Consistent Alpha Generation through Structure

Abstract

Successful money management over long periods of time rests on two foundations. The first is “a secular outlook”—that is, a three- to five-year forecast that forces one to think long term. The second is the “structural” composition of portfolio management—the portfolio's genetic makeup, how it is constructed without regard to short-term strategic decisions, principles that are longer than secular. Duration, curve, credit, volatility, and other tilts to a portfolio's steady-state status are a portfolio's inherent structure. Recognizing the structural elements of the investment equation will allow the investor to be the one walking away with a pile of chips.

Successful money management over long periods of time rests on two, somewhat disparate, foundations. The first is “a secular outlook”—that is, a three-year to five-year forecast that forces one to think long term and to avoid the destructive bile arising from the emotional whipsaws of fear and greed. The second is what might be called the “structural” composition of portfolio management. A portfolio's structure is akin to its genetic makeup: It is how it is constructed without regard to short-term strategic decisions. Structure incorporates principles that are longer than secular; for example, duration, curve, credit, volatility, and other less obvious tilts to a portfolio's steady-state status are a portfolio's inherent structure. Those who fail to recognize the structural elements of the investment equation will leave far more chips on the table than they could ever imagine.

An example of successful investment structure is banks, which have a formidable investment structure: Borrow short near the risk-free rate; lend longer and riskier. Another example is the successful Berkshire Hathaway structure, which depends on “float” combined with bottom-up, secular stock picks and has produced one of the world's greatest investment success stories. And a third example is PIMCO's BondsPLUS and related approaches. This structure involves the use of financial futures or future-related investments and the successful placement of the residual cash into higher-yielding, slightly longer-dated investments.

In addition to their profit-generating elements, these structures share the common element of longevity, near permanence. They span time periods beyond the secular segments of three to five years, which define typical forecasting periods, and secular stretches of inflation/disinflation that have endured for several decades.

An inherent part of the structure of the markets is the price involved in the buying/selling of volatility. The “noise” content of volatility allows for overpricing, and other features of volatility-based option prices lead to structural overvaluation and thus to profitable structural sales. For example, because the U.S. government and U.S. homeowners are systematic buyers of volatility (with little recognition of the price they are paying), others can profit structurally by taking the other side of the bet. Long-term performance numbers for mortgages versus straight agency notes, for instance, favor mortgages over almost any five-year (or longer) period. Moreover, the mispricing/overpricing of the prepayment option by U.S. homeowners leads to continuing profit opportunities. No amount of buying in the past decade seems to have “arbitraged” away the overpricing of this option.

The essence of my structural investment thesis is that applying the appropriate structure to an investment portfolio over long periods of time can add value and alpha before any strategizing—short-term or secular—takes place. Individuals as well as institutional money managers can apply this structural philosophy. It can be done via the futures and options markets. Investors should do it but not overdo it. And they should pick the structures in concert with their long-term secular view of the economy.