Saturday, September 26, 2009

Downside Protection and the Concept of Risk

As we already indicated in earlier entries, good investment strategies are not only about 'picking' the right stocks or other securities. It is also about recognizing that 'games' involving real, serious money are dangerous games in which downside protection is needed. This may sound like a more than obvious statement, but somehow people always forget it during a good period. If the good period lasts a bit longer than expected and/or generates higher returns than imagined, the ones in the market tend to exaggerate what they do and new groups enter in a situation that is actually too dangerous already (in general, and especially for them). After a prolonged bad period - like the Global Credit Crisis - we see a different, but still comparable pattern.

Those who got really scared and/or squeezed by the downturn seem to believe that things will never be like they were before. They avoid the market's recovery, and get into a cynical mood. They prefer to stick to cash. And with growing groups of scared investors doing this - at a time when governments and central banks keep interest rates already low because they use it as a mechanism to stimulate the recovery - this excess supply of funds for money market and other cash instruments presses interest rates even further down. That is what we see at the moment. When you look at our performance chart (Graph 1 below) you see that Money Market Cash scored a mere 0.13% return in 4 weeks. By far the worst of all strategies and benchmarks analyzed. True, with an annualized interest rate of 1.65% on money market funds (in USD) we could start to argue that - for our strategies - it might be better to switch to another currency

After all, when we look at the second chart (Graph 2), the USD was and is one of the weaker currencies in the whole series lately. Wouldn't it be a good idea to switch to another big currency? E.g. the Euro or the Pound Sterling? These countries do have higher interest rates. Since we have decided to use the dollar as our home base, this would of course introduce more currency risk in the portfolios but when opting for an allegedly strong currency this might be a good option.

On the other hand the exchange rate Euro - USD has shown over time a very volatile behavior. Are we sure that the interest rate gap is not some kind of compensation for a USD expected recovery?

Difficult to take a decision, because it was exactly this week that the FED announced that it wanted to talk with money market funds to discuss a kind of reverse repurchase deal in which the central bank would withdraw liquidity from the financial system through borrowing. Money market funds have a combined portfolio of more than USD 2.5 trillion so they could easily discuss with the FED the desired liquidity crunch of USD 400-500 billion. The FED wants to withdraw excess liquidity from the system now that the markets are recovering in an effort to avoid renewed inflation. It was also hinting that interest rates might go up. And at the same time of course, if the FED believes that too much money is put into money market funds by paralyzed investors, it can - in this way - get a hold of the funds itself and use them in a - for the economy - better way.

Damocles' Sword

So what to do? Stick to USD and expect increases in interest rates soon? Or switch to Euro Money Market funds? We decided to use Damocles' sword: from next week onward half of our money market allocation will be in USD and the other half in Euro


In this week the leading world nations came together to discuss the economy. This meeting was initiated by president Obama and his team of economic advisers. 

The most important result according to us was that the G20 agreed in Pittsburgh to create a watchdog institute that will play a 'board of economic directors' role for the global financial system. And what is also indicative: it was the G20 taking the lead and not the G8. This is also a clear sign of a changing balance of power in the world. You cannot run the global economy anymore without incorporating the leading developing countries in your team. It is good to know that Obama's team of economic advisers - led by Larry Summers - is fully aware of this fact. Summers has done a lot of work in his academic career that was related to this theme.

The President and his economic adviser, Larry Summers

Back to our portfolios.

Graph 1; Portfolio Performance Week 36-39
Four EM Model Portfolios versus relevant benchmarks 

As the graph indicates it was a poor week (week 39, in purple). Only cash and MSCI Frontier posted positive returns. The MSCI EM and the MSCI World had the lowest returns. The Emerging Markets index dropped 1.31% and the developed world index dropped even more: 2.14%. Our four model portfolios MORFAV, EM Winner, EM Loser and EM Next 11 behaved like we predicted last week. They went down, but less than the major benchmark indices due to the fact that a) we selected solid, financially stable large firms; and b) we added 5-10 percent money market allocation to our portfolios. As a result of this downside protection measures, the cumulative return difference between our best portfolios and the thus far leading MSCI EM has shrunk.  The EM Loser portfolio is just a mere 24 basis points (0.24%) behind MSCI EM. The EM Winner portfolio shows the worst performance with a cumulative return of 2.87%. Not bad for a month, but compared to the others less good. Our EM Next 11 portfolio is still outperforming the MSCI Frontier, although that index posted a +0.89% weekly return versus a -0.08% for EM Next 11.

Currencies did not really play a major role this week. Some went up, others down, but all in all the picture is quite similar to what we showed last week.

Graph 2; Cumulative Currency Movements
Week 36-39 

When looking at the individual firms in our portfolios, NBP is really our gemstone. The Pakistani bank did once again resist market forces by adding a few basis points return while the rest was struggling. The cumulative return on this stock is now +25.12% for the 4 week period.

The top-3 stocks were:
  1. National Bank of Pakistan (NBP) +25.12%
  2. Vale (BRA) +14.61%
  3. BMF Bovespa (BRA) +12.28%
Two new names in the top-3, and both from Brazil. Vale, the Rio de Janeiro-based diversified mining conglomerate (2nd largest in the world), and the Brazilian Stock Exchange itself. We bought shares in Bovespa (the Exchange) because it is clear that - with Brazil's booming economy growing into a true Emerging Market leader - the Exchange will benefit as well via more activity, new issues et cetera.

The bottom-3 stocks are:
  1. America Movil (MEX) -9.64%
  2. Turkiye Is Bankasi (TUR) -6.16%
  3. Teva Pharmaceuticals (ISR) -1.99%
When comparing the top-3 with the bottom-3 and taking the average, we see a positive combined average return of 25.12+14.61+12.28 = 52.01/3 = 17.19% on the one hand and a negative combined return of -9.64+-6.16+-1.99 = -17.79/3 = -5.93% on the other. That translates into an average of 17.19%-5.93% = 11.26/2 = 5.63%. This is neatly in line with the average returns of the portfolios with EM Loser doing somewhat better, MORFAV and EM Next 11 posting more or less this return and EM Winner doing worse.

We can be satisfied with our portfolios in this difficult week. Now let's wait and see if this was a kind of breathing pause for markets after which we will go back to our growth path, or if it was somehow a first indication of a renewed period of doubts. To be frank, we believe that markets will be reasonably OK, albeit that returns like in week 2 and 3 are probably a bit too much. Not to the least, because October is not exactly famous for being a fantastic stock market month in general.

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