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.

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?”

Chowhounds: A simple way to mix it up a little bit

If you’re like me (and on several levels, I strongly advise you to pause at least a moment to thank your personal God that you’re not), you enjoy food a great deal. That’s easy enough. For some, cooking is intuitive and easy. Me, not so much. I was blessed by having two excellent cooks for parents, but I don’t think the genes carried over too well. I am a spastic mess in the kitchen. Klutziness, sloppiness and general ill temper mark my periodic kitchen disasters. Well, at the ripe old age of “a lot more than I feel like I am,” I’m fixin’ to fix all of that. For those of you that share the same gastronome and kitchenphobe profile, here’s what we can do:

New Cookbook Sunday

OK, I know damn well that I’m not the first one to think of something like this; New [blank] Sunday concepts are just about everywhere. But screw it…give it a shot. Enjoying food in the age of information overload means that we have an infinite number of recipes at our disposal via the Internet, cookbooks assembled by an ever-increasing cast of celebrity chefs and more traditional sources indigenous to the 20th century. Maybe you have a slew of cookbooks that you’ve looked at but never really got much out of. We may have 30 or 40 such tomes on our dining room bookshelf, yet only a select few have the true mark of honor – pages that are waterlogged or crusty from ingredients and other friendly fire from use of a few select recipes repeatedly. Let’s tap a different one of these once a week to strengthen our chops and rid us of the kitchen anxiety, no? Every week, reach for a cookbook or similar source that you think has been relatively untapped. Pick out a recipe you’re at least a little comfortable with, discuss with your Beautiful Bride or other significant other, shop for the ingredients and let it rip. Start off slow – I picked out a wicked easy shrimp dish myself – but who cares…we all learned the basics on how to ski on the bunny hill, didn’t we? Next week I’ll go for something a little more challenging. While you’re at it, try working out pairings of wine and/or beer with each of your dishes to complete the experience. You can always spend an extra 15-30 minutes in the gym on Monday to work off your newfound culinary success. Good luck and enjoy!

Memo to Dick Jauron from the days of common sense

Dick:

Sure...Leodis McKelvin decided to fight momentum and come out of the end zone. Twice. Once with a tide-changing fumble and again with a time-wasting saunter to the 21 when Standing Hampton would keep you at the 20 with a few extra seconds. Bad. Wicked bad. But Leodis isn't the no-talent-ass-clown that called the D that allowed the Best of the Best to saunter down the field to knock your nostalgic lead from 11 to 5. It's all on you, Yale boy. Your team hit all game and all of a sudden you turn turtle and play prevent. Is this what Ralph's paying for? Crash Davis says, "don't think...it can only hurt the ball club...

It's bottling day for Flying Taco BrewVentures!

While I contemplate the waning of my latest momentum trade in the 3rd month of the quarter (it's still actually doing well; just not as well as it was a couple of weeks ago), I'm finally getting around to bottling a Saison that I have anticipated since the Beautiful Bride bought me the homebrew setup for the holidays. The latest Flying Taco BrewVentures creation has a working title of "Rye Not? 'Tis the Saison" or a recent title of "Saison du Beavis," in honor of our 15-year old cat Beavis who was found cozying up next to the brew barrel during the final days of dry-hopping. It's definitely not been the same for Beavis since we had to say goodbye to his closest companion Butt-Head right before the new year; hell, they've basically been partners in crime since birth. But Beavis soldiers on...and I digress...

I was supposed to brew this deal in June. But Saison yeast requires higher fermentation temperatures, and anyone familiar with Boston weather patterns this summer remembers that we basically got shafted out of the first 6 weeks of summer. Additionally, we had a kitchen project and a few other things pushing the schedule back, so I finally had a chance to brew on July 16. In addition to using the lightest extract I could find (hey, after all it's only my 4th batch), I steeped some Belgian Pale and Pils and about a pound of Rye malt. Toss in some candied ginger, a bunch of candi sugar and a little coriander with Styrian Goldings and Saaz hops and away we go. In addition to needing higher temperatures, Saison yeast also has a habit of setting the world on fire early and petering out for a while before it finishes the job. This was the case with my batch; with an original gravity of 1.062 it worked down to 1.020 but needed a fair amount of time in August to get down to 1.006; of course, cooler temperatures in the back end of July didn't help. It wasn't cold enough to safely put a BrewBelt on the fermenter but wasn't warm enough for the yeast to clear out the remaining fermentables. So I let it take its sweet time and when we hit below 1.010 I dry-hopped with a little Saaz and Styrian Goldings. And now is the fateful day, a day to rejoice, taste the final sample before bottling, and be exceptionally stoked about the project. Right?

Not exactly.

Bottling day is all of that. But from a tactical perspective, bottling day sucks. Royally. For a homebrewer, bottling day is chock full of cleaning, cleaning, cleaning, sanitizing, sanitizing, sanitizing and a whole bunch of stuff that can easily go wrong (not enough bottles, caps or cleansing equipment; broken cappers, broken bottles, earthquake, a terrible flood, locusts, "it wasn't my fault I SWEAR TO GOD!!!"). Two quotes come to mind that are extremely relevant to a homebrewer when thinking about bottling:

• On football when the forward pass was a new, exciting and somewhat scary wrinkle to the "three yards and a cloud of dust" game of yore: "three things can happen when you put the ball in the air, and two of them are bad."

• On golf from the neighbor of the real Beavis & Butt-head, the immortal Tom Anderson, after our two favorite unruly teenagers spent the afternoon following him around the course and bogarting all his golf balls: "Boy, I tell ya what, Dusty...I felt like a one-legged cat tryin' to bury turds on a frozen pond out there today."

It's all that and a bag of chips. Bottling day is like being a flaky art student who just got cut off from the 'rents cash flow and has to balance the checkbook after a 2-week jaunt to Europe. Kicking the tires on a job requiring project management skills? Developing and implementing a homebrew calendar for a year requires both project management and organizational skills...not to mention significant attention to detail. If you do it right, it goes something like this:

1. Soak bottles in water and cleansing (I use PBW = Professional Brewers' Wash) solution
2. Soak bottling bucket and equipment (hydrometer, beer thief, auto siphon, racking cane, tubing) in water and PBW solution
3. Rinse bottles
4. Wash bottling tree
5. Wash bottling spigot
6. Rinse bottling bucket, equipment and spigot
7. Sanitize bottling bucket and equipment
8. Sanitize and rinse bottling tree
9. Sanitize and rinse bottles
10. Sanitize and rinse pan for priming solution (the priming solution of water and sugar gives the remaining yeast just enough to feed on in the bottle to generate natural carbonation)
11. Sanitize caps
12. Prepare priming solution
13. Cool priming solution
14. Sanitize bottling spigot
15. Rinse bottling bucket, equipment and spigot
16. Prepare bottling bucket and auto siphon
17. Pour priming solution into bottling bucket
18. Take final gravity measurement of beer and sample for taste
19. Siphon beer from fermenter/carboy into bottling bucket
20. Bottle and cap
21. Optional per Bluto: "My advice to you is to start drinking heavily."

OK, it's a little more than a 12-step plan but a little less than Kerry Healey's mystical 50-point plan she noted during her unsuccessful bid to become Governor of the Commonwealth of Massachusetts (leaving us with Deval Patrick, who has less soul and personality than Tiger Woods. We won't even discuss the comparison of efficacy in each of their chosen crafts/professions).

Invariably, something goes wrong. I have brewed and bottled a whopping four...count 'em...four...batches on my own this year and can name something from each batch in which I screwed the proverbial pooch. No need to bore you with the details, but prepare yourself. Have at least 24 bombers on hand (22 oz. or 650 ml bottles) and at least a 6-pack of typical 12 oz. bottles. Make sure the labels are off before Bottling Day, because not a lot is more annoying than scouring glue-y labels off bottles when you're supposed to be filling them with your luscious creation. Cleanliness and sanitation are critical to keeping unruly microscopic critters from tainting your finely-crafted beverage. Another useless metaphor: If homebrewing is a football field, then bottling is a First-and-Goal situation from the 9-yard line...those last nine yards are the most important, so they can be the toughest to get. Accordingly, they require a great deal of strength, brute force and a tremendously plodding work ethic. This, my friends...is Bottling Day. Don't fret, though...in two to three weeks you'll pop the cap on your latest (and now carbonated) elixir and enjoy it with family and friends...just like you thought when you started this crazy hobby of yours. As always, enjoy!

Consumer Products Analysis, Volume 1

Here's my review of diet Ultraviolet Mountain Dew:

It really sucks.

Even worse than Ma Kelly said about the Lower East Side in "Johnny Dangerously."

The first day...

--
Taking Jr. to lunch @ Regina to celebrate 1st day of kindergarten. Felt like a bigger deal than we expected, but parents and son doing just fine.

What's that smell?

I’m not sure when I got the whiff of 2006 wafting over to me from Fenway but it was at least a couple of weeks ago. Since then quite a few people have chimed in about the eerie similarities between this Red Sox season and that debacle from three summers ago. Well, why not me? Everyone enjoys a good piling on from time to time…and if you see any factual inaccuracies in here, well…my bad, since this was written off the cuff past midnight after an extremely long weekend. Please feel free to drop me a dime; I can take the criticism.

At least you have your health…

This is one banged up team right now - so banged up that Victor Martinez is part of it. Sure, he'll mash...but he's a defensive house of horrors. The last thing this crew needs is to play extra outs. If Varitek and Lowell weren't as hurt/banged up as they are, Justin Masterson is still eating at least a fair amount of innings for this crew in some way or another, which is exactly what the Sox lack right now. The pen is under a serious stress test right now, which almost never ends well. When you have exactly two members of your starting rotation reliably providing 6 innings of work each time out and are eagerly anticipating the second coming of Paul Byrd, you're not where you expected to be. Let's not forget the gaping crater of a roster spot that is Takashi Saito.

…or your depth? Try again…

Major-league-almost-ready position player depth is sorely lacking in Pawtucket and Portland. Really don't have any bench to speak of, either. And there's that shortstop deal. Hurt or not, Jed Lowrie looked like a heaping dessert helping of cowpie at the plate across the board when on the 25-man roster and there's more than enough film on Nick Green to pitch to him and it shows. He looks wretched at the plate...sort of like the AAA/AAAA player that he is.

Bullpen in a china shop

Papelbon will be rusty the next time he throws 'cause they haven't been able to get to the guy a whole lot lately. More extra pitches for him. Bard, for all his heat, doesn't have a whole lot of movement on it. Straight 99mph gas is still straight. He's got that nasty breaking ball but needs to set it up a little better. A 2-seamer or a cutter would be something I'd like to see more of, but that'll take some time.

Meeting expectations

So you basically have 5 or 6 members of your 25-man roster performing in pretty much good health and at the level they need to: Youk, Beckett, Lester, Pedroia (more or less, probably a little less), Ellsbury (sort of) and Bard (tonight's outing excepted). Pretty much any excuse you can use to sit Big Papup right now (lefty starter and even righties with poor history) and DH Martinez, you go for it.

Oh, that would be me…I’ve been swimming in raw sewage…I LOVE IT!

One of my favorite quotes from the Naked Gun series (2½)…almost right up there with “The truth hurts, doesn't it, Hapsburg? Oh sure, maybe not as much as landing on a bicycle with the seat missing, but it hurts!” It may not be as bad as 2006…or raw sewage even…but it's definitely getting a vaguely familiar stench. Sort of like beef fat tossed in the garbage can that sits in the hot sun for 4 days.

Deconstructing Risk and the Magic 8-ball

Until the broad proliferation of exchange-traded funds (ETFs) it was difficult to find a low-cost option for investing in international markets. Now, not only do we have numerous options in this space and others, but there are reasonable choices for investing in segments of many markets that may provide more efficiency than a position in the broad market itself.

Disclaimer (of course)
I am not a registered investment adviser, nor do I play one on TV. No information contained in The Blog of the Flying Taco on this site is intended to be a recommendation to buy or sell securities of any kind.

Developed International Markets
Whenever I hear someone suggest an allocation to the EAFE (the Morgan Stanley Capital Indices Europe, Australasia and Far East Index; all information © 2009 MSCI Barra. All Rights Reserved), I cringe. Why? Well, let’s look at the last 10 years ending June 30, 2009. On a US dollar basis, with dividends reinvested, the EAFE has clocked in an annual return of a whopping 1.59 percent. Not exactly blowing your doors off, eh? Hell, that’s not even keeping up with inflation! Looking at the variability of monthly returns, you’ll find that the annualized standard deviation of the EAFE during that span is 17.73 percent. Worse yet, if we estimate the 10-year annualized risk-free return to be 3.26 percent, the EAFE hasn’t even beat the risk-free return and tallies up a less-than-impressive Sharpe ratio [(asset return – risk-free return)/asset standard deviation] of MINUS 0.094. The Sharpe ratio is a “bang for the buck” measure of how well you’re compensated for a given level of risk. Numbers south of zilch in this department aren’t exactly what we’re looking for. At face value, if you bought the EAFE at the end of June 1999 you’d have been better served by rolling T-bills. You’d be only a little better off than if you’d stuck your loot in a mattress.

Widely-followed domestic stock indices
The EAFE isn’t alone. The venerable S&P 500 (Standard & Poor’s 500 Index; all information Copyright © 2009 by Standard & Poor's Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved.) LOST an annualized 2.22 percent with an annualized standard deviation of 16.06 percent, for a less-than-stellar-to-say-the-least Sharpe ratio of -0.204. Widely regarded as THE benchmark for American equity investors, the S&P 500 has been worse-than-dead money for the last 10 years…ouch! Its middle brother, the S&P 400 index of mid-cap stocks, has done better over this time period, generating an annual return of 4.61 percent with an annualized standard deviation of 18.32 percent, leading to a positive Sharpe ratio of 0.074. The baby of the family, the S&P 600 index of small-cap stocks, had a slightly higher return of 4.74 percent, but with higher risk - annualized standard deviation of 20.00 percent on the nose – its Sharpe is just about identical to the 400’s at 0.074.

What HAS worked?
I’m not trying to pile on by any means; the last 10 years have been challenging for the equity markets since they included not one, but two difficult periods: the 2001-2003 recession and the global deleveraging that started in 2007 and is still in progress. Still, there have been mildly successful investment strategies in hindsight. Let’s start with the easy one first…a domestic balanced portfolio. Allocate 65 percent to an S&P 400 index fund and the remaining 35 percent to an intermediate-duration US Treasuries fund. If you rebalanced back to the original 65-35 split each quarter (ignoring transaction costs and fund expenses), where would that leave us? We end up with an annualized return of 6.13 percent with a much lower standard deviation of 11.52 percent and a Sharpe of 0.249. Not setting the world on fire by any means, but at least there’s moderate compensation for risk.

The trusty Magic 8-ball
I ran my asset allocation model to determine, in hindsight, what would have been the ideal portfolio to generate real risk-adjusted returns for the past 10 years if we had the investment choices we have today. The model includes 86 different investment options. For this exercise I’ve measured risk tolerance simply based on my age - just over 40 at June 30, 2009. To keep it relatively simple I won’t include local currency investments, because for the individual investor that would entail buying a single-country or region ETF and shorting a currency ETF against it – this isn’t always achievable or even allowable. If you started with the original allocation and let it run for 10 years, you’d end up with a return of 8.86 percent net of fund expenses (at current levels), a standard deviation of 7.67 percent and a Sharpe ratio of 0.731. If we rebalance this allocation quarterly (again ignoring transaction costs but including the current level of fund expenses for each option), we’d generate an annualized return of 9.11 percent with an annualized standard deviation of only 5.30 percent. Our Sharpe ratio on this magic 8-ball portfolio is a tidy 1.165! So what kind of stuff, you may ask, would generate such results? Here goes…

Investment (Allocation percentage)
Intermediate US Treasuries (78.93%)
Chile (9.27)
Latin America (2.95)
Nickel (2.48)
Copper (1.84)
Emerging Europe (1.67)
China (0.78)
Brazil (0.73)
Precious Metals (0.70)
Sugar (0.65)

So there you have it…the bulk of the portfolio is allocated to an intermediate duration US Treasuries fund…a whopping 79 percent! Of the rest, 15 percent is in emerging markets equities (including 13 percent in Latin America), and 6 percent goes to commodities. Now look at what ISN’T there…you guessed it…absolutely ZERO domestic equities. What else is missing? You don’t see any broad market indices here…no S&P 500, Barclays Aggregate Bond Index or MSCI EAFE or MSCI Emerging Markets indices. We’ve deconstructed the risk in these and other larger indices to select smaller segments that fit well together to provide decent, risk-adjusted real returns. Some of these investments on a stand-alone basis exhibit extreme risk characteristics, but when assembled as part of a portfolio of complementary assets we can diversify a significant portion of that risk away.

WARNING! Ummm…we don’t have a trusty Magic 8-ball
That’s right, you don’t. Y’know what? I don’t either. It may be easy to say “well, that weird portfolio of Treasuries, Latin America and commodities worked in the past, so I’ll just do that in the future.” What words do you see in literature and advertisements for just about every mutual fund and investment product?

Past performance is not a guarantee of future performance.

This is so true it’s not funny. The model portfolio above tells us what we should have done ten years ago, not what will work for the next ten years. Besides, I’ve backtested my optimization model to see if what worked in the past several years will work in the future. Guess what…it doesn’t! So what’s an innovative individual investor to do?

Is there an easy way out? Not really…
Say you do a version of the plain-vanilla portfolio I mentioned above – split between domestic equities and domestic fixed income. It’s easy, it’s regarded by a lot of people as “safe” and won’t get you dirty looks at any cocktail parties. Will it work? That’s debatable. Looking at ten years of information, the results over that time aren’t horrible, but consider the strategy’s largest drop from a previous high – the “max drawdown.” This point would have you in the hole to the tune of 31.80 percent after February 2009 from a previous high set in May 2008 – only 9 months earlier. Almost a third of your portfolio…that’ll leave a mark! The “magic 8-ball” portfolio’s hole was much shallower with a max drawdown of 12.42 percent in October 2008 from a March 2008 high – but that’s with 20-20 vision in your rear-view mirror. Easier to stomach, but since it’s in hindsight, it’s not an investable portfolio. Like Marc McGwire, “I’m not here to talk about the past; I’m here to talk about the future.”

...but there's a glimmer of hope
I mentioned that I backtested the “Magic 8-ball” portfolio to see it would work in future periods, and it didn’t work out too terribly well. So it was back to the drawing board. All that historical information has to be good for SOMETHING, doesn’t it? Well, it turns out…maybe. I’ve never considered myself a momentum investor by any means, but I looked at correlations between performance of shorter historical time periods and the following three months of performance. None of them are huge by any means, but I’ve seen a few things that may be interesting enough to discuss once I determine how best to temper the risk profile of the model portfolio.

Leave no stone (or its pebbles) unturned...the sum of the parts is greater than the whole
I’ll be honest; I’m a weird investor. If I can figure out a mathematically sound model for investing, I will be less likely to care about what the portfolio will look like to other people because I can justify it with the numbers. I can sleep at night knowing I've done my all to generate the best risk-adjusted real returns I can. That’s not how everyone works. There are political, currency and other risks associated with many segments of the investable markets. China GDP growth slows and the copper and nickel markets end up tanking, for example. Additionally, some of the investment options trade less frequently than others, so the bid-ask spreads may be wider (adding to de facto transaction costs). A lot of these risks are too much to handle for many investors. The key is to keep your mind open and be honest with yourself about the type and level of risks you’re willing to take. Then be sure to explore ALL available options within your comfort zone and investable segments of larger options. For me, it’s easy to tailor a model to include as many or as few choices as possible from the investment options that I track. By deconstructing the risk of larger indices into their smaller investable components, you’ll often find that the sum of these smaller parts can indeed be greater than the whole.

Godfather reference of the day, and it's barely 9:15 AM!

"When the Corleone family sends a son to the (Massachusetts) legislature, they don't send Michael; they send Fredo. Michael's too important."

- Michael Graham (@Natural_Truth) on 96.9 WTKK

Huuuge grains of salt…2009 Cubs = 2001 Red Sox?

When I was a kid I spent a couple of years in the Chicagoland area and the next couple of years in the Boston area. For some reason my borderline-nomadic self has kept the allegiance to both the Cubs and the Red Sox. Because of this sickness, late October 2003 was a wicked crappy time for me…with one exception – I didn’t have to expend too much effort to think up a Halloween costume. I just wore my Red Sox jersey and my Cubs hat and was instantly transformed into the World’s Most Pathetic Baseball Fan.

I had a Tweet the other day noting that this year’s disheveled Cubs squad reminded me a lot of the 2001 Red Sox. You may argue that the 2009 Cubs may have even more potential talent on their roster with their reasonably solid pitching and slightly less dead weight than the likes of the 2001 editions of Mike Lansing and Troy O’Leary. But examine a few ailments befalling both teams and the likeness is uncanny…

Affliction: Malcontent behavior in the dugout
2001 Red Sox: Manny Ramirez slouching during the National Anthem before first game back after September 11 terrorist attacks (note absence of the term "man-made disasters")
2009 Cubs: The Gatorade cooler as endangered species

Affliction: Crotchety episodes from a manager whose act is wearing thin
2001 Red Sox: Jimy Williams' “manager’s decision”
2009 Cubs: Lou Piniella ripping Milton Bradley a new one after yet another meltdown

Affliction: Ace fragile diva extraordinaire
2001 Red Sox: Pedro Martinez
2009 Cubs: Carlos Zambrano

Affliction: OBP nightmares
2001 Red Sox: Troy O’Leary (.298), Mike Lansing (.294), Shea Hillenbrand (.291)
2009 Cubs: Alfonso Soriano (.298), Micah Hoffpauir (.287), Aaron Miles (.240)

Affliction: Heart attack closers
2001 Red Sox: Derek Lowe, Ugueth Urbina
2009 Cubs: Kevin Gregg

Affliction: Big-ticket, overpriced free agents signed in prior years never living up to erroneously high expectations
2001 Red Sox: Jose Offerman
2009 Cubs: Alfonso Soriano

Affliction: Injured catcher
2001 Red Sox: Jason Varitek (broken elbow)
2009 Cubs: Geovany Soto (strained oblique)

Affliction: Coaching staff sacrifices
2001 Red Sox: John Cumberland
2009 Cubs: Gerald Perry

Affliction: Beleaguered GM
2001 Red Sox: Dan Duquette
2009 Cubs: Jim Hendry

Affliction: Old ownership with a callous personality towards its fan base
2001 Red Sox: John Harrington, once dubbed “the world’s luckiest CPA,” CEO of the Yawkey Trust
2009 Cubs: Tribune Company (but as a former public company and LBO gone bad, a sharper eye on the bottom line and maximization of stakeholder return is required)

Affliction: Charming yet rotting ballpark in desperate need of a face lift
2001 Red Sox: Fenway
2009 Cubs: Wrigley

Affliction: Impending sale with hiccups
2001 Red Sox: Sale to John Henry’s group at a not-quite-highest bid and the ensuing Commonwealth of Massachusetts inquiry on the trust’s fiduciary duty to get maximum price
2009 Cubs: Possible Cubs bankruptcy to expedite sale to Ricketts group

Solution: New leadership with keen eye on financial markets
2002 Red Sox: John Henry, a longtime commodity trading adviser
2010 Cubs (projected): Tom Ricketts of Ameritrade and Incapital

Based on this admittedly highly superficial yet convincing evidence, the stars have re-aligned in 2009 in a similar pattern to 2001. Knowing what we know about that brutal Red Sox season (regardless of how many days Dan Duquette said the Sox were in first place) and the following years, several conditions must ring true for the Cubs to win a World Series:
· The sale can’t go through soon enough. This organization needs a thorough housecleaning of all that is previous ownership – not for change’s sake alone (after all, there was an ownership ticket-scalping fracas in 1908, too…how’d that work out for ya?), but so the new group can develop, articulate and execute their plan with efficiency and purity.
· Strong chance that when the Cubs win the World Series, Lou Piniella isn’t their manager. Maybe a calmer, less impulsive voice with a keener eye towards statistics and in-depth analysis. Perhaps a former manager with thickened skin from an unfortunate and untenable situation (Manny Acta, anyone?)
· A new GM is a safe bet. Like Duquette with Pedro, Hendry made some good moves during his tenure (Aramis Ramirez, Derrek Lee) but others have been questionable (Jacque Jones, Soriano). The farm system isn’t the greatest in the world, either. Still, new bosses bring their own people in. May I suggest a youthful voice unencumbered by tradition and old methods? Maybe someone from Sox baseball operations (Ben Cherrington, Jed Hoyer or Mike Hazen are names that come to mind).

· The Sox reached the Promised Land in three years after the sale…with a little help from Yankee Lobster (I’ll explain one of these days). Provided the sale goes through by the offseason, that gets us to 2012. There’s the Cubdom mystique of the year 2014, but why wait two extra years?
· Enough of the friggin' goats already!

And another thing...when it finally happens, don't sign the guy that made the last out of the World Series against you.

Wicked good beer in cans for the summertime. No, really!

Well, believe it or not, summertime has finally made its grand entrance here in Boston. So now we're all fixin' to hit beach, or go camping, or to have a nice cookout with friends and family. If you're like me, you may want to enjoy some good beer in moderation with these fun activities but don't want to be hassled with the breakability and heft of glass bottles in your coolers, travels and/or exploits. Hey, glass may even be prohibited at a lot of beaches, campsites and parks. You may say to yourself, "OK, I'll try to stick to canned beer..." but the first thing a lot of people think of when considering beer in cans is mass-market, industrial strength adjunct-laden fare that we all (OK, some of us) drank at Quarter Draft nights in college. I'm not the first one by any means to say this, but bucker up, little camper! There's hope!

There is a great deal of excellent beer in cans being produced by small craft brewers throughout the country these days. Some of my personal faves (with links to write-ups I've done in the past on BeerAdvocate):

Oskar Blues
Oskar Blues in Lyons, Colorado makes Dale's Pale Ale, Old Chub Scottish Style Ale and recently started canning their Mamma's Little Yella Pils. All are great fare for the outdoors...Dale's is a great, refreshing, hoppy all-purpose pale ale that can provide a good spot start in just about any situation. Old Chub's smokiness makes it a prime candidate to pair up with stuff off the grill or a campfire. Mamma's is an easy-drinking Pilsener that's extremely smooth, and just a hair over 5% ABV. If you want a nightcap, there's always Gordon, their excellent imperial IPA...or the treat that is the great Ten FIDY. FIDY pours like spent motor oil to the uninitiated but coats the palate with deep, dark roasted malts and huge hoppiness and viscosity. OB is probably one of the first outfits a lot of the craft beer crowd thinks of when considering great beer of the canned variety. It definitely makes it to Boston and quite a few other pockets of the country.

Butternuts Beer & Ale
The blokes at Butternuts Beer & Ale brew their stuff out of a barn deep in rural Central New York in a town called Garratsville in the 607. It's also about 30 miles from where I went to high school (Sherburne-Earlville, class of 1986). In addition to having hysterical labels that even include the calorie count (most in the 150 range - not too bad at all!), they brew some solid beer.
Heinnieweisse is an easy-drinking, great, straightforward Hefeweizen that is nicely carbonated and gives off a fair amount of those banana esters that we know and love from the Hefeweizen yeast strains. Porkslap Pale Ale is more of a traditional "old school" pale ale that provides a solid malt backbone with enough hoppiness to keep it interesting. Then there's Snapperhead IPA, which to me is more of an English IPA than American IPA - again, more maltiness than today's ultra-hoppy IPAs, but still very solid. For something in the deeper and darker category, check out Moo Thunder Stout for a dry and sessionable stout. Not sure of their availability outside of the Northeast but they're definitely worthy of a spot in your cooler.

Surly
If I lived in Minnesota, I'd have stuff from Surly Brewing in my fridge and cooler all year-round. Furious is one of my favorite IPAs. The citrus hop bite oozes grapefruit (especially when fresh), yet it's still extremely well-balanced and an utmost pleasure to drink. The first time I tried one of these I poured it into a Reidel Vinum Cabernet Sauvignon glass to get as much of the aroma as possible, and it didn't disappoint. CynicAle adds a little bit of Belgian, Saison-style spunk to the mix, which goes perfectly with warm weather. Again, I'm pretty sure their canned offerings are only available in Minnesota, but if you have access, they're a sure thing.

There are quite a few more canned craft brew offerings out there (even Brooklyn Lager is available in cans now, with pretty wide distribution). A lot of them have regional distribution, such as Southern Star's Pine Belt Pale Ale in Texas and New England Brewing stuff from Connecticut, but there's a very good chance that at least some of them are available where you are. Almost forgot Coconut Porter from Maui Brewing Company, who also has a nice note on the positives of cans. So there's no need to trade down just to pour it from the can! Snag one or more of these fine offerings and (in moderation) enjoy!

Welcome to The Blog of the Flying Taco

Well, there's the Rime of the Ancient Mariner, so why not the Blog of the Flying Taco?

Welcome and thanks for taking the time to read this, even though most of us experience serious information overload quite frequently. I live just outside of Boston and have extensive interest in the investment management and financial services industry. I may about the markets and investing/trading (disclaimer: I'm not a registered investment adviser, nor do I play one on TV, so no recommendations here; more like observations and insight). But it doesn't end there, by any means!

Brewing & beer
I am a nascent homebrewer (Flying Taco is the working name of my brewing exploits...Flying Taco Brewventures, to be exact). Some, including my Beautiful Bride, may call me a beer obsessive, as I enjoy trying beer from all over the world and of many different styles - so I'll definitely write about beer quite a bit.

More "consumables"
Food, wine...that too! Really anything in the "gastronomic arts" is on the table. I enjoy cooking even though I'm an absolute manic and stressed slob in the kitchen. Really the only thing I haven't managed to splatter all across our kitchen is homemade ice cream. Thankfully our CuisinArt ice cream maker has a very deep bowl to save us all from that indignity.

Sports
I enjoy the hell out of sports. As far as spectator sports go, baseball, hockey (my favorite live sport to watch)...football and basketball, too...and NASCAR. Hey, I even catch rugby on Setanta every once in a while, though not often enough. I don't just sit on the couch and watch 'em on TV, though, I participate too. I bike frequently and enjoyed playing soccer until I left my ACL on the field last June, but hopefully I'll start that up again in limited duty soon. Racquetball is something I must get back into very soon. Baseball, softball, too. I'm a fan of just about all of the Boston pro teams (first and foremost the Red Sox and Bruins). As a former Buffalo resident I continue to suffer alongside the Bills and Sabres, too, and still have solid Chicago ties to the Cubs, da Bearsz and the Hawks. Especially the Cubs, despite what a mess they are.

Music
One of the most useful gifts I ever received was my first iPod from my Beautiful Bride. Wouldn't have bought one on my own, but now I'm lost without it. Once I loaded it up I realized that I had collected a whole lot of music that was all over the place. From my Buffalo days I had a lot of Canadian indie stuff from listening to CFNY 102.1/The Edge in Toronto. Nine Inch Nails, Grateful Dead, southern fried, jazz, classical (Mom's influence as a professional flutist (flautist?) with a couple of Russian ballet companies in the 1960s when she lived in the City), new wave, techno, even some country in there. I've lately been on a big Canadian indie kick; we've caught quite a few Ron Hawkins (formerly with The Lowest of the Low) gigs lately with more coming soon. Also, our son is 5 and he's turning into a Deadhead. His favorite Dead tune is "Sugaree." It's amazing what XM 57 (Sirius 32) in the car has done for child development, apparently.

Many thanks to y'all for stopping by, and enjoy!

Thanks again,

Larry