How to Stop Losing Money on the Right View In the global macro community, it’s fairly common to express a general view on commodities, or even a specific one, by positioning via a highly correlated instrument. Let’s say you are bullish oil for example, you might get long one of the traditional commodity currencies such as the Canadian Dollar (CAD), Mexican Peso (MXN) or Russian Ruble (RUB). Looking at the charts lining the right side of this page, it would seem that really any of these would make for an excellent proxy.
These are the kinds of charts that salespeople and analysts like to include when making trade suggestions, and for good reason. By appealing to our inherent desire to simplify what is a rather complex world with a nice, neat, coherent story where A leads to B and B leads to C, they get us to take action. Unfortunately, neither the world, nor our investment mandates work so linearly, and that creates some real problems. It is what often leads to us getting our view right, while simultaneously experiencing losses.
There are a couple of key issues we are dealing with here. Firstly, you have to not only get your view on oil right, you have to do so both in the long run and the short. Secondly, the commodity currency must also be highly correlated not just in the long run, but in the short run as well. That last aspect is made all the more significant when markets become more volatile, as they have been recently.
Before I detail how difficult a task this is, and particularly just how much more difficult you have made it for yourself by using what is essentially a derivative instrument, let’s take a look at a classic study from cognitive psychology, published by Kahneman and Tversky in 1983, that can provide some perspective. It’s called “The Linda Problem”.
Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social injustice, and also participated in anti-nuclear demonstrations.
Rank the following from most to least likely to be true:
Linda is a teacher in elementary school.
Linda works in a bookstore and takes Yoga classes.
Linda is active in the feminist movement.
Linda is a psychiatric social worker.
Linda is a member of the League of Women Voters.
Linda is a bank teller.
Linda is an insurance salesperson.
Linda is a bank teller and is active in the feminist movement.
85% of respondents ranked H as more likely than F, a statistically impossible occurrence. At best, they could be equally likely, but that would mean that every single female bank teller is active in the feminist movement.
What Kahneman and Tversky were attempting to exhibit is an inherent flaw in our judgment called Representative Conjunction Fallacy. It combines the representative heuristic (a fancy term for mental shortcut), wherein we note some key characteristic of someone or something, and elevate its importance well beyond its statistical significance. In Linda’s case, most of us see the feminist label as highly representative of who she is, while the bank teller label is far less certain. Therefore, it’s easier to see her as a feminist who happens to be a bank teller, than simply being a bank teller.
It’s a very similar leap that we make when we develop a bullish view on oil. Let’s consider a few possible (& fictitious) reasons for our optimism on oil. Perhaps OPEC has made some comments reflecting their displeasure with current low levels, consumption numbers have unexpectedly increased recently, a pipeline project has been shutdown or fear of war is growing in one of the major oil production countries. (Note: This list is fictitious, created purely for the purpose of a hypothetical analysis.) These are all excellent reasons to tilt the odds in favor of higher oil prices rather than lower.
Given this information, rank the following from most to least likely to occur:
Oil goes up
Oil and Commodity Currencies go up
Commodity Currencies go up
Fact is, when you imagine oil going higher, it’s difficult to imagine that a country like Russia, what many see as a one trick pony, and its currency, not benefitting as well. Intuitively, it makes sense, and when combined with the charts above, it only serves to solidify that intuition. Still, let’s dig a bit into the data, just to confirm what we feel in our gut.
On a quarterly basis over the past 5 years, WTI has a 0.78 correlation to the Russian currency against the Dollar (RUB/USD), confirming what jumped out at us in the chart. So you might put on a short USD / long RUB position in anticipation of higher oil prices. Maybe we diversify a bit, going long CAD and MXN as well. In that moment, when we have a clear view and thoughtfully establish a position to express it, it’s difficult to imagine how many different ways our p&l can diverge from the path of that vision. It seems almost unfathomable that oil could trade 20% stronger 6 months from now, yet we somehow lost money not just on these 3 positions, but “hedges” that were established along the way. Unfortunately, it happens all the time.
Truth is, very, very few investors have the investment time horizon and tolerance for pain they believe and/or pretend they do. Therein lies the real issue. You see, although the correlation between WTI and RUB is 0.78 on a quarterly basis, it is 0.65 on a monthly, 0.46 on a weekly and a mere 0.29 on a daily basis. Its R-Squared is 0.60 on a quarterly basis, but daily it’s a minuscule 0.09.
Over the last 5 years, WTI has gone up just 50% of the time on a daily, weekly, monthly and quarterly horizon, but let’s assume your timing is impeccable and you nail oil perfectly. Even when oil went up, RUB strengthened just 60% of the time, and yes, that includes quarterly snapshots. So, if we pretend that the data in the chart above represents roughly 1200 balls in a jar, with each of them painted one of 4 colors representing WTI up/RUB up, WTI up/RUB down, WTI dn/RUB up and WTI dn/RUB dn, the probability of you drawing one that represents your perfect scenario, is just 30%.
Perhaps you’re thinking, “that’s not bad”. Fair enough. Now consider that so far we have only been concerned with the matching of direction. How far they diverge when going in opposite directions is also significant, both to your p&l and your emotions, especially when markets become more volatile. Let’s say they suddenly diverge by 5%, 10% or even 20% in a given week, which they have done several times. All these positions that are “highly correlated” suddenly don't feel that way. So, you improvise. With commodity currencies down 15% and a big event on the horizon for oil, perhaps you buy some short-term oil puts to protect against things getting even worse for your portfolio. After all, if oil rallies, your currency positions are likely to reverse, more than making up for the loss of premium. Then, oil rallies, you take a deep sigh of relief, write-off the premium and look forward to better days ahead. The option expires and the currencies sink again. Finally, exhausted from the markets “not making sense”, you call it quits and stop out of all the related positions. That’s when the currencies play catch up and in the end, as the charts above appear to show, it all winds up exactly as you had anticipated, only without the profits to show for it.
Consider one more data point for this highly correlated pair. On a quarterly basis, the beta of RUB to WTI is 0.56. When WTI goes up, the beta is 0.44 and when WTI goes down, it is 0.87, or roughly two times greater, making it a tricky play for relative value enthusiasts.
It’s difficult when you’re focusing on one driver, like oil in this case, to recognize that there are other significant factors to consider at the same time. For instance, while Mexico is a major player in the oil industry, roughly 80% of its economy is tied to the US. So, if you were instead focused on the US economy and predicting a sizable decline in economic activity, you might short MXN as a high beta play on that view, while ignoring other factors, like oil. Yes, cognitive science has a name for that too. It’s called “Availability Bias.”
The reason I bring this up is that many long/short equity managers are struggling for this exact reason. Correlations that continue to hold up over a quarterly or annual basis are either breaking down in the short run or even when reflecting the same old short term correlations, because of the spike in volatility, those low correlations have become much more painful. Too painful to ride out. That is how you can get your view right, while losing money. The best defense is a more proactive, evidence based approach to position structuring, portfolio construction and risk management, which is what we work on with our clients everyday. About the Author For nearly three decades, Stephen Duneier has applied cognitive science to investment and business management. The result has been 20.3% average annualized returns with near zero correlation to any major index, the development of a billion dollar hedge fund, the turnaround of numerous institutional trading businesses and career best returns for experienced portfolio managers who have adopted his methodologies.
Mr. Duneier teaches Decision Analysis in the College of Engineering at the University of California Santa Barbara.
Through Bija Advisors' publications and consulting practice, he helps portfolio managers and business leaders improve performance by applying proven decision-making skills to their own processes.
As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America and Managing Director of Emerging Markets at AIG International. His artwork has been featured in international publications and on television programs around the world, and is represented by the world renowned gallery, Sullivan Goss. He received his master's degree in finance and economics from New York University's Stern School of Business.
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