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