2010 Year End Thoughts and Economic Politics

THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

As we close the curtains on 2010 with positive performances across all of our strategies, we search for new themes and new opportunities to exploit in 2011.

The past two years, in the aftermath of the most devastating financial crisis since the Great Depression, have witnessed a strong politicization of the economic process with encompassing ramifications in most investment models. The liquidity flood of 2009 and collapsed volatility reignited one-directional trades in equities and gold. 2010 presented a continuation of such trends.

Making a call for next year implies, in our view, being able to read the political tea leaves more accurately than ever. We feel most political dynamics will not change dramatically in the next twelve months and we will continue to see easy monetary policy from the US and an ECB put strategy in Europe. However, these themes are eventually unsustainable by themselves and asymmetrical risk is building up into the investment framework.

Assuming most political decisions will mimic the past trend, we expect equities to still be an attractive asset class, especially in sectors characterized by high dividends and CPI protection. Lip service to our energy infrastructure MLP strategy is evident here but honestly disclosed. Inflation, in developed economies and especially in Emerging Markets, is a reality in spite of a system in desperate need to de-leverage some parts of its balance sheet.

In this light, commodities and gold specifically will probably experience volatile moves but within upward trends. Beyond gold, which was our successful 2010 call, we think crude oil will be a natural price leader in this asset class.

Bonds look more risky than most other investment options. US Treasuries suffer from undefined fiscal restraints and debt monetization and therefore only inflation protected securities should be included in portfolios where a risk free instrument is still required. Among other sovereign bonds, we continue to favor Emerging Markets bonds but with a lot less enthusiasm than a year ago. Corporate bonds should also provide lackluster performance if the general level of interest rates continues to move higher.

Potential game changers: Forex dislocations, large sovereign default in Europe, social instability in China due to uncontrollable inflationary pressures. It should be interesting…

--Davide Accomazzo, Managing Director
(Written January 7, 2011)

Alpha, Beta and Heisenberg Uncertainty

In physics, complementarity is a basic principle of quantum theory closely identified with the Copenhagen interpretation, and refers to effects such as “wave–particle duality,” in which different measurements made on a system reveal it to have either particle-like or wave-like properties.

Niels Bohr is usually associated with this concept, which he developed at Copenhagen with Heisenberg, as a philosophical adjunct to the recently developed mathematics of quantum mechanics and in particular the Heisenberg uncertainty principle. The Heisenberg uncertainty principle states that certain pairs of physical properties, like position and momentum, cannot both be known with precision. That is, the more precisely one property is known, the less precisely the other property can be known.

In Chinese philosophy, the concept of “yīn yang” is used to describe how polar or seemingly contrary forces are interconnected and interdependent in the natural world, and how they give rise to each other in turn. Yin yang are complementary opposites within a greater whole. Everything has both yin and yang aspects, although yin or yang elements may manifest more strongly in different objects or at different times. Yin yang constantly interacts, never existing in absolute stasis as symbolized by the Taijitu symbol.

A similar paradox exists within the CAPM paradigm involving the relationship between the concept of "beta," as determined by the market portfolio, and "alpha," which loosely represents "a proxy for manager skill". As suggested by our blog, "The CAPM Debate and the Search for 'True Beta'", the yin yang “whole” relates to the “True Beta” concept which Jagannathan and Wang (1996) theorized must encompass “the aggregate wealth portfolio of all agents in the economy”.

Schneeweis (1999) in his article, “Alpha, Alpha, Whose got the Alpha?,” writes about a related problem with respect to measuring “alpha” by raising the question of “how to define the expected risk of the manager’s investment position”. In other words, when marketing “alpha” portfolio managers often assume “the reference benchmark is the appropriate benchmark and that the strategy has the same leverage as the benchmark”. Further, “[w]ith the exception of a strategy that is designed to replicate the returns of the benchmark, the alpha generated by this approach is essentially meaningless”.

Schneeweis (1999) makes the case that investors often make the mistake of relying on a single-index model as a meaningful benchmark from which to gauge the factors “driving the return of the strategy” when often a “multi-factor model should be used to describe the various market factors that drive the return strategy”. The problem is that statistically it is “better to over-specify a model… than to under-specify. If the model is over-specified, many of the betas will simply be zero. However, if under-specified, there is the possibility of significant bias”.

Which brings us back to the Heisenberg uncertainty principle...

Just like the physical properties of position and momentum cannot both be known with precision, the properties of “alpha” and “beta” can also not be measured precisely. This statement has been interpreted in two different ways. According to Heisenberg its meaning is that it is impossible to determine simultaneously both properties with any great degree of accuracy or certainty. According Ballentine this is not a statement about the limitations of a researcher's ability to measure particular quantities of a system, but it is a statement about the nature of the system itself as described by the equations.

- Mack Frankfurter, Managing Director

Alpha Alpha Whose Got the Alpha - Schneeweis

References:
Schneeweis, Thomas. “Alpha, Alpha, Whose got the Alpha?” University of Massachusetts, School of Management (October 5, 1999).

Jagannathan, Ravi; McGrattan, Ellen R. (1995). “The CAPM Debate” Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 19, No. 4, Fall 1995, pp. 2-17.

Bohr, Niels. Atomic Physics andHuman Knowledge, p. 38.

Heisenberg, W. Über den anschaulichen Inhalt der quantentheoretischen Kinematik und Mechanik. In: Zeitschrift für Physik. 43 1927, S. 172–198.

Ballentine, L.E. The statistical interpretation of quantum mechanics, Rev. Mod. Phys. 42, 358–381 (1970).