Active Portfolio Management

[Sai]

Hi All,

Just thought I would start a new thread and may be help a few people out there that are looking to improve their trading and investment decisions in general. Its all educational and nothing in this thread should be construed as investment advice in any way shape or form.

My background is in short term trading. However I am a professional wealth manager and advise wealthy clients on investments, tax and estate planning. This role requires quite a few things that are not related to trading but I will focus on ideas relevant to short term traders.

This thread is really for people wanting a few ideas on how to grow wealth within acceptable risk parameters over the long term. It is not really directed to fast paced traders looking for 30% returns every month.

I will reveal the actual composition of a portfolio I have constructed for a new client who is looking for wealth preservation and long term capital growth. The client has specified that he is willing to accept up to 10% volatility in his portfolio for 6.5% net returns p.a. He has specified that only FX as an asset class should not be included in the portfolio.

My clients portfolio is called SC Macro Global Growth and its performance is measured against the FTSE APCIMS Global Growth Index. More info about this index can be found here: FTSE APCIMS Private Investor Index Series - FTSE

The transactions for the client were completed on14th December 2011. The portfolio has been optimized to meet the risk/return characteristics agreed with the client.

A more detailed break down of the actual portfolio is attached in the PDF below. I will post updates every week and answer questions as soon as I can.

Equities and Fixed income asset classes within the portfolio will generally remain unchanged barring a few transactions to re-balance. However it's in the commodities space where I will go to work with active short term trading. I have picked securities associated with relatively cheap dealing costs and will look to maximize the risk/return profile through market timing. Hopefully by the end of the year we will stay within the 10% portfolio volatility range and achieve 6.5%+ net returns.

I will cover more concepts as we go along.

Thanks

 

[NVP]

Hi S

what does 10% volatility mean ?

 

[sj8070]

i would echo the above question. 10% average aboslute change in NAV? different to volatility.

having browsed your portfolio breifly i actually like your trades. I expect XAU and XAG to drive your upside but i dont like your exposure to "Asia" though i admit I haven't delved into the details of that particular basket / OEIC

 

[Sai]

Hi S

what does 10% volatility mean ?

Variance in portfolio returns over a given period. Technically volatility means the degree to which a variable will deviate up or down from its mean. However in this context we are interested in controlling the deviation (or standard deviation) from average portfolio returns over a year.

So for example if we achieved average returns of 1.625% per quarter for all 4 quarters a year from now, we hope we did our job and that our returns over each quarter didn't fluctuate by more than 11.625% or less than -8.375% (1.625% +/- 10%) from the 1.625% average.

You might ask why does +10% need to be controlled, isn't that a good thing? Yes that is a good thing but both risk and return are positively correlated. Meaning we have to take on more risk for more return. This is especially true when approx 79% of your portfolio is composed of risky assets like equities and commodities which are prone to wide gyrations in returns.

So for an investor who is looking for steady and consistent growth in the value of their portfolio, limiting the variation in returns to a specific % becomes essential.

 

[Sai]

i dont like your exposure to "Asia" though i admit I haven't delved into the details of that particular basket / OEIC

Basic rationale for Asia is that there are greater growth prospects in corporate earnings in the east, especially India, given the clients investment time horizon (10+ years).

 

[sj8070]

wrong. you are talking about average absolute return here NOT volatility/std dev

imagine a price process 1 1 1 1 1 1 1 1 1 10
(so 9 ones and then a 10)

the average change in price per day is [(0*9)+10]/10 = 1
Variance in price change = 100/10 - 1 = 9

This is the mistake you are making, whether it be terminology or understanding. it is a classic error and consistently underestimates true volatility

for someone that is managing nearly 1mm of client money, the fact that you make this mistake is alarming. then again, the vast majority of real money managers are no better than a coin flip

 

[Sai]

wrong. you are talking about average absolute return here NOT volatility/std dev

imagine a price process 1 1 1 1 1 1 1 1 1 10
(so 9 ones and then a 10)

the average change in price per day is [(0*9)+10]/10 = 1
Variance in price change = 100/10 - 1 = 9

This is the mistake you are making, whether it be terminology or understanding. it is a classic error and consistently underestimates true volatility

for someone that is managing nearly 1mm of client money, the fact that you make this mistake is alarming. then again, the vast majority of real money managers are no better than a coin flip

Sorry but I was not talking absolute returns in my response to NVP I was responding to a specific question about volatility which relates to the gyrations from average returns over a specific period.

To simplify it for you the target absolute return is 6.25% after 1 year. The reporting period is every quarter. There are 4 quarters in 1 year. 6.45%/4 = 1.625% per quarter. If we posted returns of :

Month 1 = 1.625%
Month 2 = -8.375%
Month 3 = 11.625%

What would the Std Dev of returns be over the first quarter?
What would our average return be over the first quarter?

Now once you've worked that out you know that for the next quarter you have to increase the NAV of the portfolio by another 1.625% in order to meet the clients return objectives. Your past gains are history, you start from scratch for the next reporting period. Furthermore you have to factor in client withdrawals and payments made into the investment account. That's what happens in the real world. I hope that clarifies any misunderstanding.

 

[NVP]

thanks for response.......:smart:

 

[Sai]

No significant changes in the investment policy for the portfolio to report so no trading at this stage.

Current performance is attached via PDF.

 

[Sai]

Just a quick overview of what I am thinking at this stage.

Equities

Well it has been another horrid week for the Eurozone. Further downgrades and Angela Merkels comments last week on how ‘Europe needs to do more’ will probably make this another highly volatile week in Equity markets globally. With the Euro near 17 month lows I’m watching the $1.2600 level very closely. If we break through $1.2600 with conviction I see the EUR/USD trading down to $1.1900.

In my opinion this will impact Equities in the medium term so with stocks making up significant portion of the portfolio hedging with CFD’s, futures or options will be sensible trades. I am keeping an eye on the $1.2600 level for confirmation. Alternatively, I will consider slightly under weighting equities and increasing exposure to a combination of lower duration bonds, money market funds and cash if dealing costs are reasonable.

Bonds

Essentially I'm looking for the flight to safety trade where the market is willing to sacrifice yields for the safety of Government Bonds. The more safety they require the more I will benefit from bond price increases. According to the DMO, 4.5% Treasury Gilt maturing March 2013 is currently yielding 0.42%. So if I consider moving some cash to prime grade government bonds it certainly won't be for the coupon but for price appreciation make up most of the gain. As touched upon before, in the event a negative scenario plays out for Equities, lower duration bonds (less volatile than higher duration bonds) will potentially offer capital gains with less volatility.

For UK residents, especially higher rate tax payers, tax efficient opportunities will come in the form of capital gains on UK Gilts. Furthermore, Investment Funds that are buying a combination of prime grade government bonds, high grade corporate and UCITS complaint covered bonds will provide decent diversification during tough times.

Commodities

I see commodities as a long term inflation hedge but shorter term geopolitics will have its say on how some assets perform this year. Specifically, the central bank of Iran being sanctioned and the assassination of an Iranian nuclear scientist last week, it’s clear that the war with Iran has begun. I see the price of Crude appreciating significantly over the coming months if Iran rejects an impending final peace offering from the U.S. If this scenario plays out I would increase my exposure to the Energy sector.

I’m expecting Gold to blow past the $2,000 mark by the end of the year given potential downside risks to equity markets with Silver outperforming Gold but I’m comfortable with the current composition of precious metals in the portfolio.

Portfolio performance for last week is attached below. As mentioned in my first post, the portfolio went live on the 14th of December 2011. Performance for last month is 0.94%. So currently ahead of scheduled to meet the returns objective of 6.5% for the year. Obviously nothing is guaranteed in financial markets and things could change rapidly. But all we can do is control risk and take advantage of opportunities when we see them to hopefully come out positive by the end of the year.

 

[Martinghoul]

Interesting... Can you estimate for me the transaction costs/management fees (obviously, wouldn't apply to all of the portfolio holdings) on something like that?

 

[Sai]

I have total costs (including spreads) down to 1.22% for this portfolio. Normal costs can go up to 5% for the initial charge and 1.5% p.a management fee for the top performing funds.

Obviously reducing your costs depends upon many factors. Assuming you have formulated your risk/return objectives correctly, the way you structure your portfolio after identifying the asset classes you want exposure to will have a big part to play in your costs and net returns at the end of the year.

For example, I intend to trade commodities more heavily than equities and bonds given the objectives for this portfolio. Therefore it wouldn't make sense to actively buy/'sell some of the commodities funds out there due to the charges associated with them. So picking the ETFs is more favorable as the only real concern there would be liquidity. Dealing costs are limited to annual management charges of 45 bps for these instruments.

Other factors to reduce costs are your relationships with the funds and your negotiation skills. If you have good relationships and your investing a meaningful amount then you can haggle for favourable rates. From a quantitative aspect obviously higher weighting of funds within your portfolio which have higher management fees will reduce net returns significantly.

Ultimately costs, tax and your relationships with funds or brokers should have zero bearing on which asset classes you think will provide the optimal risk/return for your trading time horizon. But they should definitely not be ignored after you've picked where you want to trade.

 

[Martinghoul]

Makes sense, thanks... I am sort of going through a roughly similar exercise at the moment and costs (esp management fees) really get me all hot 'n bothered.

 

[Sai]

Performance for last week attached.

U.S and European Equities have made great gains since October but I believe bulls should be cautious here given that trading volumes need to pick up for this to be sustained.

As stated a few posts back the underlying fundamentals are still weak, with Europe's problems well documented I believe its a lot worse than what we are being led to believe. However taking advantage of short term opportunities is just one way of creating a buffer for the hard times if you operate a long only portfolio.

 

[Sai]

Performance for last week attached.

May start to re-balance the portfolio slightly to keep within the optimal weighting ranges for our portfolio objectives.

Will update if this happens during the week.