Author Archives: Scalper1

5 Outperforming CEFs That Are Insulated From Market Corrections

Summary The 2015 market correction caused a 10% drop across the market, but some CEFs were unaffected. Investing in market-neutral CEFs can help you protect your portfolio in the event of an event. I present a list of the 5 most profitable CEFs that are also uncorrelated to the general market. The previous market correction was a three-day selloff that led us to a market that trended sideways for two months. In total, the market lost 10% of its value before climbing back to its original place: (click to enlarge) Knowing not to freak out and to hold onto your investments is good, but having investments that are uncorrelated to the general market in the first place is better. This article is a follow-up to two other articles on investments uncorrelated to the S&P 500. The first article was on investment categories; the second on index funds. This article will be on CEFs, as per a reader request: (click to enlarge) Correlation In my previous article, I used a five-year lookback period. But if we are to really consider these investments uncorrelated to the market, they should not fall when the market does. Hence, the following comment: For this purpose, in this article, I will only be looking at the most recent market correction as my lookback duration. Thus, the correlation calculation will be from August to November, 2015. Whenever we look at the correlation of two investment instruments, we must use the log of those investments. In this way, we find the correlation of returns, not simply price movement. The result will tell us whether two investments are likely to give the same returns over our lookback period. I wrote some R code to screen CEFs according to the following criteria: Trading above $5 (therefore not a penny stock). Has a correlation of less than 0.3 (in magnitude) to the SPDR S&P500 Select ETF (NYSEARCA: SPY ). I then arranged those CEFs in order of greatest return over the past year. I chose the top five CEFs in this list to present to you. Because the top five actually had 3 municipal bond CEFs, I went down the list to add 2 more CEFs outside of this category. The Winners Nuveen Long/Short Commodity TR (NYSEMKT: CTF ) This CEF is a portfolio of long and short futures contracts. CTF purposefully plays a flat game, not taking too many long or short positions. Though it would have been nice to see CTF short energy, making their shareholders lots of cash over the past couple years, CTF has avoided such high-volatility trades. Though CTF’s Nav growth is rather slow, dipping into negative territory, this CEF is trading at a decent discount: -4.36%. The yield is currently 7.54%. Whether CTF can maintain these payouts at its current Nav growth is questionable. The discount is disappearing, however. The discount bottomed out at over -20% in 2014 and has recently bounced back. Thus, if you’re interested in getting in on this high-yield CEF, you should consider doing it soon. Remarkably, CTF is the only CEF in the top five that is not a bond-based fund. Correlation with market-correction phase SPY: 0.27 Babson Capital Corporate Invs (NYSE: MCI ) Here, the focus is on non-investment grade corporate debt. The equities involved are conversion rights, preferred shares, and warrants. Because of the inclusion of conversion rights, the debt here is convertible, which can lead to a dilution of shares. Nevertheless, the yield is high, at 6.80%. However, the surge in price has caused MCI to outgrow its Nav. The Nav sits at a stable 14.70, while the CEF trades at over $17. This CEF is selling at a 10.82% premium. If you buy this CEF, you will be overpaying for the portfolio. But for a long-term investment, MCI seems to provide noteworthy returns. Correlation with market-correction phase SPY: 0.19 Municipal Bond CEFs EV NJ Municipal Bond (NYSEMKT: EMJ ) Blackrock VA Municipal Bond (NYSEMKT: BHV ) Blackrock Muniyield Arizona (NYSEMKT: MZA ) These CEFs offer generous distribution rates of around 5.00. Both BHV and MZA trade at a premium, while EMJ trades at a slight discount. That discount is soon to be gone, as it has been shrinking over the past year. Buying a municipal bond fund can especially benefit you via tax exemptions if you live in a state with high taxes, as these bonds are tax-free investments in most cases. However, realize that EMJ will cause you to pay capital gains taxes on your investment, as it is currently trading at a discount. All of these regions – New Jersey, Virginia, and Arizona – are, to my knowledge, in good shape. But you should perform due diligence and ensure that the local governments aren’t facing problems of paying their debts. Residents in states with high taxes, such as New York, New Jersey, and California, should consider these CEFs. EMJ’s correlation with market-correction phase SPY: -0.09 BHV’s correlation with market-correction phase SPY: 0.25 MZA’s correlation with market-correction phase SPY: -0.11 Doubleline Opportunistic Credit (NYSE: DBL ) With a yield of 8.22, it’s no surprise that DBL isn’t trading at a discount. DBL has almost consistently been trading at a premium. But there have been dips into the discount region. An investor looking for a good deal might keep an eye on DBL and buy at one of these rare discounts. Just remember that a drop in the premium/discount will also typically drop the yield toward the sector’s average. In addition, as time goes on and rates increase, credit-based CEFs such as DBL will likely take a hit. You should also consider leverage here, as rates will likely be rising in the future. Higher leverage implies higher borrowing fees for the fund. DBL might be a good short-term hold, but you should consider dropping it for non-credit CEFs with less leverage before rates rise. Correlation with market-correction phase SPY: 0.02 Strategic Global Income (NYSE: SGL ) Speaking of leverage, here’s a non-leveraged CEF. Previously trading at one hell of a discount, SGL is now trading at “only” a -4.12% discount. This offers the highest discount of all the market-neutral CEFs we looked at today, with a yield of 9.42%. As the name suggests, SGL invests in global bonds. Its holdings branch from Argentina to Russia. These bonds are diversified, with both sovereign paper and corporate notes in the mix. Although a portfolio of such a wide geographical array of holdings is more likely than a focused portfolio to encounter a holding that cannot repay its debt, the fact that SGL is diversified should minimize such problems. The risk is there, but the reward is higher, I believe. This fund doesn’t have many downsides other than the exposure to iffy countries (the average credit rating of SGL’s holdings is still A) and the fact that SGL is taxable. Correlation with market-correction phase SPY: 0.11 Conclusion Overall, we have a wide selection of market-neutral CEFs that can help us generate stable income even during a market correction or crash. Of the five we looked at, I would recommend SGL most to investors in low-tax states, while recommending the municipal bond CEFs to investors in high-tax states. But no matter your choice, rest assured that these CEFs will be least affected by another market correction. Obviously, I simply don’t have the time to cover every industry. While reading this article, you probably thought of at least one investment that should have gone in my “Winners” section. Let me know about it in the comments section below. Request a Statistical Study If you would like for me to run a statistical study on a specific aspect of a specific stock, commodity, or market, just request so in the comments section below. Alternatively, send me a message or email.

Apply Kelly Formula To Investing: Is Volatility Just Risk?

Summary Kelly Formula is one of the most important formulas in the investment theories. It is also very interesting and useful since it is against our intuition. Volatility is commonly seen as just “risks”, but it is much more than that, since volatility can affect performance too. Theoretically, Kelly Bet is also the “optimal bet”, but that is often not true in practice. Since reducing volatility can help performance too, I will also talk about many methods to reduce the volatility of a portfolio. Kelly Formula Kelly formula or Kelly bet was found by John Kelly in 1956. This formula gives the optimal bet, given fixed odds in a gambling game. Although it has some fairly simple math behind, it didn’t get much attention from the financial world until much later. On the surface, its application is limited. Financial activities such as investments don’t always have fixed odds, and may not have a fixed period for its return either. However, what is profound in that formula is that it gives a “maximum bet” that is optimal even if one is completely non-risk-averse. If we really think about it, it is actually against regular people’s intuition. Normally we would think the returns are always related to the risk we are willing to take. The more risk we can take, the more returns we will get. So the investment return is a function of our risk tolerance. The Kelly Formula, however, says returns don’t always go up when we take more risk, even if we can ignore the risk completely, and have a very good risk appetite: there is a maximum risk we should take, more risk taking will only bring worse returns. In other words, “volatility” is more than just the risk we have to experience during the process, or more than just the wider dispersion of possible returns; higher volatility may also reduce the eventual expected return. Why is that? That is because the returns of sequential investments multiply on each other, instead of “adding” onto each other. For example, if you lose 50% in the first year, you have to make 100% gain on the next year to get back even. It is (100% – 50%) * (100% + 100%) = 100%, rather than (50% + 100%) = 150%. In math terms, the returns are multiplicative, instead of additive. (The log-returns or log-assets are additive instead). This concept is very interesting and very useful, when we start to apply it to many financial decisions. For example, many years ago, I used to think that I should invest 100% on stocks since historically stocks had higher returns than bonds or bank CDs, and since I was very young, I shouldn’t be too concerned about the risks of stocks. That seems very logical, right? Well, not after you get familiar with the Kelly Formula. The fact is, if stocks are very volatile, 100% invested in stocks may not give your best returns even if the stocks do turn out to have better returns than bonds/CD’s, and even when we assume you don’t care about the risks at all. Let’s work through an example to better understand this: Suppose you had $100 at the beginning of 2008, and stock market dropped 50% and it became $50 at the beginning of 2009. Two years later, the stock market fully recovered, rose 140% and your asset got back to $120, therefore you had a 20% gain in 3 years. Very bumpy and scary roller-coaster ride indeed, but assuming you have very good risk tolerance, that didn’t matter much to you. What if you had 70% on stocks and 30% on bonds? At the beginning of 2009, because of the government’s monetary policy, the bond interest rate dropped significantly, and your bonds had a 20% return in 1 year, but your stocks had a 50% loss. Together, it is $70 * 0.5 + $30 * 1.2 = $71, or 29% total loss. At this point, you should do a rebalancing (assuming you rebalance every year), and get back to 70% stocks and 30% bonds, so you would sell some bonds and buy more stocks. After that, you would have $49.7 in stocks, and $21.3 in bonds. Then assuming 2 years later, stocks went up 140%, and bonds had a return of 0% during these 2 years, your total asset became $49.7 * 2.4 + $21.3 = $140.58. This is a total return of 40.58% in 3 years, which is much more than the 20% return in the 100% stock case. What is more interesting here is that both underlying assets (stock and bond) only had 20% return in 3 years, yet the portfolio had 40% return, much more than the return of any of the underlying assets. (See the “magic” of financial engineering can sometimes turn toads into princes!) Now it seems to be a no-brainer for you to always invest some of your capital in bonds? After all, if it gives you more return and less risk, why not? Not too fast. In the example above, I used 2008 – 2010 as an example, and my figures are hypothetical. After all, you won’t see a lot of 2008s happening down the road. That said, the basic reasoning here still applies: Reducing the volatility of a portfolio can also help to improve returns, not just reduce the risks. The ultimate decision of portfolio allocation depends on how risky the underlying asset is. Maybe 100% stocks is optimal, maybe not, but it really requires you to have a fairly accurate estimate of the future volatility of your stock assets. Is Kelly Bet The Optimal Bet? Another interesting property of Kelly Bet is that it is the “optimal bet”. Well, I just said it is the “maximum bet”, but why am I also calling it the “optimal bet”? The reality is that the “maximum bet” part of the theory is actually agreed upon by almost everyone: normally you never want to bet more than Kelly Bet, unless you were too conservative on estimating your winning odds. In other words, if you bet more than Kelly Bet, you are not just aggressive, you are “insane”, since it will bring higher risk AND worse performance too. But calling it “optimal bet” becomes much more controversial among investors and traders. The theory does show that it is indeed the optimal bet, but that has a lot assumptions attached to it, such as: the bet can be made frequently (not exactly true for long term investments), the bets have the same odds, the odds could be estimated accurately, and you could never lose 100% of your asset. As you can see, the first 3 conditions are not true for long term investments, and the last one is probably true if you have fairly good diversification and don’t use any leverage. This is where the theory diverts from reality, and why we have to be careful when assuming Kelly Bet is the optimal bet. If you want to learn more about Kelly Bet, you can check out my blogs here and here . Common Methods on Reducing Volatilities As I mentioned above, reducing volatilities is so important that it not only helps to reduce your risk and overcome your emotions, but can also help to improve your performance. Therefore, managing volatilities of a portfolio becomes a central topic of risk management and money management. A following question is: how can we reduce the volatility? As you will find out below, this is much more than just diversification. Diversification Despite all the caveats and potential drawbacks, diversification is still the most powerful concept in financial engineering on reducing the volatility. However, people sometimes either over-extend this concept or didn’t apply it in full scale. Diversification should not be just among stocks Normally, money managers often talk about how many stocks they should hold, or how big each position should be, such as whether each position should be 1%, 5% or 20% of the portfolio. However, diversification should not just be among the stocks you hold. First, stocks usually have high correlations, or we can call it “systematic risk”. If they are in the same sector and the same country, they will have even higher correlations. So when you have more than 7 – 20 stocks in your portfolio, additional stocks may not do much good to your portfolio at all. On the contrary, it may harm you more than help you, especially when you are a small investor. This is because over-diversification will spread you too thin, make you have less information edge over the stocks you own. It may also make your performance suffer because you have to put money into your less favorable ideas. One thing we should all realize is that investment is hard and highly competitive. For this reason, the chance that you can find a good idea is slim. You may get 1 or 2 really great ideas in a year, but expecting to get many great ideas is not realistic, even for those superinvestors. As Charlie Munger said, if you remove the top 20 best ideas Buffett had in the last 40 years, the rest of the ideas’ performance is not much better than the average index. In this sense, while having low volatility is important to improve performance, having higher expected returns is just as important. (I’d like to think higher expected return as “offense”, and lower risk as “defense”.) Also, diversification is not limited to just stocks, since it can be done in many other ways: Diversify over different asset classes Bonds, cash, commodities, gold and real estate are all asset classes that could be used for diversifying risks. Historically, bonds are one of the most favorable choices since they usually have negative correlation with stocks, which helps to reduce the volatility even more. But since bonds are not attractive right now due to all the QEs, cash and gold are probably good choices, too. Cash is stable, but has inflation risk. Gold has no inflation risk, and is especially helpful in doom scenarios, but its value is more dependent on supply-demand since it has no clear “fundamental value”. Diversify over different strategies This method may not be very practical for small investors, but money managers can often utilize different investment strategies to diversify the risks, such as allocating capital among trading strategies and investment strategies, so that they have less correlations. Or they can maintain short positions in addition to long positions. Downside Protection Is As Important Instead of diversification, value investors often make very restrict requirement on the downside protection on their stock picks. In Buffett’s words, the secret of investing is his: Rule No.1: Never lose money. Rule No.2: Never forget rule No.1. Here, “don’t lose money” doesn’t mean that there should be no loss at all, because that is certainly impossible. It only means “no significant loss” and you have to be really careful about protecting yourself from any significant downside on each individual stock you select. Usually this protection requires many of the following traits in the company you are investing in: Sufficient Margin Of Safety Low P/B ratio, and good tangible book value or liquidation value Durable competitive strength and low/reasonable P/E ratio Long product cycles Not overly dependent on one product, or one customer Low financial leverage and low operating leverage Good pricing power Recurring Revenue Good management Conservative accounting Non-cyclical industry Non-commodity product or has durable low-cost advantage “Certainty” is the basis of all investment theses As mentioned above, diversification has limited effectiveness and has significant drawbacks too. For this reason, successful value investors often use the downside protection of the business itself to reduce volatility. However, any investment thesis requires “certainty” or “information edge” as its basis. Without “certainty”, any conclusion could be built on imagination instead of facts. Therefore, to reduce volatility, investors have to devote their efforts to achieve an information edge and achieve high “certainty”, instead of just focusing on diversification. In other words, “certainty” and downside protection of each stock pick reduces the volatility of each position, and diversification reduces the overall volatility of the entire portfolio. Both of these methods are needed, but it is more of an art than science to find the balance between these two. In some sense, that also depends on personal style and personal strategies. Conclusion I remember Charlie Munger once said many smart people should better devote their talents to real engineering projects instead of financial engineering, since he thinks financial engineering doesn’t really generate much value for our society. While I am a fan of Munger, I don’t really agree with this particular comment. I believe understanding the math behind financial engineering can not only achieve better returns for our investments, but also help us to make better capital allocation decisions in general. There are many financial engineered products that are very useful to us, such index, index fund, ETFs, options, interest rate swaps, ABS or even the infamous CDOs. Many of these products used the powerful concept of “diversification”. It is undeniable that there are new problems coming up along with these new things, such as the loss of insight with over-diversification, or lack of incentives to ensure the quality. However, I would compare that with stock exchanges. While so many small investors unconsciously used the stock exchange as a casino (except that they wouldn’t bet all their savings in a casino like they did in the stock market), and sometimes lost all their lifetime savings (especially in immature markets, like the Chinese stock market), overall, stock exchanges still provided tremendous value for both businesses and investors. It does take time to get regulations in place to make it more mature though, as what we have seen in the US since 1930s. All in all, it is my opinion that financial engineering and the math behind it do provide good value to us, although it is also important to recognize its limitations and don’t lose our “common sense”.

Dollar/Yen As A Hedge To Oil Investments

Summary Oil and oil companies seem like attractive bets, however there are many near term risks. In an environment of persistent low oil prices, the BOJ has assured continued QE or increases in QE. The dollar has an inverse correlation to oil, therefore a dollar hedge allows for a pure supply/demand bet on oil. The case for being long oil (NYSEARCA: OIL ) has been made numerous times on this website and others, but I will recap a few of the salient points here for completeness. Oil may be attractive from a supply point of view. Most of the new supply that led to the recent glut came from shale oil wells in the United States. In fact, oil production from other sources of world oil actually declined during the period from 2012 to 2014. Source: Resilience.org Shale oil wells have rapid decline curves compared to conventional wells. Source: oilprice.com As shown above, the production rate is a small fraction of the initial production by years 2-3. Therefore, we ought to expect that roughly two years after oil rig counts began to decline, the supplies of crude oil ought to begin to fall rapidly. However, the timetable for this recovery in oil price has been delayed due to the fact that several E&P companies were slow to stop drilling. In a last ditch effort to produce cash flows from their land, many companies continued to drill even at unfavorable prices. Source: marketrealist.com Though crude began to fall in July of 2014, companies didn’t start reducing rig count until many months later, and rig counts didn’t reach the current lower range until the spring of this year. This led to a situation where US supply didn’t start to roll over until the beginning of this year. Despite the drop in rig counts, the supply coming out of US shale is still higher than it was at the start of the crash in oil prices: Source: QuintoCapital.com This makes for an interesting situation of time arbitrage. The sharp decline in shale wells, combined with a lack of new drilling in the U.S., means that by 2017 (2 years from the peak shale oil supply seen in the above chart) the U.S. supply should be low enough to begin to positively affect oil prices. Investors who are convinced of the above argument may take a long position either in the commodity (via futures) or in specific, cash-rich E&P names that are unlikely to go bankrupt, and wait out the supply-demand imbalance. However, there is a danger in catching a falling knife – commodity speculators are currently riding the trend for lower prices, and stock traders are following suit with oil stocks. In addition, there is a risk that the oil supply/demand mismatch may worsen when Iran brings new production online. A long position in oil or oil stocks could pay off eventually, but lead to disastrous portfolio results in the meantime. Therefore, it is desirable to hedge such a position. The Case for Shorting the Yen ( YCS ) Japan’s central bank, unlike the Federal Reserve, uses a measure of inflation that includes the cost of energy. Thus, the fall in oil prices has set back its goal of ending deflation. Though Haruhiko Kuroda has been insisting that this is a temporary setback, one must consider what would have to happen for an investment in a cash-rich E&P firm to go poorly – namely, we would have to see much lower oil prices before the supply glut ends. Take a look at comments Kuroda made earlier this year (emphasis added): “…however, based on the assumption that crude oil prices are expected to rise moderately from the recent level , the CPI is likely to reach 2 percent in or around fiscal 2015. Needless to say, the Bank maintains its policy stance that it will make adjustments as necessary without hesitation, when there are changes in trend inflation, in order to achieve the price stability target at the earliest possible time. The Bank will not respond to developments in crude oil prices themselves, but in conducting monetary policy, it will closely monitor how they affect inflation expectations — or, in other words, whether conversion of the deflationary mindset will nevertheless proceed.” And, more recently, “The timing of reaching the inflation target depends on oil, he told reporters in Tokyo. Kuroda, 71, reiterated that the BOJ won’t hesitate to adjust policy if necessary.” And “Kuroda said he didn’t see limits to further policy steps, amid concern among private analysts that the BOJ’s campaign — mainly purchases of Japanese government bonds, or JGBs — is running up against constraints. He didn’t think a limit on buying JGBs would come soon.” The latest inflation numbers for September showed inflation at -.1% , a far cry from the 2% goal. While Kuroda stated that the BOJ will not specifically respond to oil prices, lower oil prices are bound to continue to bring down inflation expectations. I take the above comments as basically an assurance that as long as oil prices stay low, the BOJ will continue its QE program, and if oil prices fall further, there is a high likelihood that the BOJ will ramp up its QE program yet again. The Case for Being Long The U.S. Dollar There has been a strong inverse relationship between the dollar (NYSEARCA: UUP ) and oil: Source: quintocapital.com This correlation makes sense: because oil is priced in dollars, the strong dollar has contributed to the fall in oil prices. While Japan has been concentrated on stepping up its QE program, the US Federal Reserve has basically told market participants that it plans to raise rates in December. This divergence in policies is driving the USD/JPY higher, and the oil price lower. So going long the dollar in addition to being long oil provides investors a way to play oil purely for its supply-demand characteristics, rather than its aspect as an alternative currency. A word about China There has been a perception that the crash in Chinese stock prices will lead, or already has led, to weakening oil demand. However, the opposite is actually true – Chinese oil demand is actually up 9.2% year-over-year , as lower prices have stimulated demand. As Stanley Druckenmiller said earlier this year , the cure for high prices is high prices, and the cure for low prices is low prices. Putting it together I think there’s a strong case out there for being long oil right now. However, there is always a risk that the fall in oil could become overdone, and we could see oil prices that are in the $20-$30 range before we see prices in the $60-70 range. In order to hedge this volatility, I think there’s a good case for being long the US dollar, specifically against the yen, which will devalue further if oil either stays low or drops further. Any thoughts are always appreciated.