Author Archives: Scalper1

Dumb Alpha: The Drawbacks Of Compound Interest

By Joachim Klement, CFA The second installment of this series presented evidence that a simple random walk forecast typically performs better than the amassed expertise of professional forecasters for short-term forecasts of about 12 months. In this post, I argue that estimation uncertainty is not reduced for long-term forecasts either, because mean reversion cannot overcome the effects of compound interest. Luckily, there is a range of techniques, from simple to sophisticated, that can help long-term investors with this challenge. The “Muffin Top” Problem As most middle-aged people can confirm, age inexorably leads to a slowing metabolism. If you don’t change your diet, your waistline expands quite generously. In my case, I refused to notice these changes until I grew an undeniable “muffin top” of belly fat above my belt line. Chagrined, I changed my diet and stepped up my exercise, but so far — muffin doin’. This little anecdote is a rather fitting (if unappealing) metaphor for long-term investing. What I tried to force my body to do was to revert back to its original state (the mean), but the forces of mean reversion were not strong enough to do so. This scenario can happen in the world of investing as well. Imagine someone who wants to invest for the next 10 years and who is thus not interested in short-term forecasts so much as the long-term average expected returns of assets. Common wisdom states that, while return forecasts can be widely off the mark in any given year, in the long run, returns should converge towards a rather stable long-term mean. Because of mean reversion, it should be easier to forecast long-term returns than short-term returns. Compound Interest Ruins the Day In an important article in the Journal of Finance , however, University of Chicago economists Lubos Pastor and Robert Stambaugh showed that, in the presence of estimation uncertainty, mean reversion is not strong enough to reduce the volatility and uncertainty of long-term stock market returns. The main reason is that an estimation error in the first year will propagate and compound over the subsequent nine years, an estimation error in the second year will compound over the subsequent eight years, etc. Take, for example, an investment you know will average an annual return of 10% per year over the next 10 years. If in the first year the return is -10%, the average return over the subsequent nine years needs to be about 12.48% per year to make up for this shortfall. In other words, a 20% estimation error in the first year requires a relative increase in annual returns over the next nine years of 24.8%. If, on the other hand, the asset in the first year has a return of 0%, the average return over the subsequent nine years needs to be about 11.17% to make up for the shortfall. So a 10% estimation error in the first year requires a relative increase in annual returns of 11.7%. Half the estimation error requires less than half the relative return increase to make up for the shortfall. The investment results of the first few years have an oversized influence on the long-term investment returns — something that retirement professionals know as “sequence risk.” If you start saving for retirement and experience a major bear market in the first few years, you are much less likely to achieve your long-term financial goals than if you experience a rather benign environment at first and a bear market later. While the research by Pastor and Stambaugh is theoretical in nature, there is empirical evidence that long-term return forecasts are, in fact, just as uncertain and “inaccurate” as short-term forecasts. Ivo Welch and Amit Goyal have looked at the predictive power of many different variables that are commonly used to forecast equity market returns. They find that the forecast error does not materially change for forecast horizons between one month and 10 years. In other words, despite the existence of mean reversion, the uncertainty about future equity returns does not decrease in the long run. Facing the Challenge If long-term return forecasts are just as difficult to make as short-term forecasts, what can long-term investors do to create robust long-term portfolios? After all, we know that traditional Markowitz mean-variance optimization is about 10 times more sensitive to return forecast errors than to forecast errors in variances . There are in my view several possibilities, increasing from least to most in degree of sophistication: The equal weight asset allocation discussed in the first part of this series does not rely on forecasts, and thus is a simple and effective way to create robust long-term portfolios. Minimum variance portfolios and risk parity portfolios do not require any return forecasts and, if done properly, can outperform traditional portfolios by a wide margin. More sophisticated methods like resampled efficient frontier methodologies or Bayesian estimators can include estimation errors into the portfolio construction process and thus create portfolios that are more immune to unexpected events. Whatever technique one favors, there are ways to deal with forecast errors. Most critically, it is time investors take estimation uncertainty more seriously for the benefit of their clients and the long-term success of their portfolios. If you liked this post, don’t forget to subscribe to the Enterprising Investor . All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Stay Away From Commodity ETFs

You wouldn’t believe the number of people that have asked us for the best way to invest in commodities; trying to cash in on the overall market moving higher. Most of them have already been to Morningstar, to see if The United States Oil ETF, LP (NYSEARCA: USO ) or the Teucrium Corn ETF (NYSEARCA: CORN ) will allow them to play the bounce in crude oil. If you’re a frequent reader, you’ll know that we highly discourage anyone from USO , and our latest table is a perfect example. It’s our monthly look at the various commodity ETFs and how they track a simple strategy of buying end of year futures and rolling them annually. Here is the result for 2015: Just so we’re clear on what’s being shown below – if you thought it was a good time to own commodities in 2015 and added each of the ETFs listed below to your portfolio, you would have lost, on average, -23.88% for the year. If you were a frequent reader of this blog and instead chose to get your long exposure through long dated futures contracts – you would have lost -18.78%, on average, for a 5.10% (5,100 basis point) difference {Disclaimer: Past performance is not necessarily indicative of future results}. Finally, if you had instead chosen the PowerShares DB Commodity Index Tracking ETF (NYSEARCA: DBC ), you would have lost -27.59% (higher than the average of our commodity ETFs because it is more skewed towards oil), whereas the BarclayHedge Ag Trader Index was down just -0.47% for the year. {Disclaimer: Past performance is not necessarily indicative of future results} For the umpteenth time – you wouldn’t buy a car that only goes forwards (you probably want reverse). So why buy an ETF that only makes money when commodities go up. If you want to own commodities and get that exposure, do it dynamically – do it via programs that can benefit from rising AND falling prices. The difference could very well be 20% or more as it was in 2015. And if you must own commodities only from the long side, make sure you do it via long dated futures instead of the ETFs. The difference there could be significant as well. (Data as of: 12/31/2015) Commodity ETF Over/Under Performance 2015 Commodity Futures ETF Difference Crude Oil $CL_F -34.17% USO -45.97% -11.80% Brent Oil $NBZ_F -40.67% The United States Brent Oil ETF (NYSEARCA: BNO ) -46.08% -5.40% Natural Gas $NG_F -33.67% United States Natural Gas ETF (NYSEARCA: UNG ) -41.30% -7.63% Cocoa $CC_F 13.47% iPath Dow Jones-UBS Cocoa Total Return Sub-Index ETN (NYSEARCA: NIB ) 8.85% -4.63% Coffee $KC_F -30.66% iPath Dow Jones-UBS Coffee ETN (NYSEARCA: JO ) -35.37% -4.71% Corn $ZC_F -15.27% CORN -20.35% -5.08% Cotton $CT_F 1.28% iPath Dow Jones-UBS Cotton Total Return Sub-Index ETN (NYSEARCA: BAL ) 1.87% 0.59% Live Cattle $LE_F -14.60% $CATL -20.66% -6.06% Lean Hogs $LH_F -21.17% $HOGS -27.72% -6.55% Sugar $SB_F -15.13% Teucrium Sugar Fund (NYSEARCA: CANE ) -15.03% 0.10% Soybeans $ZS_F -12.33% Teucrium Soybean Fund (NYSEARCA: SOYB ) -16.62% -4.29% Wheat $ZW_F -22.47% Teucrium Wheat Fund (NYSEARCA: WEAT ) -28.16% -5.69% Average -18.78% -23.88% -5.10% Commodity Index [DBC] –27.59% Long/Short Ag Trader CTAs -0.46% Showing 1 to 15 of 15 entries (Disclaimer: Past performance is not necessarily indicative of future results) (Disclaimer: Sugar uses the October contract, Soybeans the November contract.) Long/Short Ag Trader CTA = Barclayhedge Ag Traders Index)

Verizon’s AOL Shines In Q4 As EPS, Revenue Beat

Amid mixed Q4 results from its wireless and landline FiOS businesses, Verizon Communications on Thursday reported a strong December quarter from AOL, a key part of the phone company’s strategy to diversify into digital media and advertising. Verizon (VZ) stock rose 3.3% on Thursday after the company reported Q4 earnings and revenue above Wall Street views, despite intensified competition in wireless service and aggressive marketing by T-Mobile US