Diversification is measured by Dimensions
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Systemic Risk and Diversification Analysis
This chart tells us that the portfolio being analyzed has a variance 60% captured in only one dimension. Minimizing the percentage of the portfolio captured in the first dimension is a routine output of our investment process and greatly reduces the susceptibility of the portfolio to system risk. We see good portfolio (made of ETF’s Mutual Funds, Asset Allocations Policies) will shed their first dimension in the 10-15% range.
Your Missing Diversification Potential – Visualized
3 Cardinal Rules of Apples to Apples Comparisons
Gsphere has the flexibility to compare any portfolio to any portfolio. You can compare the same portfolio over different time periods, various versions of the same holdings optimized with different settings or contrast a prospect’s holdings to a recommended model. Whenever looking at a client facing comparison, it is critical to make those comparisons apples to apples. Apples to apples can be either historical or forward looking, however we suggest that historical is a more definitive approach. Our SaaS technologies do this automatically, but in the desktop application we need to follow these 3 simple rules.
1. Use the same time period
2. Use the same correlation calculation option
3. No editing or shrinking the risk and return data
These 3 simple rules will provide for fair apples to apples comparisons. However, because these tests do not account for investment selection process or re balancing actions we recommend limiting the backtests to shorter periods. I like to use 3 year tests because a portfolio is tested in both bull and grievous bear markets.
The Performance Edge
All investment managers search for and nurture the development and refinement of an edge. Better Investment managers employ more edges. I took a look at our process and found 14 edges we use in models right now. I think we can continue to develop a few edges every year and some edges will occasionally expire. About 2 out of 3 of these edges are unique to Diversification Optimization and Gsphere.
Another part of the system is to have edges that compliment one another. In the same way that we want to increase the dimensionality of a portfolio with respect to risk factors, we want to increase the dimensionality of the edges used to create models. As we continue to quantitatively assess these edges we will be better able to shift the emphasis towards the best producing facets.
Diversification Analysis
Paradox Theory
can anyone out there think of a contradiction to this apparent explanation of any and all paradoxes?
A paradox occurs when the context of the answer to a question is supposed in a dimensionality of the solution space that is less that required.
U.S Soverign Goverment Debt and the Fallacy of the Risk Free Asset
USA GDP: 14.7 trillion
USA Cumulative Deficit: 14.3 Trillion
Percentage of GDP usurped (taxed) by Government at all levels: 27%
US Government corporation equivalent revenue = 3.86 Trillion (.27 * GDP)
The median valuation multiplier of the S& P 500 index is 1.74 X revenue
Implied valuation for the Unites States based on large cap corporate entity equivalence = 6.72 Trillion (tax receipts * 1.74)
Median S&P 500 debt to equity ratio: .49
US equivalent debt to equity ratio: 2.19
The equivalent debt to equity rank of the United States compared to the 500 largest publically traded companies: 463 / 500 or in the bottom 7th percentile of large cap public companies.
In publically traded entities we assume generally that the equity is a function of discounted cash flows or earnings. Of course, our government, in whole does not make money which only serves to exasperate my point.
Furthermore; let’s compare the United State to the notorious PIGS many of which are undergoing severe austerity measures: The follow compares the debt per GDP of U.S. and the PIGS:
United States: 97%
Portugal: 97%
Spain: 74%
Italy: 130%
Greece: 130%
What’s my point? For most of the reasons why one would own U.S government debt, there are likely better alternatives. Second, let’s strike the notion of risk free assets from our collective vernacular.
Diversification Analysis Checklist:
- How does the balance look?
- How many diversification boxes are they currently in?
- How many of those boxes have substantial exposure?
- What is the IPC?
- What is the total diversification?
- What is the concentration score?
- Look at the KLD chart, how much of the portfolio is one dimension? This is the exposure to systemic risk.
- Look at the KLD chart, does the chart make a steady climb or is it parabolic? This is the diversification of diversification. A steady climb means you are not as reliant upon a few prominent correlations and assets as the sources of the total diversification.
Volatility Investment Choices
The strong contango in the futures market for the VIX is not expected to relent in the next six months.
In my analysis by holding the VXX will result in an annual loss of 60 – 70% given unchanged levels of volatility in the ^VIX.
Despite the advantages we see in holding the VIX (great diversification, autoregressive predictability) we can no longer recommend holding this position as the hurdle is just too high. In fact I am strongly advocating a replacement investment in XIV. (nearly the exact opposite) This is a non-leveraged daily inverse to short duration volatility. It profits from the roll. This means that given no change in volatility levels, this instrument is expected to increase 60-70% annually.
I expect this trading opportunity to be available and worthwhile over the next 2-3 years and gradually closed with arbitrage style pricing.
Current trading volume in 444X larger in the VXX. I expect this opportunity to be available until there is some semblance of parity in the trading volume, or more precisely when the contango disappears.