Patrick Armstrong talks to Pieria about central banks and the forward guidance problem.
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Securities as a derivatives analyst and began his career at Templeton
management in Toronto. Patrick has an MBA from the Rotman School of
Management and is a Chartered Financial Analyst.
Q: How do you approach the search for investment opportunities?
A: We think about things the way investors think about things. That may sound straightforward but it’s actually novel. Most fund managers are focused on beating a peer group, a benchmark and are not thinking the way investors do. We have a risk budget for all of our portfolios. In the short term the risk is losing capital value and in the long term the risk is not keeping up with inflation and losing your purchasing power. Clients put their capital at risk in order to achieve higher purchasing power in the future, whether they are pension funds or individual investors. That’s the starting point of our process. Our risk budget in the short term is value at risk and the long-term target is inflation plus. We think this is the evolution of where things should go.
Q: What do you think has traditionally distinguished hedge funds from retail products?
A: Hedge funds say they are all about their skill, or alpha, while traditionally retail funds are all about beta – they buy the benchmark do little increments above it. At the core of what we do is harvesting risk premia and the rest of the returns we try to generate are more skill-oriented. Sometimes that just means capturing more obscure risk premia, such as commodity arbitrages where we short something that’s ridiculously inefficient and go long something that’s more efficient. It’s often quoted that 91% of portfolio returns come from what asset classes you buy. What’s less talked about is that 91% of your risk is also coming from what asset classes you’re in. Fundamentally diversification is the way to control portfolio volatility. Asset allocation is where the focus should be but the industry actually doesn’t play there as people tend to be specialists despite the fact that it is where all the return and all the risk are coming from. The traditional buy-and-hold strategy should work in an environment where there’s global growth and nominal higher prices. If we get into an environment where that isn’t the case then you shouldn’t expect that to work. Markets are not completely efficient, although there are varying levels of inefficiencies. As such you shouldn’t just be buying the benchmark, indeed it might be better to be short a structurally flawed benchmark simply because it is so poorly designed.
Q: One of the key problems of the financial crisis has been that in moments of market panic traditional correlations have broken down and all asset classes have fallen together. Should there be a redefinition of value at risk during these types of market environment?
A: I think so. For me 2000 was the genesis of multi-asset diversified investing. Everything worked. Equities crashed, but property, commodities and government bonds all did incredibly well. That suggested a free lunch of strategic static asset allocation models. Yet the world has moved on. There are much higher correlations, especially as more asset classes are opened up to everyone and become prone to the same risk- aversion. So you don’t get a structural diversification, particularly in panics. As such just buying a variety of asset classes is not always the way to reduce risk. Sometimes diversification comes from the fact that you can short more expensive asset classes or something with deteriorating fundamentals.
Q: Unlike long positions, theoretically shorting leaves an investor open to an unlimited loss. How can you control this risk?
A: People seem more fearful of a short position. For some reason when you lose money on a short, simply because it’s not a natural part of an investor’s psyche, it’s more painful and you think about it more. The reality is that if you think in a portfolio context, if you’re long something else that’s negatively correlated it should protect you from heavy losses. The unlimited loss is solely a theoretical phenomenon not a practical concern. If you shorted Apple 40 years ago and kept the short it would be pretty painful but not unlimited. I think it’s really more of a behavioural concern.
Q: Do you have an example of this technique in practice?
A: This year you’ll get 3.3% global growth, which is a 20-year norm for the world despite what it feels like in the West. So we’ve been long companies that have done incredibly well, such as luxury goods companies that are selling into emerging markets with high economic growth and rising purchasing power. These include Richemont, LVMH, BMW, Coca Cola, L'Oreal etcetera, which all fit the model of a rising share of revenue coming from emerging countries. This month these all reached close to 19x earnings so we’ve taken short positions in three of the most loved companies in the world – PG&E, Unilever and Nestle. They are actually slightly more expensive than these other companies that have much higher growth and, although they have access to emerging markets as well, they don’t have pricing power. Consensus forecasts see the margins of these three companies expanding this year, but we think that is at risk. Expensive should be associated with growth. If you’re in a risky asset class you shouldn’t only be looking for the safest part of it, it’s just a way to kid yourself.
Patrick Armstrong discusses growing market risks and the prospects of a "Great Rotation".
Patrick Armstrong, Chief Investment Officer at Armstrong Investment Managers, discusses the need for a dynamic approach to risk management.
Patrick Armstrong, chief investment officer at Armstrong Asset Management discusses the behavioural biases of shorting a stock and how to think like an investor.
For about five years now, Greece has been giving the euro area authorities a test in economics and politics. The test must be retaken until the authorities produce the right answers.
Visiting Professor of International Economic Policy, Princeton University14 articles | View profile
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