2010 Performance Review:
As we review our performance for 2010, and enter 2011, I'm reminded of the two main risks in the investment world: 1) The risk of losing money, and 2) The risk of missing opportunity. You can completely avoid one or the other, or you can compromise between the two, but you can't eliminate both. One of the reasons investing is so challenging (in a good way) is this balancing act between risk and reward. When do you emphasize one over the other? When most people hear the word "risk" they generally think of loss or harm, but when it comes to investing missing opportunities can be equally as harmful. During bull markets the risk of loss rises, but the lure of missing opportunity is very seductive. During bear markets the risk of loss is low, but the fear of losing even more can be paralyzing. God I love this job.
At Rockhaven our goal is to manage our assets, and those of our investors, to generate the highest possible risk adjusted returns, in order to preserve and increase our purchasing power. I've found that nearly all investors have the same goal, "Get me the highest possible return with the least amount of risk." Sounds good doesn't it? Well, how do we go about measuring this admirable goal? Fortunately Wall Street is not lacking in mathematicians, and in the early 1960's William Sharpe developed the Sharpe Ratio. The Sharpe Ratio measures the amount of excess return generated for each unit of risk taken. Calculating it is rather simple, you take your return (R) subtract the risk free rate (Rf) and divide by the volatility of the returns (σ or standard deviation). The higher the Sharpe Ratio the higher your risk adjusted return.
Let's do an example. Last year the S&P 500 returned 15.02%. The risk free rate was 0.14% (the 90 day T-Bill yield). And the standard deviation of the monthly returns was 5.54%. So the Sharpe Ratio for the S&P 500 for 2010 was 2.69 = ((15.02-0.14)/5.54). The higher the Sharpe Ratio the better. When an asset marches consistently higher with little volatility (i.e. Gold and its 9.26 Sharpe Ratio) you can get a very high Sharpe Ratio.
OK, this is probably way more math than any of you signed up for. All I'm trying to do is present a way (definitely not the only way) of comparing risk adjusted returns. Its great to know that the S&P 500 was up 15%, but how much volatility did you have to endure to get that 15%? Of course during bull markets investors don't worry nearly as much about risk adjusted performance as they do in bear markets. Hopefully this will help you make a more educated comparison of performance.
The following table shows the performance, and risk adjusted performance of our model portfolio and our major asset categories:
Performance Comparison 2010 | ||||||||||||||||
Benchmarks Ranked by Risk Adjusted Returns | Ticker | Jan | Feb | March | April | May | June | July | Aug | Sept | Oct | Nov | Dec | Total Return 2010 | Risk (Std. Dev.) | Sharpe Ratio |
Gold ETF | GLD | -1.26% | 3.27% | -0.44% | 5.88% | 3.05% | 2.35% | -5.09% | 5.71% | 4.78% | 3.68% | 2.11% | 2.44% | 29.25% | 3.14% | 9.26 |
US Real Estate REIT | VNQ | -5.52% | 5.58% | 10.20% | 7.15% | -5.33% | -5.16% | 9.59% | -1.28% | 4.46% | 4.74% | -1.85% | 4.54% | 28.44% | 5.80% | 4.88 |
Rockhaven GTAA Model | -3.56% | 2.13% | 3.19% | 1.51% | -5.40% | -1.05% | 2.88% | 0.25% | 5.21% | 3.37% | -1.73% | 4.77% | 11.52% | 3.32% | 3.42 | |
Treasury Bonds 10-20 yr | TLH | 2.82% | 0.11% | -1.13% | 2.29% | 3.25% | 3.85% | 0.78% | 5.43% | -0.87% | -1.62% | -1.38% | -4.15% | 9.33% | 2.78% | 3.30 |
Commodities CRB Index | CRB | -6.27% | 3.46% | -0.52% | 1.60% | -8.25% | 1.46% | 6.12% | -3.71% | 8.58% | 4.82% | 0.24% | 10.42% | 17.44% | 5.67% | 3.05 |
S&P 500 Index SPDRS | SPY | -3.63% | 3.12% | 6.09% | 1.55% | -7.90% | -5.21% | 6.80% | -4.50% | 8.96% | 3.80% | 0.00 | 6.68% | 15.02% | 5.54% | 2.69 |
Int’l Real Estate REIT | IFGL | -6.05% | 2.43% | 4.55% | -1.24% | -9.70% | -0.28% | 10.01% | -0.11% | 11.61% | 4.46% | -5.93% | 6.27% | 14.60% | 6.52% | 2.22 |
International Stocks EAFE | EFA | -5.07% | 0.27% | 6.39% | -2.80% | -11.19% | -1.98% | 11.61% | -3.80% | 9.97% | 3.81% | -4.82% | 8.30% | 8.26% | 7.07% | 1.15 |
International Treasuries | IGOV | -1.03% | -0.02% | -1.22% | -1.36% | -3.29% | 0.78% | 5.52% | 0.70% | 4.76% | 1.00% | -6.73% | 2.60% | 1.10%% | 3.33% | 0.29 |
A Quick Look Back At 2010, And A Glance At Where We Stand Today:
As the above table shows 2010 was a year of repeated ups and downs...Risk On, Risk Off and a big Risk On in December. The year was mostly up for all assets other than bonds, therefore our Tactical Asset Allocation model spent most of the year near fully invested.
The most important event of 2010 was the record setting size of the liquidity-creation cycle, led of course by the Feds Quantitative Easing II (QE2). But it wasn't just the Fed, corporations are also experiencing record profit margins and are generating record amounts of free cash flow. This liquidity event is starting to show up in increased capital spending and maybe even a little increase in hiring. The US recovery seems to have finally reached a more virtuous phase, and the self-reinforcing nature of crowd behavior may just keep it there.
Gold, Real Estate Investment Trusts, and Commodities were the big winners last year, while Developed Market International Stocks and Bonds lagged. Emerging markets posted strong returns.
Where we stand today:
1) Cheap Money = Speculation - The Fed's zero rate policy and quantitative easing have clearly increased investors risk appetite. It's working so far, but just like plastic surgery, what looks good initially can look pretty scary when taken to extremes.
2) Inflation is the Fed's Destination - The Fed is hoping that all of this excess liquidity finds its way into capital spending and job creation, and it appears that some of that is happening. The problem arises in the fact that they can't control where that liquidity ultimately flows, or where the jobs may be created. With all of our excessive regulation and taxes it is not surprising that a lot of the hoped for job creation is happening in emerging markets. This is resulting in inflation (sometimes rather dramatic) in consumable resources (sugar, cotton, rice, oil, etc).
US Equities --
Bullish, stocks are showing no signs of weakening yet, but investors bullishness is getting extreme.
Int'l Equities --
Bullish, especially emerging markets, but developed markets slowing somewhat.
US REITs --
Bullish, but showing some signs of tiredness.
Int'l REITs --
Bullish, but nearing neutral.
Gold -- Bullish, but moving in a range near record highs.
Commodities --
Bullish, but overbought after a strong year-end rally.
US Fixed Income -- Neutral, but showing signs of weakening to bearish territory on inflation expectations.
Int'l Fixed Income -- Neutral, but weakening towards bearish.
Cash Equivalents & Currencies-- Currently at 9% divided between US, China, Australia, and Brazil.
As we head into 2011 we are prepared to adjust our weights as the markets dictate, being "In Harmony with the Markets."
Be careful out there, and keep the light's on,
Chris Wiles, CFA
412-260-7917
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This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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