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Global Macro – Generate Superior Returns With Less Risk

Summary Global macro not only generates higher returns but does it with far lower risk than equities. Long-only equities have been profitable, but has had some very long and deep periods of negative returns. Not only are stocks usually in a drawdown, but over the past 20+ years, we have had two massive drawdowns that took years to make up. We at The Macro Trader are obviously fans of Global Macro as an investment strategy and even philosophy. Fortunately, the data backs us up showing that global macro not only generates higher returns but does it with far lower risk than equities. The chart below shows how you would have done if you had invested $1,000 into the Credit Suisse Macro Hedge Fund Index, SP500, and Barclays Aggregate Bond Index since 1994. As you can see, the CS Macro Hedge Fund Index did drastically better than either stocks or bonds. To be more specific, the CS Macro Index beat the SP500 by 2.11 times and the AGG Index by 2.75 times. So, that shows the returns, but what about the risk taken to achieve these returns? (click to enlarge) Global Macro vs SP500 vs Lehman AGG Bond Index We have a few different charts to display the risks taken to generate the returns in each index. First, we will show the historical drawdown charts. A drawdown is simply anytime you are not at new highs in your account. If you have $100 and lose $5 you are in a -5% drawdown. The deeper the drawdown the higher the return needed to get back to breakeven and the math, while simple, can be tricky. For instance, if you lose -50% many think you need to make 50% to get to breakeven. The reality is that you need 100% to get to breakeven. In our case of being down -5%, you only need a 5.26% return to get to breakeven, but it gets harder the deeper you get. Looking at a drawdown chart of the SP500, you can see that not only are stocks usually in a drawdown, but over the past 20+ years, we have had two massive drawdowns that took years to make up. We know them as the dotcom crash and the GFC (Global Financial Crisis). It took the SP500 57 months to recover from the dotcom crash and 50 months to recover from the GFC. (click to enlarge) SP500 – Drawdowns At the opposite end of the spectrum, we have the drawdowns of the Barclays AGG Fixed Income Index. As you can see, the AGG Index has frequent but small drawdowns with the worst one barely dropping below -5%. It only took nine months for the AGG index to fully recover from the worst drawdown and three months to recover from the second deepest drawdown. (click to enlarge) Lehman/Barclays AGG Fixed Income Index Drawdowns Finally we have the CS Global Macro Index drawdowns. As you can see, its worst drawdown was a -26.79% and its second worst was -14.94%. It took 19 months to recover from the -26% drawdown and 19 months to recover from the -14.94% drawdown. (click to enlarge) Credit Suisse Global Macro Index Drawdowns Another way to show the depth and length of the drawdowns is to plot both the equity line as well as the new-highs line. In each of the next three charts, the green line equals the highest equity line got; notice that it never dips down, and the red line is the equity curve which goes both up and down. Here is the SP500. As you can see, while it hit a new high in 2007, it then went back down. In essence it took about 12 years before investors were really making new money. While this is a worse-than-“normal” period, it is also not the first or the second time that the stock market has had a rough decade. (click to enlarge) SP500 DD and NH Looking at the AGG Fixed Income Index, we see that the drawdowns are both shallow and short. If you were in the AGG Index, you would not make the most money but you also took very little risk. (click to enlarge) Lehman-Barclays AGG Fixed Income Index DD and NH Finally, we have the CS Global Macro Index. As you can see, the drawdowns, while larger than that of the AGG index, are far smaller than the SP500 index. It kind of takes the middle route in regards to risk but it drastically outperforms both in regards to return. (click to enlarge) Credit Suisse Global Macro Index DD and NH Another way to look at the risk and return is to look at the 12-Month Rolling Returns. At any point in the chart, you are looking at the returns you would have gotten if you had invested 12-Months ago. As you can see, the SP500-red line has the highest 12-Month returns, but also the lowest 12-Month returns. The AGG Index (green line) almost always shows positive returns, but it never has a really big year. Finally, the CS Macro Index (blue line) again comes somewhere in the middle. It is positive almost as often as the bond index but the 12-Month period to 12-Month period returns are less than stocks. (click to enlarge) Global Macro-SP500-AGG 12-Month Rolling Returns Basically global macro has lower volatility and more consistent returns than the stock market and almost as consistent returns and far more gains than the bond market. The main reason that this is possible is that as opposed to either the stock or bond index a global macro fund can go long and short anything and trade derivatives on anything. Most macro managers stick to liquid instruments but that still means you have hundreds if not thousands of tradeable instruments. The flexibility inherent in global macro allows you to always find a bull market somewhere whether that is being long stocks, short stocks, long the Australian Dollar, or short the Australian Dollar. You can bet on U.S. Treasuries against German Bunds or across almost any other market relationship you can think of. Not only is global macro flexible but macro managers are famous for stringent risk management practices. It is almost cliche, but in the end risk management is one of the keys to success in any trading approach and one of the most important things that separate macro from long-only buy and hold. What about claims in the press that “hedge funds have underperformed the SP500 since the GFC?” Well that is true but if you are picking only half a cycle, then it is probably not a fair comparison. In the chart below, you can see what happened to the CS Macro Index and the SP500 from the end of 2008 until the end of August 2015. As you can see the stock market is ahead. (click to enlarge) 2009-Now Of course that was just in a bull move when everything was headed up. If instead of the end of 2008 or the end of February 2009 we use 2007 as our starting point we get a drastically different result. In this case the flexibility and risk reduction inherent in the global macro approach shines as the CS Macro Index outperforms the SP500 with both higher returns and far lower risk. (click to enlarge) 2007-Now As far back as we have data global macro has outperformed both stocks and bonds across full market cycle. On the other hand, long-only equities have been profitable, but has had some very long and deep periods of negative returns. We are obviously biased towards global macro. We have a site and run a research service dedicated to it. You could say we drank the kool-aid and live and breathe this stuff. At the same time, however, many of the most successful money managers in history have been macro managers and the data shows that when done right, it can lead to both higher absolute and risk-adjusted returns. So, while we are indeed biased, we think that the case is fairly strong in our favor.

Fidelity Magellan Fund: Getting Better In A Good Market And Coasting On Past Successes

FMAGX is a storied name in the world of mutual funds. But the fund hasn’t been what it once was in a long time. It’s hardly a bad fund, and it may be turning itself around, but there may also be better options for you. The Fidelity Magellan Fund (MUTF: FMAGX ) has a hallowed place in the history of mutual funds. Former manager and mutual fund icon Peter Lynch is probably the name most associated with the fund. And while he led it to great success, he hasn’t been the manager for a long time… and performance has been less than inspiring for a long time, too. What’s it do? Fidelity Magellan’s objective is capital appreciation. It achieves this by investing in stocks. That may sound a bit simple, but that’s really what Fidelity puts out there. What this is basically explaining is that the fund owns stocks and doesn’t have specific style, region, or sector preferences. So it will own both growth and value names, invest in domestic and foreign stocks, and basically go where it thinks it can find opportunity. With an asset base of around $15 billion, however, you’ll want to keep in mind that it isn’t likely investing in too many small companies. So FMAGX is really a large cap style agnostic stock fund. Current manager Jeffrey Feingold is looking for companies with, “…accelerating earnings, improving fundamentals and a low valuation.” He believes these are the main drivers of performance, but admits that finding all three in one investment can be hard. So he works to find stocks with at least two of these factors going for them. Broadly speaking he also tries to diversify the holdings across aspects like type of company (fast growers, higher-quality growers, and cheap with improving fundamentals) and risk profile (for example, stocks with different leverage levels and earnings predictably). In the end, he explains, “…because of the way I manage the fund, security selection is typically going to be the primary driver of the fund’s performance relative to its benchmark.” How’s it done? Feingold has been at the helm of the fund since late 2011, putting his tenure at a little over three years. And in that span he’s proven pretty capable. For example, over the trailing three year period through August, the fund’s annualized total return was roughly 16.4%. The S&P 500’s annualized total return over that span was 14.3%. Assuming there was a bit of a transition period as he took over, that three period is probably a fair time frame over which to look at his performance. And its a big difference from longer periods. Despite the recent solid showing, the fund’s five-, 10-, and 15-year trailing returns all lag the index and similarly managed funds. Often by wide margins. So Feingold has been doing something right at a fund that’s been missing the mark for some time. However, there’s more to the story. The manager’s tenure has coincided with a mostly positive market. In fact, 2012 (the S&P advanced around 16%), 2013 (the S&P was up 32%), and 2014 (the S&P was up nearly 14%) were all fairly good for the market based on historical average returns. In other words, the manager has had a good backdrop in which to work. Looking to the future, however, it’s fair to say that he hasn’t been stress tested at this fund yet. So I wouldn’t get too excited by the recent performance. That said, so far this year, the fund has held up reasonably well. It’s lost less than the S&P and similarly managed funds. But I’d argue that this isn’t enough of a test to get a real feel for how the fund will handle a major market correction with Feingold at the helm. But it is at least encouraging. Not too expensive, lots of trading Looking a little closer at owning Fidelity Magellan, it’s got a reasonable expense ratio of 0.7%. Although you could argue that a fund with around $15 billion in assets could probably be run with a lower expense ratio, 70 basis points isn’t out of line with the broader fund industry. If you take the time to look at the fund’s annual report, though, you’ll notice that expenses have increased from around 0.5% in the last couple of fiscal years. But that’s really a statement to the improving performance. Magellan’s expense ratio is based on the cost of running the fund plus a performance adjustment. In other words, the expense ratio is going up because Magellan has been doing better. I think most would agree that this is reasonable. That said, Magellan’s 70% turnover looks fairly high to me based on the large cap names it’s pretty much forced into because of its large asset base. That number has been fairly constant over the manager’s tenure, as well, so this looks like a reasonable rate to expect year in and year out. There are a number of very good funds that manage to do well with turnovers in the 20% range, so the 70% figure is something I’d watch. For example, that level of trading in a falling market, as noted above, has yet to be tested at the fund. I make that comparison because a fund with a 20% turnover is clearly buying and holding companies it likes and knows well. Companies that it believes have solid long-term prospects. A fund that turns over 70% of its holdings in a year looks like it’s investing with a shorter time period in mind. You may be OK with that, but if you aren’t, then this may not be the right fund for you. If you’ve gone for the ride… Investors often buy funds and then forget they own them. If you have been in FMAGX for a long time it has probably served you reasonably well, overall. That said, you have also lived through some periods where management hasn’t lived up to the fund’s storied past. That appears to be turning a corner with a new manager running the show. However, the new manager has so far been running things in a good market. There are few solid clues as to what you might expect in a real downdraft. So improved performance is nice to see, but it’s too early to call an all clear-especially with the market turning so turbulent of late. In fact, Feingold might be on the verge of a true test of his abilities in a falling market. Only time will tell. In the end, if you own Magellan I wouldn’t be rushing for the exits. However, if complacency is what’s kept you in the fund I’d suggest looking around at other large cap funds. Magellan is hardly a stand out performer, despite the fund’s impressive history, and based on the management changes over time it may no longer be the fund you bought. So a little perspective on your options wouldn’t hurt, even if you decide to stick around.

Don’t Invest With Your Convictions. They’re Wrong.

Summary Investors overestimate their knowledge of financial markets. Realized returns of individual investors substantially lag benchmark results. There is no clear evidence of persistence in mutual fund returns. Most investors have some kind of view on today’s stock and bond markets. It’s only natural. Financial media is everywhere. Investment news and opinions are delivered to our smartphones as soon as they are written. While the bandwidth of financial information has expanded dramatically, its noise to signal ratio remains stubbornly high. Buy Gold! Metals are dead! The Stock Market is too high! The Market has room to run up! The reality is that almost no one knows. And it’s virtually impossible for John Q Public to identify those few who do know. This newsletter talks about investor convictions and their impact on financial outcomes. The Big Picture One way to evaluate the success of individual investor sentiment is to take a look at aggregated performance. How is everybody doing? As a group … very poorly. DALBAR is an independent consultancy that reports annually on the success that individual investors enjoy relative to various financial benchmarks. In effect, they measure the ability of the public to time movements into and out of mutual funds over long periods of time. There is a lag between expectations and performance. For the 30 years ending 2014, average equity and bond fund investors massively underperformed their respective benchmarks – the S&P 500 and Aggregate Bond Index. Why is the Investor so Wrong? There are two basic explanations for the lag. Investors repeatedly demonstrate tendencies injurious to financial health. Collectively, they lurch from euphoria to panic – based on recent market performance. In fact, investor performance lags are largest during periods of heightened market volatility. These general conclusions deserve some anecdotes. Gallup and Wells Fargo conduct a quarterly survey on investor sentiment by interviewing over 1000 individuals with stock market exposure. They distill the responses into an index of overall market optimism. It reached its apex in January 2000 – 2 months before the dotcom bust. The sentiment index reached its nadir in February 2009 – one month before what has become the 3rd longest bull market in American history. So much for investor convictions. It has been my experience that investors overestimate their own ability to maintain rationality in the face of market turbulence. The aggregated date supports this view. According to a Wells Fargo/Gallup survey conducted in early February, 76% said they were either very or somewhat likely to take no action during market volatility. Yet investors exited the equity markets en masse in late 2008. The second problem with investment outcomes are the products themselves. The mutual funds that investors choose to implement their beleaguered strategies also fall short of the mark. Fund companies spend fortunes to convince the public that their portfolio managers can beat the market through astute security selection or tactical asset allocation. These superstars get paid well. Data compiled by Morningstar indicates that the cost structure of mutual funds has remained high in the new century. The average US equity mutual fund still charges 1.25% annually. Given the secular decline in bond yields, this resilience of high fees is especially surprising in the fixed income space. Fees in the average bond fund now exceed 25% of the yield to maturity of the ten year Treasury bond – up from 13% a decade ago. Have the expert fund managers delivered? The aggregate data tells us no. In fact, actively managed mutual funds lag the performance of a corresponding index by an amount that is not significantly different than the expenses they charge. A reasonable response to this result might be that mutual funds cannot beat the average because they are ultimately competing against themselves. It’s up to individual investors or their investment consultants to identify the “best of breed” managers in each asset class. A foundational approach in this effort is the evaluation of past performance. Again the data throws cold water on this theory. Past performance demonstrates virtually no persistence across a wide range of equity mutual fund asset classes. Top quartile performers depart the top quartile at the rate faster than predicted by random chance. If returns were completely random from year to year, there would be a 25% likelihood that a dart throwing manager could return to the top quartile. Doesn’t work that way as selected data from S&P Dow Jones indicate in the table below. Is There a Better Way? There is a corollary to the rather pessimistic findings of the previous section. If moving assets around is a destructive behavior, then keeping them in place is a better option. Long term performance of the major classes has been sufficient over the last ten or even hundred years to deliver comfortable retirement outcomes to most serious investors. Sure, it’s no guarantee that the public financial markets will continue to serve as stores of value. But stocks and bonds are about the best option the investing public has. A qualified investment advisor can play a constructive role here. Besides the technical ability to craft and implement an investment plan, a key advantage is the discipline that investors gain to stick to the plan amidst the financial noise that is sure to follow. Vanguard estimates that behavioral coaching is worth about 1.5% to investors each year. Based on a Vanguard study of actual client behavior, we found that investors who deviated from their initial retirement fund investment trailed the target-date fund benchmark by 1.5%. This suggests that the discipline and guidance that an advisor might provide through behavioral coaching could be the largest potential value-add of the tools available to advisors. Although the financial markets have suffered few reverses over the past six years, rest assured that market panics will follow at some point. Consider the wisdom of Meir Statman, Professor of Finance at Santa Clara, who wrote the following in the Wall Street Journal near the nadir of the recent financial crisis when investor sentiment was stacked against the stock market. Don’t chase last year’s investment winners. Your ability to predict next year’s investment winner is no better than your ability to predict next week’s lottery winner. A diversified portfolio of many investments might make you a loser during a year or even a decade, but a concentrated portfolio of few investments might ruin you forever. Consistency will get you there. Have the courage NOT to act on your own beliefs. It will be worth it. (click to enlarge)