We recently read an interesting story about increasing risk for better returns – Well That’s Fantastic!
First, we will give some context for those of you who are unfamiliar with the name Paul Tudor Jones. He is an American businessman who founded Tudor Investment Corporation, a private asset management company and hedge fund. As of March 2014, he was estimated to have a net worth of US$4.3 billion by Forbes Magazine and ranked as the 108th richest American and 345th richest in the world.
His trading style and beliefs are summarised below:
- He attempts to buy and sell at contrarian turning points. Fundamentally, he continues to try a single trade idea until he changes his mind. Otherwise, he keeps cutting down his position size. Then he trades the smallest amount when his trading is at its worst.
- He considers himself a premier market opportunist. When he develops an idea, he pursues it from a very low-risk standpoint until he has been proven wrong repeatedly, or until he changes his viewpoint.
- He is a swing trader – the best money is made at the market turns. He has missed a lot of meat in the middle but catches a lot of tops and bottoms.
- He gets himself out of a losing position that makes him uncomfortable. There is nothing better than a fresh start. The key is to play a great defence, not a great offence.
- He never averages losing positions. He decreases his trading size when he is doing poorly, and increases when he is trading well.
- He has mental stops for both price and time. If a stock hits a certain number, he is out no matter what.
- He monitors the whole portfolio equity (risk) in real time.
- He believes prices move first and fundamentals come second.
- He doesn’t care about mistakes made three seconds ago and focuses on what he is going to do from the next moment on.
- “Don't be a hero. Don't have an ego. Always question yourself and your ability. Don't ever feel that you are very good. The second you do, you are dead.” – Paul Tudor Jones
Source: VIP Wealth Solutions & Bloomberg
In a recent article published by Bloomberg, Tudor’s tone changed. He told investors in an August 16th letter that he will manage a larger chunk of their money himself. He also said managers at his $11 billion Tudor Investment Corp. will be forced to take more risk.
The key part of this that caught our eye was to take more risk. His main fund is the Tudor BVI Global, and as reported by Bloomberg, is down about 2.3% year to date.
This got us thinking about the art and math of expected returns. Consider that some time ago there was a capital asset pricing model called CAPM. It describes the relationship between risk and expected return, and it serves as a model for the pricing of risky securities (stocks).
The model is simple in some respects:
CAPM = Risk Free Rate + (Market Return - Risk Free Rate) x Beta
What does this mean?
Risk-Free Rate = Rate of return on risk-free assets (Government Treasury Bills)
Market Return = The return of the overall market (S&P 500)
Beta = The measure of risk for an individual security relative to the market
Let us consider this in real context:
The time was not too long ago in a land called the USA where risk-free assets (US Treasury Bills) were something greater than zero. The chart below shows the yield curve of US treasury bills going back 10 years.
Source: VIP Wealth Solutions & Bloomberg
So let us create two scenarios with CAPM
In this example, it is 2006, and T-Bills are yielding 5%. CAPM tells us that a generic security with about half the market risk should return 5.5%. Here is how the formula works:
CAPM Scenario One
Market Return = 6%
Beta = 0.5 (half the risk of the market)
CAPM = Risk Free Rate + (Market Return – Risk Free Rate) X Beta
= 5% + (6% -5%) x 0.5
Fast forward to today, and under the same assumptions, the Risk-Free Rate is now 0.30%. The result is a 3.15% return on the same security.
Mathematically, this all works out, but it speaks to what Paul Tudor Jones is seeing in the current global environment. You have to take more risk to get the same return you did 10 years ago. This is somewhat worrisome.
We are hearing this and feeling this in the global markets as well. Paul is not the first global manager to speak out and struggle in this environment. There are a lot of smart people out there right now scratching their heads.
We are not suggesting that we are going to start to add risk like Paul Tudor Jones, but actually somewhat the contrary. His core value or tenant as outlined above was to play great defence, not great offence.
We are going to continue to stick to the defensive approach and watch how Paul makes out with his shifting of gears.
Thank you for reading!
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