Obiter Dicta: Sharpe Ratio

The relative calm of the recovering market means I have had more time to ponder theory surrounding financial mathematics rather than the pragmatic application of theory to real life when a crisis is unfolding. 

Having gone through the recent downturn and observed the gains by some investors, it made me wonder whether or not return on investment was the single best measure of performance. Considering that some have taken higher risk than others to achieve comparable returns, I recalled  ボーイフレンド had mentioned that the Sharpe Ratio was a good measure of this, so it was time for a bit more technical research.

The Sharpe Ratio is calculated as follows:

rx is the rate of return for the investment
Rf is the risk free rate of return, which we can take to be the RBA cash rate (currently 0.25%)
StdDev(rx) is the standard deviation of the portfolio. A guide on calculation can be found here.

The higher the Sharpe Ratio of your portfolio is, the better the returns are at the undertaken risk. As good a tool as it is, the Sharpe Ratio does come with drawbacks, substantively the premise that the lower the volatility, the better the portfolio, it negates the positives of upside volatility. Those who are familiar with the formula are also able to cherry pick performance to demonstrate stable earnings to boost risk adjusted returns as well, so as with most blunt instruments, due consideration needs to be given in application.

In the end, both return and risk need to be considered when evaluating whether or not a portfolio is superior. Just because you took a very high risk and it paid off handsomely doesn't make you a skilled investor so much as it means that you are a lucky gambler (for now).

By 小福

Case Study - BBUS and BBOZ: The First One's Always Free

Those who have been dabbling in stocks during the most recent period of volatility will undoubtedly have gained invaluable experience in the market during the Feb to April downturn and subsequent uptick. In summary, from 19 Feb to 23 Mar, the S&P 500 lost 33.9%, making it the fastest crash in history. This was followed by growth of 17.5% from 24 to 26 Mar, being one of the biggest three day gains for almost a century. It would not be an exaggeration to say that what we lived through was truly extraordinary. What was even more amazing was to watch the market response to these violent movements. 

As my readers will now have discerned, my investment strategy has been a fairly conservative one where I dollar cost average twice a month, largely into index funds and by exception individual shares where they appear to be of exceptional value and worthy of the additional risk involved. Whilst I stuck to my plan throughout, I have found it to be infinitely fascinating to watch the response of average retail investors who succumbed to the dark side and were burned hard by the market. 

In observing the people around me and a plethora of online forums, there were two main poisons which decimated portfolios, one was Put Options, the other was Inverse Indices. Today's topic of discussion will revolve around two highly popular inverse indices, BBUS and BBOZ. 

 

The simple way to explain inverse indices is that it is exactly what the name purports, an inverse of an index fund. While BBUS is a leveraged inverse of the S&P 500, BBOZ is a leveraged inverse of the ASX 200. By utilising futures contracts, every 1% lost in the relevant index results in a 2% to 2.75% gain for the holder. As you can envisage, this became a highly attractive investment vehicle to make some gains during the intense drop. Although it may sound like a good idea to buy when the market is falling, there are a number of reasons why a beginner or even novice investor shouldn't touch these products.

Market Timing

When you buy into index or a fairly stable blue chip share, it is almost an inevitable outcome that the shares will go up in the long run. Since BBUS and BBOZ are inverse indices, they obviously go down in the long run as demonstrated in the chart below.



When you look at the prices for BBUS in the last several months the returns look extremely attractive after the fact. If you bought on 20 Feb for $2.67 per unit, this would have become $6.63 by 23 Mar. However, given the state of the economy on 20 Feb, who would have been able to foresee the impending crash and buy into BBUS? Very few. Given the uncertainties surrounding the impacts of coronavirus on the economy and subsequent fall out, most people held onto their portfolios for at least several days until a downward trend was established when it was somewhat higher in price. I know of at least one friend who put their whole portfolio into BBUS at peak for $6.63.

Given investor psychology surrounding the Dunning Kruger effect, even the investor who bought in at the peak was determined that the falls were not yet over and any minor dips constitute bear market rallies and the big crash has yet to come. Of course the media also fanned flames during this period, hyping up death stats and forecasting the end of civilization as we know it, but the unsavvy investor failed to realise that this was already priced in when the market tanked. As a result of this, they consistently held on whilst their portfolio was was violently wiped out.

As of today, BBUS currently stands at $3.39, almost down to what it started on. Are we in the middle of a massive dead cat bounce and the big crash is still coming, or whether we are in for a V shaped recovery? I don't know, which is why I will continue with my dollar cost averaging. Short of being able to accurately time future market movements, it would be imprudent to purchase such a risky vehicle. Having said that, if you are able to accurately foresee the future, why wouldn't you just maximize your gains on minimal cost by buying next week's lotto ticket and min maxing your profits.

Compounding Risk aka. Volatility Decay

Another reason why leveraged inverse indices shouldn't be held for an extended period of time, but isn't apparent to most until demonstrated by a worked example.

For simplicity, let's do two worked examples on the following parameters:

• Starting portfolio is $10,000
• Every day the market moves up or down 1% (10% in the other simulation) returning to parity every second day
• For simplicity we will take the leverage of inverse index at a multiple of 3.

As you can see, whilst market returned to parity every second day, the value of the portfolio was gradually reduced, whilst the results were subdued when volatility was small, when movements were violent, decay was also extremely brutal. Given the fluctuations of the last several months, I have no doubt that quite a few people suffered considerable losses from volatility decay.

For further clarity, consider the fund strategy that BetaShares proposed for both BBUS and BBOZ whereby returns of 2% to 2.75% for every 1% drop are only for any given day, thereby indicating that those returns cannot be expected to continue for periods over one day.

Expenses

Due to the nature of inverse indices attaining their benchmark leveraged returns through use of complex mechanisms like derivative contracts, the associated expenses of high fees, high transaction costs and re-balancing costs also eat into returns considerably. Although simple, for someone who puts money into ETFs for their low management costs, this is clearly reason why inverse ETFs should be considered with a grain of salt.

Conclusion

The last months have provided me with precious insight into the workings of the human mind and how the fear of loss coupled with greed to make gains have pushed innumerable investors to the dark side. From moderate gains during the remainder of the bear market to the eventual wipe-out with the recent rally, millions have been lost on the market because The First One's Always Free and the lure of quick gains is intoxicating. For this, I am grateful to have held firm to my resolve and weathered the storm.

It has also provided a practical example to ボーイフレンド as to why retail investors often under perform when compared to index returns.

As a final point, for those who are wondering. Mr A, who got bored of checking on his brokerage account and continued to DCA through the dip on a preset diversified spread has now returned to -13% on his portfolio whilst the market is still at -20% from peak, outperforming everyone that I know personally.

By 小福

Book Review: The Millionaire Next Door - Thomas J Stanley and William D Danko

As the turmoil starts to subside, and the VIX falls back to 40 after some all time highs I'd 80, I finally have some time to go back to some general reading without having to follow current affairs like a hawk every day, so of course it is time for another book review(´｡• ω •｡`).

The Millionaire Next Door by Thomas Stanley and William Danko was actually recommended to me by ボーイフレンド during our first date(=`ω´=). Of course I went home and read it all within a matter of days and it proved to be more insightful than I expected.

Essentially the book covers some studies that were done on households with a net worth over one million dollars and compares the behaviour and habits of Under Accumulators of Wealth and Prodigious Accumulators of Wealth. In terms of spending, PAWs are far more likely to spend significantly less than they earn and they also tend to make considerably less purchases of luxury goods and status items (・_・)ノ. The book shows surprising evidence that the supposedly wealthy people you see living in lavish mansions driving luxury vehicles are often only able to do so via debt, leaving them with a considerably reduced net worth. As someone who doesn't really indulge in luxury goods, it served as a firm reminder that the sacrifices that I was making towards my goals were worthwhile. In summary, the book demonstrates that with hard work, discipline and prudence, almost anyone living in a first world country can attain millionaire status.

It was quite eye opening to me when thinking about friends and family around me and considering what their underlying financial situation was. For instance, I have a beloved relative who inadvertently ticks all the boxes of a UAW whilst I had never noticed it in the past (〃＞＿＜;〃)  and I have a work colleague who appears to be very low key pragmatic but is almost a textbook exemplar of a PAW. Guess I know who to go to for advice in the future╰(*´︶`*)╯ .

One surprising fact that I did also note, which turns out to make sense when you think about it, is the concept that offering financial aid to children often results in financially underperforming children who become entitled to the regular handouts. For people considering raising a child, this is also quite sobering and offers ideas as to how to raise your child to ensure they become PAWs.

For those who are interested, Thomas Stanley and his daughter Sally Stanley Fallaw have recently published a follow up of the study, The Next Millionaire Next Door. Apparently the book demonstrates that in modern times it has become even easier to grow wealth than before. No doubt I will read it in due course („• ֊ •„).

By 小福

Case Study: On UNV, TER and margin of safety

One highly technical post calls for another. I hadn't intended to go into another so soon but due to the recent chain of events, it was too good an opportunity to pass, so today's post will be on the complete debacle that was TerraCom's (ASX: TER) purchase of Universal Coal (ASX UNV). In the words of ボーイフレンド it was basically a murder suicide with retail shareholders forming unwitting collateral damage. 

All good stories though, start from the beginning. So that's where we will commence. Late last year ボーイフレンド was considering industries that would be likely to outperform in the medium term. With a fairly contrarian perspective compared to the average retail investor, he decided that with the uprising popularity of renewable energy and the social pressures surrounding ethical funds, traditional fuel sources like coal and oil would be fairly discredited and undervalued in the short term. As a result of this, he and Mr D started looking into individual companies in the industry for potential individual picks for investment. 

In their research, they came across UNV, a London based Thermal Coal company with operations in South Africa. One look at their financials shows why it was such an attractive company to buy into. With steady growth in revenues, reasonable and proportionate expenses, healthy cash flow, a history of generous dividends as well as excellent asset to liability ratios whilst management also appeared to be sound. In applying discounted cash flow models to value the shares, ボーイフレンド determined that each share was worth within the vicinity of 0.6 to 0.9 which obviously meant that his purchase price of 0.24 when the PE was about 5 (and my subsequent purchase at 0.23) was definitely a steal, so we purchased a small amount of holdings each.

For reference, I have extracted some financials of UNV current as of 6 Apr 2019. Although there has been a bit of time lag, you can definitely see the solid fundamentals in the reports.

Testament to the unpredictability of stocks and also a lesson in the importance of diversification, the unexpected did in fact happen and TER, an Australian based coal producer with projects in Queensland and Mongolia launched a takeover bid for UNV. Judging by the condition of the health of the company from its financial reports, it was easy to see why they wanted the takeover. TER had sustained a couple of years of losses with an increased net loss projected in the current year with an indeterminate time for return to profitability despite an increase in revenues. Cash flows were abysmal and assets to liability ratios were not ideal. This was definitely not a company that I would want to hold.

Again, for reference, I extract a copy of the financials currently posted on 6 Apr 2020.

Under the offer, UNV shareholders will get 10 cents in cash and about 0.6026 new TER shares for each UNV share held. As at the point where we were made this offer, TER was selling at around 0.24 per share. This meant that accepting the offer, I would break even at 10 cents plus roughly 14.4 cents of TER per UNV.

At this point, the board of UNV issued advice to shareholders not to take any action with respect to the unsolicited bid whilst they instigated litigation to suspend voting rights of TER but strangely three members of the board itself Tony Weber, Shammy Luvhengo and Hendrik Bonsma proceeded to accept the offer on 22 March 2020, raising serious concerns to me about acting in good faith when they undertook a course of direction to which they advised shareholders not to. In the end, ボーイフレンド and I held out to the end and didn't accept until we saw that 75% of shareholders had accepted. The final figure stood at over 90%.

Within a couple days my cheque for $4,347.80 arrived in the post and 26,200 shares of TER appeared in my SelfWealth Account. The cheque was easy enough to bank and transfer back into my SelfWealth but the 26200 shares of TER were a lot harder. There was no doubt in my mind that TER was not a company to hold for the long therm, but with the continued falling price and no fundamentals to even justify a potential rebound at a later date, there was nothing to do other than to sell.

Initially when I was first issued my shares, TER was trading for around 14 cents per share, wanting to break even at around 17 cents, I held on as I watched it drop to 12 cents, by which point ボーイフレンドcashed out. Holding for another two days, I finally gave up and sold for 10.5 cents per share, the lesson to be learnt is apparently not to be greedy, because even though you may hope that a share may go up, without sufficient justification as to why it ought to go up, it has just as much or maybe even more reason to go down.

In the end, my $10k investment in UNV resulted in a payout of $7,098.80. Although by absolute figures this was a pretty big loss of almost 30%, given the most recent drops in the market, the outcome was largely the same as what I would have gotten if I had bought into index instead. If nothing, this highlighted to  me the importance of making individual purchases with a generous margin of safety, because if individual equities are not bought at a price that is significantly below their intrinsic value, when unexpected situations like this do happen, the losses that are sustained could be critical indeed.

As to what I put my $7,098.80 into? VGE and WGB.

 By 小福