Commodities and Inflation

The stock markets are very close to bear territory (one more day like today and it will be an official bear market in the S&P 500). I love this Bev Doolittle painting so I had to repost it.

Long time readers know I am a big fan of commodities. After today’s dump in stocks (and run up in commodities indexes) I thought I would write a very brief post that is similar to the post I did a few weeks ago on asset allocation and interest rates. I think this table speaks for itself.

It shows the average return to five indexes over two periods. 1972-1981 is characterized by rising interest rates and high inflation. 1982-2007 is characterized by falling interest rates and low inflation. Note the only asset class that performs better in the latter. In periods of low inflation and declining interest rates stocks, foreign stocks, bonds and REITs all performed better which makes intuitive sense because they are all capital assets and benefit from lower interest rates. Commodities on the other hand, turn in much higher returns when interest rates are going up, which makes sense due to their correlation with inflation and unexpected inflation.

If you don’t have commodity exposure (or your portfolio manager doesn’t), why not? That is probably a hard question to answer right now. Some example ETFs are: DBC, GSP, GSG, DJP, RJI, DBA, DBB, DBE, DBP.

Click on the table to enlarge.

Book Cover Design Contest

Here are three designs from the first book cover design contest. I currently have another contest running on Worth1000 that you can view here. Please be honest with your opinions – leave a comment on what you like and don’t like. If you don’t like any, say so!




Does This Signal a Top in Commodities?

Kind of like PowerShares launching their private equity ETFs, does the slew of new commodity ETFs signal a top? In my inbox today:

iPath® Global Carbon (GRN)
iPath® Dow Jones-AIG Softs Total Return Sub-Index (JJS)
iPath® Dow Jones-AIG Precious Metals Total Return Sub-Index (JJP)
iPath® Dow Jones-AIG Aluminum Total Return Sub-Index (JJU)
iPath® Dow Jones-AIG Cocoa Total Return Sub-Index (NIB)
iPath® Dow Jones-AIG Coffee Total Return Sub-Index (JO)
iPath® Dow Jones-AIG Cotton Total Return Sub-Index (BAL)
iPath® Dow Jones-AIG Sugar Total Return Sub-Index (SGG)
iPath® Dow Jones-AIG Platinum Total Return Sub-Index (PGM)
iPath® Dow Jones-AIG Tin Total Return Sub-Index(JJT)
iPath® Dow Jones-AIG Lead Total Return Sub-Index (LD)


Goldman just launched the a mutual fund based on the Absolute Tracker Index (ART) Symbols GARTX, GCRTX, GRRTX, GSRTX, GJRTX.

Brochure here.

I have always been curious about the hedge fund indexes. Isn’t beta the one part of hedge funds you don’t want? I bet a simple allocation equally weighted of US Stocks, Foreign Stocks, Bonds, REITs, and Commodities performs better (especially after the 1.6% fee). Some of the share classes have loads as high as 5% (and why anyone would buy a load fund is beyond me).

Goldman’s site here.


Alpha Hedge Fund Hall of Fame

Who is added next? My money is on Thorp.


Looking for a new Summer cocktail?

My new favorite – The Palmoa. (Although I use grapefruit juice + soda rather than grapefruit soda).

Big Brother is Watching

Glad I didn’t write my book on Google docs.

“11.1 You retain copyright and any other rights you already hold in Content which you submit, post or display on or through, the Services. By submitting, posting or displaying the content you give Google a perpetual, irrevocable, worldwide, royalty-free, and non-exclusive licence to reproduce, adapt, modify, translate, publish, publicly perform, publicly display and distribute any Content which you submit, post or display on or through, the Services. This licence is for the sole purpose of enabling Google to display, distribute and promote the Services and may be revoked for certain Services as defined in the Additional Terms of those Services.”


Reading anything interesting? Send me your links. . .


It is always nice to see a model continue to perform out-of-sample. Below are the results of the “Quant Approach to TAA” paper since it left off in 2005. Equity-like returns with bond-like volatility and low drawdowns. Obviously much of this outperformance is due to the spectacular run in commodities and the (relatively) high allocation this model uses at 20% of the portfolio. This does not include June and the additional 5% dump in the S&P500. One could use five simple ETFs to replicate the asset classes mentioned in the paper (VTI or SPY, VEU or EFA, BND or AGG, VNQ or IYR, and DBC or GSG).


Alpha’s top 100 hedge funds. ESL is the worst performer at -27%. With the exception of 4 funds, all are US and UK firms.


I love napping (and it looks like I’m not the only one) – here is a good link on “how to nap“.


I’m giving Jott a try, and so far I like it.


The Netflix Player by Roku – very cool.


Some really cool “American consumer” art over at Chris Jordan’s site. Can you guess what the below picture depicts?

Doggy Dogs

I’m not much of a ranter, but it doesn’t make any sense to me to continue to focus on dividends when there has clearly been a structural change in the market (that happened way back in 1982). (For newer readers there is background reading with lots of links at the end.)

Dogs of the Dow is simply to top ten stocks in the Dow sorted by dividend yield.
Flying Five further sorts those by lowest price.
Net Payout yield is the top ten Dow stocks sorted by net payout yield.

For the past 30 years or so the Dogs strategy has outperformed the DOW by ~ 3% per annum, and the Net Payout Yield strategy another 3% on top of that (ditto for Flying Five). All underperformed the Dow in 2007 but had monster years in 2006.

2008 is shaping up to be potentially the worst on record since 1972 for the Dogs and Flying Five strategies. Previous worst years are -8% and -15% respectively. Payout Yield is doing much better:

Dow: -10%
Dogs: -15%
Flying Five: -22%
Payout Yield: -6%

You can find the current payout yield stocks here. The top 10 right now are:


Flying Five (Link to original post here.)
Dogs of the Dow (Link to original post here.)
Net Payout Yield (Link to original post here.)
Assets and Defending Them.

Sharpe Ratios of Managers

The Sharpe Ratio is a measure of the risk-adjusted return of an investment. While there are a lot of ways to measure risk, the Sharpe Ratio uses the volatility as measured by the standard deviation of returns. Originally developed by Stanford Professor William Sharpe, it is simply the return of an investment (R) minus cash sitting in T-bills (otherwise knows and the risk free rate, Rf), divided by the volatility of the investment (σ). Cash will have a Sharpe Ratio of zero.

S= (R – Rf) / σ

A good rule of thumb for Sharpe ratios is that asset classes, over the long term, have Sharpe’s around .2 to .3. A “dummy” 60/40 allocation to stocks/bonds is around .4. A good all-weather allocation is around .6. However, over shorter periods the numbers can bounce all over the place. From 1900-2007, the S&P 500 has had Sharpe Ratios per decade ranging from -.08 (the 1970s) to 1.4 (the 1950s). If you want more info on the Sharpe Ratio, Bob Fulks has a great piece here.

One of the problems with the Sharpe Ratio is that it “penalizes” upside volatility. An investor likes volatility to the upside, but dislikes volatility to the downside.

Here is a good PowerPoint that shows some historical Sharpe Ratios for some very successful managers. (It is excerpted from the book Scenarios for Risk Management and Global Investment Strategies ). Ziemba’s point is that managers should not be penalized for upside volatility, only for their losses. So even though Berkshire did almost 25% a year over this time period, it has a lower Sharpe than the S&P500 that returned only 18%. (Great Ziemba PDF here.)


The Symmetric Downside-Risk Sharpe Ratio (Digest Summary)
William T. Ziemba
Journal of Portfolio Management, Vol. 32, No. 1: 108-122

Vanguard Windsor Fund – Managed by John Neff for 30 years, this fund was regularly in the top 5% of all mutual funds.
Berkshire Hathaway – Warren Buffett’s conglomerate holding company has returned over 20% for the past forty years.
Quantum Fund – George Soros co-managed this fund with Jim Rogers, and it returned over 40% a year in the 1970s. From 1969 to 2001 he did over 30% per year.
Tiger Management – Managed by Julian Robertson.
The Ford Foundation – One of the top performing foundations.

The first observation is how outstanding the returns were for stocks in this period, which inflates the Sharpe Ratio for the S&P 500 to one of the highest levels it has seen in the past century. The second observation is that many of these successful managers are getting penalized for making money with their upside volatility.

To gain a full understanding of a manager’s performance investors should use alternative metrics to evaluate managers. Some alternate metrics include:

Sortino Ratio: uses the volatility of negative asset returns in the denominator (similar to Ziemba’s downside symmetric Sharpe Ratio)
Sterling Ratio: uses the average max drawdown in the denominator
MAR (or Calmar) Ratio: uses max drawdown in the denominator
Ulcer index: Measures the length and severity of drawdowns.

The average return and volatility can tell you a lot, but if you really want to get nerdy check out the third and fourth momements of the return distribution, skew and kurtosis. Check out the white paper “Skewing Your Diversification” by Mark Shore.

Non-linear strategies like option selling can artificially inflate the Sharpe Ratio as they have incredibly consistent good performance until they don’t (which is usually a huge or total blowup ala LTCM).

Below is a chart from fund manager Bob Fulks who shows how an asset can have varying Sharpe Ratios depending on the time period.


Princeton-Newport is one of the best performing hedge funds of all time, and for a good review check out the great book Fortune’s Formula(more in the next post). 15% per year for 20 years and 3 down months is a pretty enviable track record.

Thorp has a chapter in The Best of Wilmott, and you can actually download the PDF for free here: “Models for Beating the Market“.


A couple of housing ETFs are coming to the market:

UMM – MacroShares Major Metro Housing Up
DMM – MacroShares Major Metro Housing Down


Dexion is launching more funds in Europe. None yet in the US.


A new managed futures ETN hits the market (LSC). As I predicted in an earlier article in mid-07, this ETN cuts the fees in half from the Rydex fund (RYMFX) down to 0.75%. Direxion is also launching a mutual fund on the sister version of the DTI, the CTI (which exclusively invests in commodity futures).


Nice blog with a good recent post on Tobin’s Q – Disciplined Investing


Bill Gates at Davos


Good post from AllAboutAlpha: Hedge funds don’t use that much leverage, and (surprising to me) most managers don’t co-invest in the fund.


A brief history of Old Lane Partners.


I wish I knew this when I was studying Engineering and Biology.


I just finished reading “The Omnivore’s Dilemma” which was pretty good. The book spent a lot of time on corn (which is in everything), and the cheap prices corn was trading for. Not anymore (from Futuresource) :


How is it that the Celtics are only trading at slightly better than even odds to win the NBA title? From Tradesports:


Brits turning down free money.


Samuel Israel clearly faked it and made a run for it. It reminds me of some the the great financial thrillers by Paul Erdman (The Set-Up).


Buffett hates fees – his bet against hedge funds. I remember having to read Clock Of The Long Nowin college.


I know some friends that could use this: Sheep flatulence inoculation developed.


New book in the mail: Beating the Market, 3 Months at a Timeby Appel and Appel.


A new asset class – investing in horses?


Apparently after Charlie Munger gave his “Psychology of Human Misjudgement” talk at Harvard in 1995 he passed out copies of this book.


In the NYTimes Monday – “The Social Sciences Top 5“. I don’t think I’ve received a star since I was in kindergarten.

When Markets Collide

I just read El-Erian’s new book When Markets Collide this past weekend.

Am I the only person to notice that his allocation only adds up to 98%? Weird. (I just added 2% to cash.) I did like this quote from the book which reminded me of my post a couple months ago on optimizing happiness:

“There is growing talk about the importance of reducing noise lest it adversely impact quality-of-life indicators.”

Anyway, below are the allocations of the Harvard and Yale Endowments vs. El-Erian’s recommended allocation. As you can see, it is a fairly similar allocation to the Harvard endowment, with a little more in foreign bonds and no allocation to hedge funds. I lumped infrastructure in with real estate so that it could be compared to the endowments on an apples-to-apples basis.

Following that is a comparison if you back out the private equity and hedge fund allocations. Special situations was lumped into cash. He described them as:

“investment opportunities that are attractive but do not fit comfortably into the categories I have covered so far…they usually relate to two types of activities: new longer-term activities that are supported by a secular hypothesis but are yet to gain broad-based acceptance; and shorter-term activities that materialize due to sharp dislocations that involve significant overshoots.”

This seems to be somewhat of a subjective recomendation and not all that useful for the retail investor. He mentioned water, agriculture, and carbon credits as three areas for the longer-term secular activities.

The expected return is right in line with the endowment allocation I mentioned in my paper, or roughly a 1:1 return to volatility ratio (about 10% return with 10% volatility and 20% drawdown over time).

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