Friday, December 18, 2009

SURPRISE!!! Max Drawdown and real returns

Everyone loves to beat their benchmark. It's a huge component of portfolio managers' incentive compensation. If a US small-cap core manager beats the Russell 2000 by 1,000 basis points, you may as well drive the Lexus with the big ol' shiny red bow into his garage for his newly-licensed 16-year-old to drive...

...but what if the Russell 2000 lost 20% this year?

Truer words never spoken than this often-repeated phrase: "You can't eat relative returns."

When I was in public accounting a few years back, I asked a COO from a brokerage client of mine how the year was going. He said, halfway in jest, "we had a better year this year...we only shot off THREE toes..."

Barring extraordinary circumstances, there will be periods where money is lost. Hopefully they are very short and the losses are extremely shallow and quickly recoverable. For investments with measurable track records (most seasoned publicly-traded vehicles or benchmark indices) it's critical to me to examine the investment's maximum drawdown (alluded to in an earlier post, Deconstructing Risk and the Magic 8-Ball)...the largest drop from a previous high...to see how strong my stomach is. If you're looking at something with an annual return over time of 15 percent, it sounds great...until you realize that its max drawdown (no, not Max Headroom - that's an entirely different unfortunate occurrence) clocks in at around 50 percent. Are you willing to stomach the real possibility of a loss of half of your investment in this case? Some are, but many others aren't. As Lou Mannheim, Hal Holbrook's character in Wall Street, said (just as Bud Fox was about 30 seconds away from being carted off to jail):

Man looks into the Abyss, and there's nothin' staring back at him. At that moment, man finds his character, and that's what keeps him out of the Abyss.

Gross vs. net returns

A not-so-little gnome eating away at your egg: Fees and expenses. That 15% gross return may look pretty solid, but if it's attached to 1.5% in fees and expenses, it's not quite as stellar as you think it is. $100,000 compounded at 15% annually over 10 years will leave you with a tidy $404,556. Nicely done. However, factor in the 1.5% and you're left with merely $347,809...which means that over those 10 years you've paid out $56,747 in fees. Keep this in mind. Different asset classes and different markets reward portfolio managers differently for skill. Domestic small-cap and international (especially emerging markets) vehicles tend to carry heavier fees and expenses than domestic large-cap and core fixed income products...generally because these markets are considered to be less efficient and, accordingly, greater rewards are to be gained from execution of an active investment strategy.

Inflation: An even bigger bite than we think?

Thanks to the wealth of data from the Bureau of Labor Statistics, I'm happy to report that as of July 2008, the year-over-year change in the Producer Price Index (PPI) finished goods/commodities segment was close to 10 percent. Even as of September 2009, the year-over-year change in the Consumer Price Index (CPI) Health Care segment was about 3.5 percent. Sure, the core CPI (year-over-year decline of 1.29 percent as of September 2009) garners most of the headlines with the PPI well-reported but in the background. This will be the first year in a long time in which the Social Security Administration does not provide a cost-of-living adjustment (COLA) to pensioners. However, keep an eye out for health care costs; invariably they're rising (the minimum year-over-year change in CPI Health Care was 1.34 percent...as of August 1950). As health care and its associated costs are top of mind to many people, this is a metric worth searching out. Let's go back to over 15% and factor in not only over 1.5% fee/expense amount but our 3.5% inflation metric from health care costs, which will potentially be a significant expense when we're getting older and wanting to reap the benefits of our 15%: That $404,556 you started out with on a gross basis represented a gain of $304,556 on your initial investment. Once fees and a 3.5% inflation bite are taken out, your "real" ending value after 10 years is $243,564, for a $143,564 increase in purchasing power in constant dollars. In truth, fees and inflation have, over the course of 10 years, wiped out over half your gain.

The risk-free rate and Sharpe ratios...and inflation (again)

I like the Sharpe ratio in theory. It measures ratio of the excess return of an investment in comparison to a "risk-free" interest rate (yield on US 91-day Treasury bills is often used) over the volatility of said investment...commonly measured in terms of annualized standard deviation. Roughly and arithmetically, let's say the risk-free rate is 1 percent and we have our investment that generates a 15 percent annual return with an annualized standard deviation of 28 percent. Arithmetically we derive a Sharpe ratio of (15 - 1)/28 = 0.50. For a single-asset, long-only strategy, that may look pretty good in and of itself. However, with short-term Treasury yields well below historic norms and at a de facto rate of zero, how much do they really mean in this context? Personally, I prefer to use an "inflation-adjusted" Sharpe ratio which measures the ratio of return of an investment NET of 1) fees and 2) the GREATER of a) the risk-free rate (I tend to use the gross return on a Treasury money market fund here, since it's more readily investable for an individual investor) or b) an inflation metric of your choosing to said standard deviation. So in the case of the original investment, our back-of-the-napkin calculations would leave us with an adjusted ratio of (15 - 1 - 3.5)/28 of 0.375, which means that for every additional unit of risk, we expect generate 0.375 or 3/8 of a unit increase in purchasing power. What would we call that...the Real Sharpe ratio? The Flying Taco or Taco Loco ratio? Either way, I like it because it provides a measure of REAL compensation for risk. Certain investments fare better than others in inflationary times; this measure does well to capture such a notion.

These are a couple of concepts I touched on earlier but deserve a bit more mention in detail because of the huge potential impact to a portfolio's real purchasing power. Hopefully they can be helpful to others in evaluating investments and constructing a solid portfolio where expenses and surprises are minimized. Let's face it - I don't like surprises, unless it's my birthday, and maybe not even then. Besides, on 364 days out of the year, it's not my birthday. So let's try to make them as surprise-free as we can.

Remember what Bud Fox told his dad when it comes to investing:

There's no nobility in poverty anymore.

Wednesday, December 16, 2009

Red Sox Offseason: Weird Harold, Bizarro Theo?

I woke up early this morning and caught the replay of MLB Network’s “Hot Stove” program to see if there was any new off-season moves that I didn’t catch earlier in the day. What I got, instead, was Harold Reynolds about 3 days behind in the news cycle. As the other panelists, including Mitch Williams and Matt Vasgersian spoke of the pending John Lackey and Mike Cameron signings by the Red Sox, Reynolds was a little slow in catching up. He wondered aloud where that left Jason Bay in the mix, noting that “the window may be closing for Bay to sign with the Red Sox.”

Ummm…have you been paying attention, Mr. Reynolds? Bay’s agent himself said over the WEEKEND (mind you, this was a Tuesday night broadcast) that Bay was prepared to move on. Toss in an imminent signing for 2 years at $15.5 million to play the same position, and you’re STILL wondering where Bay fits in? It was funny to watch Wild Thing deadpanning his expression in letting Weird Harold (Fat Albert is one of the most underrated cartoons of the 1970s, by the way) know that he probably doesn’t. I won’t speak for anyone but odds are that Mitch was wondering at that exact moment what was in Reynolds’ coffee, and also wondering if he could get some.

The moral of the story: Peter Gammons can’t get to that desk soon enough. I tired of just about everything ESPN over the last few years so I haven’t been able to catch Gammons on TV much at all, so it’ll be good to see him on MLB Network and NESN in the coming months. Sure, he uses his Twitter account to express his political views on an unsolicited basis (@pgammo, I get it. You don’t like Sarah Palin. You live in Massachusetts. That fact alone puts the smart money, sight unseen, on you leaning a little towards the left), but there’s nothing wrong with expressing your opinion. He’ll be a great add to both sets.

Regarding the signings of Cameron and Lackey, as a Sox fan, I don’t really care for them. Unlike many, I am OK with the “bridge year” concept if it involves creating payroll flexibility. A LF manned by a platoon of Jeremy Hermida, Josh Reddick and a non-tender would work fine. Paying almost $8 million/year for TWO years for an aging outfielder seems to be a bit much for the organization. Paying $16.5 million/year for an over-30 pitcher with durability issues and a less-than-stellar record in his new home park seems steep as well. Lackey was the only solid option of the barren free agent starting pitcher class of the 2009-2010 offseason. He was the best house in a bad neighborhood, if you will, and of course he was going to be overpaid. That doesn’t mean Theo Epstein has to be the one overpaying. If I have to guess, this was more Larry Lucchino’s call in a gut reaction to keep pace with The Empire rather than the emergence of Bizarro Theo. I can’t see them keeping Josh Beckett now. Really, I couldn’t see them keeping him before this; the last two years haven’t been stellar for him; he seems to be reverting to fighting himself and trying to Nuke LaLoosh everyone with his heat. That’s not going to work now, and it sure won’t work as age and loss of velocity set in while he toils well into his 30s.

Not sure what’s going on with the Sox tripping over themselves to eat $9 of $12 million for Mike Lowell in 2010. Sure…he was defensively a shell of himself at 3B, displaying range almost as bad as a previous Sox aging infielder (Mark Loretta at 2B c. 2006). He can still hit, though. It’s well-documented that he was annoyed with the ramifications of the Sox pursuit of Mark Teixeira last year. Do his declining range and ill temper over being dangled as bait for 2 years add up to a salary dump? I guess they do. Still, Adrian Beltre is NOT the answer, unless you want to overpay a Scott Boras client for declining production and advanced age, regardless of how solid the glove is, all the while further hampering payroll flexibility. If that’s the case, be my guest…y’all just go on with your bad self. It’s much cheaper to sign a 1B or go with Kotchman and move Kevin Youkilis to 3B than to find a 3B option on the open market. I don’t really like Theo’s track record with free agent signs on the left side of the infield, either. Not since Bill Mueller, anyway.

As for Harold Reynolds, as Marty McFly said in “Back to the Future,” “watch for the changes, and try to keep up, okay?”