED RETURNS FROM THEORY Claim: Investing in low-beta stocks provides better returns than the market. Expected Return and Sharpe Ratio Beta Expected Return Sharpe Ratio In practice, the expected return rises slowly with beta. Volatility, however, rises linearly with beta. 19

20 SHARPE RATIO Claim: Investing in low-beta stocks provides better returns than the market. Sharpe Ratio = E R i R F σ i Although the expected return rises with beta, the volatility increases faster. The low-beta anomaly effectively states that low-beta stocks have lower volatility. 20

21 THE LOW BETA ANOMALY Claim: Investing in low-beta stocks provides better returns than the market. Summary: It is true that low beta stocks provide higher Sharpe Ratios than high beta stocks. The reason is that the Sharpe Ratio uses volatility as a risk measure, and low-beta stocks tend to have low volatility. However, low beta stocks will not maximize expected returns. If one wants to maximize the Sharpe Ratio, one should not invest in equities at all. 21

22 CONTENT I. Avoidance of Potential Losses II. III. Trend Following Low Beta IV. Quality Factors V. Hedge Funds VI. Summary 22

23 SOME BASIC FACTORS OF QUALITY 1. Size of economic moat 2. Size of firm 3. Consumer trends 4. Large capex and growing sales at the same time 5. Long company history 6. High dividend yield 7. Corporate management execution 8. Headcount in management 9. Turnover rate in management 10. Transparency 11. Profitability 12. Cash flow 13. Positive financial momentum for several years in a row 14. Operating CF versus profit 15. Inventories 16. Accounts receivable 17. DCF 23

24 SOME MORE QUALITY FACTORS 1. Growth of 2. Stability of 3. Stability of growth of 24

25 AN EXPERIMENT: THE GERMAN QUALITY INDEX The German QIX is based on the following factors : Historical profit margin and its volatility (20%) Low volatility of equity price (15%) Historical ROE (10%) Low financial leverage (10%) High historical sales growth and stability (10%) High historical dividend growth and stability (10%) Some other factors (25%) 25

26 THE GERMAN QUALITY INDEX SDAX MDAX DAX TecDAX QIX Deutschland Source: Bloomberg 26

27 CONTENT I. Avoidance of Potential Losses II. III. IV. Trend Following Low Beta Quality Factors V. Hedge Funds VI. Summary 27

28 HEDGE FUNDS PROVIDE ALPHA Claim: Only invest in hedge funds with a proven track record of alpha. We should define what alpha actually is. 28

29 RETURN SOURCES OF HEDGE FUNDS Alpha or Beta α Alpha is the part of performance that cannot be explained by the regression model. β Beta is the part of performance that can be explained by the model. There are many markets, asset classes, and return sources. Therefore, there are many alphas and betas. The definition of beta should also include such alternative betas as Merger Spreads, RMBS Spreads, Short Interest, VIX, Momentum. 29

30 DYNAMIC FACTOR ADJUSTMENT An equity long-short fund with an average net exposure of 40% to a sector Fund Index Fund Adj. Index Fund Adj. Index + Factor Fund Adj. Index + Factor 1 + Factor 2 30

31 EQUITY MARKET EXPOSURE OF HEDGE FUND STRATEGIES Source: Credit Suisse, Q

32 HEDGE FUNDS PARTICIPATE MORE AND MORE ON THE DOWNSIDE Source: Credit Suisse, Q

33 ALPHA AND BETA Significant (alternative) beta means, the return sources are well identifiable. High Alpha means, the return sources are not yet well identified. Optimally, a hedge fund shows low alpha and several significant alternative betas. 33

34 CONTENT I. Avoidance of Potential Losses II. III. IV. Trend Following Low Beta Quality Factors V. Hedge Funds VI. Summary 34

35 SUMMARY Over the long run, it is not optimal to try to avoid any potential loss. Trend followers are driven by their positive delta. Low beta stocks do not provide higher expected returns, yet higher Sharpe Ratios. The historical outperformance of many quality factors is based on data-mining. The higher the historical alpha the less one understands the hedge fund s return sources. Factors induce a positive risk premium only if they 1. represent risks that are not diversifiable (i. e., the risk cannot be eradicated with diversification), and 2. are associated with a real, adverse risk (e. g., reputation risk, market risk, liquidity risk). 35

36 Dr. Thomas Maier, CFA FERI Trust GmbH Haus am Park Rathausplatz Bad Homburg Die vorliegende Präsentation (die Präsentation ) enthält Angaben, Analysen, Prognosen und Konzepte, die lediglich ihrer unverbindlichen Information dienen. Die Präsentation ist keine steuerliche, juristische oder sonstige Beratung und stellt kein Angebot für die Verwaltung von Vermögenswerten oder Empfehlung/Beratung für Vermögensdispositionen dar. Die Präsentation ist auch kein Angebot für ein bestimmtes Investment. Für jedes bestimmte Investment und/oder für die Verwaltung von Vermögenswerten sind ausschließlich die jeweiligen Zeichnungsdokumente und/oder Verkaufsprospekte und/oder Vertragsunterlagen allein maßgeblich. Die Präsentation ersetzt nicht die individuelle Beratung. Jeder Interessierte sollte eine etwaige Anlage-/Abschlussentscheidung erst nach sorgfältiger Abwägung der mit einem bestimmten Investment/ Vermögensverwaltungsvertrag verbundenen Risiken treffen und zuvor rechtliche sowie steuerliche und ggf. sonstige Beratung einholen. Wir akzeptieren keinerlei Verantwortlichkeit gegenüber dem Empfänger der Präsentation und von dritten Personen im Hinblick auf Handlungen, die auf der Basis der vorliegenden Präsentation vorgenommen werden. Die Präsentation ist auf Basis subjektiver Einschätzungen von uns erstellt worden. Die Wertentwicklung in der Vergangenheit ist keine Garantie für eine zukünftige Wertentwicklung. Preise für und Erträge aus einem bestimmten Investment können sowohl steigen als auch fallen und in keinem Fall garantiert werden. Einige, in der Präsentation enthaltene Informationen basieren auf und/oder sind abgeleitet von Informationen, die uns von unabhängigen Dritten zur Verfügung gestellt wurden. Wir handeln stets in der Annahme, dass solche Informationen richtig und vollständig sind und aus vertrauenswürdigen Quellen stammen. Eine Gewähr für die Richtigkeit und inhaltliche Vollständigkeit der Angaben in der Präsentation kann von uns nicht übernommen werden. Die Präsentation ist streng vertraulich zu behandeln und darf nur von demjenigen verwendet werden, für den sie erstellt wurde und zwar ausschließlich für dessen interne Zwecke. Vervielfältigungen jeglicher Art sind nur mit unserer vorherigen ausdrücklichen schriftlichen Zustimmung erlaubt. 36