When you are managing money in the financial markets for more than a couple of years, there are a two or three things you can be sure of:
- You will go through market crashes. 2001 with the dot.com bubble, 2002 with Enron / Worldcom scandals, 2008 with subprimes and Lehman Brothers or 2011 with the peripherals countries and that’s only looking at the last 15 years. Markets are overreacting, on both sides, and you have to be aware of that.
- You have to pay attention to what the main central banks are saying. People always think about Georges Soros fighting and winning against the bank of England, but most of the time you will end up losing money betting against a central bank. And everybody is not Georges Soros.
- If you are a good portfolio manager, with a strong investment process and a strong team, you may be right 60% of the time and wrong 40% of the time. Meaning that to make money, you will have to make sure that you earn more when you are right than what you lose when you are wrong.
And all these points are even more accurate now than they were 10 or 20 years ago. We are living in a world with cycles becoming shorter and shorter and with markets focusing on short term movements more than anything else. All of this means that you need to allocate your capital dynamically and above all, you need to know what your risk is at any given point in time.
When you allocate money in the financial markets, what matters most are the risk / reward characteristics of your trades. You need to know, or at least have a strong opinion, on what is currently pricing the markets. You need to know how the main financial players are positioned, what are the dynamics of the financial flows, how much you are going to win if you are right but more importantly, how much you are going to lose if you are wrong. You may have the best macro analysis there is but if you are not paying attention to those indicators, it may cost you in the end.
The following chart stresses the correlation between investors positioning and markets. Investing when people are underweight usually yields attractive returns.
Sources: Bloomberg, AAII
Let’s take the Japanese equity market for instance: from the end of 2012 to the end of 2014, the market is up 72%, which is huge and one of the best macro calls you could have at that time. Now look at how this performance has been achieved: You are up 54% from end of 2012 to May 2013 and then you lose 22% in three weeks. 1 year later, you are still at the same level before making 25% in 2 months during Q4 2014. All of this means that it was possible to get almost all the positive P&L by being invested only twice during that period but it also means that if you invested at the wrong time, you would have possibly have ended up losing money. The Japanese market is typical of those big moves and the analysis would be different if you had taken the US equity market but still, it would have shown that being able to size your position in accordance with what is priced in the market would have been very beneficial.
What we want to highlight here is the importance of what we call the “technical” of the markets, and by that we do not mean technical analysis but all the parameters that might help you to forecast your risk / reward ratio. Sentiment analysis, flow analysis, technical analysis, calendar analysis, etc… We think that if you are able to gather the relevant information, analyze it and understand it, you will be in a position to invest your money when the upside potential is superior to your downside risk.
As of today, investor positioning gives interesting clues on geographical asset allocation: in the last 3 years, investors have poured money out of Europe into the US. These flows could potentially reverse in the coming quarters, occurring better performances on European equity markets than in the US.
The next important point is to understand the future behavior of your investments, and by that we mean to know how the different buckets of your portfolio will react to different scenarios. Any trade or theme can be characterized in term of correlation to risky assets, and this is something you need to analyze constantly as it is changing over time. Most of the time, being long the US dollar is a hedge to risky assets (2008 is a good example, but also the first half of 2010 during the fear of the Eurozone break up) but this has not been the case since the middle of 2014 with the US dollar showing positive correlation to equity indices. And this is true for almost any asset, which is why it is very important to assess the current and future correlation of your investments to risky assets. Not doing this analysis will lead, over time, to potential negative surprises in terms of performance, and if this is taking place during market turbulence, you may end up posting a very negative performance even if you thought that you weren’t that risky.
With yields being very low and central banks pushing investors to take risk, markets will stay nervous in the next few years, with periods of low volatility followed by violent correction, which is why we think that having a dynamic capital allocation and a strong focus on your risk control framework is currently key.
François Rimeu is fund manager Total Return Cross Asset at La Française