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Theme Investor

A tough month for the model portfolio (April 2018 review)

  • MTD portfolio performance: -0.76% (-0.62% since inception)
  • MTD benchmark performance: +0.10% (-0.70% since inception)
  • Net performance: -0.85% (+0.08% since inception)

Markets recap

Developed market equities trended up this month while emerging markets and frontier markets lost ground. Meanwhile, volatility levels receded, US treasury yields climbed higher and oil continued on its upwards trajectory.

  • The S&P500 returned +0.38% but on year-to-date basis is still down -0.38%. Emerging Market stocks (EEM) lost -2.8% and frontier markets (FM) as much as -3.9%
  • The VIX volatility index declined from 20.0 at start of the month to 15.9 at the end of the month. Besides some volatility early in the month it mostly was a gradual decline.
  • US 10 year treasury yields saw a strong spike upwards from 2.74% to 2.95% (+21bps), intra-month touching above the 3% for the first time since 2014.
  • Brent Crude Oil continued its march upwards, increasing from 70 to 75 (+7%)

Theme returns

Broad Market (VT)-1.29%+0.42%-0.88%
Hard Brexit-1.79%+2.88%+1.04%
Rising interest rates-0.48%-0.05%-0.53%
The next market crash+0.32%-0.96%-0.64%
Trade wars+1.32%-0.10%+1.22%
Low volatility high yield-0.20%+1.40%+1.20%
Robotics / Automation-2.45%-2.51%-4.90%
Water scarcity+1.56%-0.20%+1.36%
Global tourism-2.41%-1.22%-3.60%
Frontier Markets+2.49%-3.94%-1.55%
Healthcare Innovation+0.48%-1.96%-1.49%
Core Bond+1.02%-1.29%-0.28%
Core Equity-0.19%-1.11%-1.30%
Space Race-2.41%-5.01%-7.30%
Clean Energy+1.71%+3.47%+5.24%
Modern Agriculture-2.23%+0.13%-2.10%
Self-driving vehicles-4.06%+0.91%-3.19%
Emerging Markets-0.21%-2.77%-2.97%
Post Trump Administration+1.05%-0.54%+0.50%
Late Cycle+0.65%+1.09%+1.75%
Dawn of Eurasia-1.21%-2.42%-3.60%

Winning themes: Cybersecurity, Clean Energy, Brexit

  • Cybersecurity. One of the biggest winners of this month was Cybersecurity, returning +4.2%. Both ETFs which make up half-half of the portfolio did well and returned 3% to 5%. Looking at the CIBR ETF (+3.2%), we see that companies like Palo Alto Networks, Symantec and VMware (together nearly 20% of the constituents), all returned in the range of +6% to +10%. Cybersecurity is a hot topic right now.
  • Clean Energy. The Clean Energy theme had a very good month, returning +3.5%. Many of its largest constituents had very strong returns, such as Siemens Gamesa Renewable Energy (+8%) and Verbund AG (+7%). But perhaps most significant was China Longyuan Power Group which returned 29% and is 5% of the ETF.
  • Brexit. Pound sterling weakened, commodities rallied (good for BHP Billiton) and British stocks rallied (good for the likes of Sky and Vodafone). As worries about a hard Brexit grew, almost everything came together for our Brexit portfolio, which returned +2.9%. I would expect this theme to keep doing its job as crucial dates creep closer.

Losing themes: Space Race, Frontier and Emerging Markets

  • Space Race. The iShares US Aerospace & Defense ETF saw terrible returns (-6%), causing the Space Race theme to sell off and lose -5.0%. Notable were returns of -5% on United Technologies Corp and Lockheed (together 14% of the ETF).
  • Frontier Markets. Frontier Markets saw mostly negative returns, largely off the back of US dollar strength. The theme lost -3.9%. The larger Frontier Markets ETF lost -5%, and especially Vietnam at -9% in one month had a fall from grace, having previously been one of the best performers YTD. Egypt saved the day returning +2%, but it didn’t help much.
  • Emerging Markets. Emerging Markets similarly had a bad time due to US dollar strength and lost -2.8%. Brazil, Indonesia and Russia all lost -4% to -8%. In local currency terms all but Indonesia actually gained value, but especially Russia could do nothing as the US imposed more sanctions and its currency went in free fall.

Model allocation and returns

2018-04 allocation2018-04 theme returns2018-04 model contributors

When coupled with the Emerging and Frontier markets constituents of the Core equity theme, the portfolio contains a total of 8.3% emerging market and 7.8% frontier market exposure. In a month where both asset classes sold off on a resurgent US dollar, that hurt returns. On their own, these two added some -0.5% to total return. Exposure to Healthcare Innovation and Robotics and Automation further sunk the portfolio.

The stock benchmark (VT) returned +0.42% and was outperformed by themes like Clean Energy (+3.5%) and Urbanisation (+1.6%). It was on the other hand underperformed by themes like Frontier Markets (-3.9%), Robotics and Automation (-2.5%), Healthcare Innovation (-2.0%) and Global Tourism (-1.2%). The Core Equity portfolio returned -1.11% due to its larger emerging and frontier market exposure.

The bond benchmark (BND) returned -0.87% as US interest rates climbed 21bps. It was still underperformed by the Core Bond portfolio (-1.3%) as there were slightly better returns on non-US developed market bonds (-0.2%) but far worse returns on emerging market bonds (-3.4%) that form part of it. Other themes that can be seen as going up against the bond benchmark fared better, for instance rising interest rates (-0.05%), low volatility high yield (+1.4%) and trade wars (-0.1%).

What changes am I making to my asset allocation?

This month I am making quite a few changes which should hopefully position the portfolio better for currently changing markets:

  • Reducing Emerging and Frontier Market exposure. Both the Core Equity theme (30% EM and 10% FM) as well as the frontier market portfolios are cut down to size. I expect more dollar strength and eventually a serious market downturn and at this point want to lower my sensitivity to that.
  • Reducing Clean Energy, Tourism and Healthcare Innovation. These are themes I have had my eye on throughout the month. Clean Energy has rallied tremendously in April but like the other two seem ripe for repricing.
  • Close the Trade Wars theme, add Cybersecurity and Blockchain. It seemed to work for a while during April, and then it did not. No harm done, but with today’s announcement that steel and aluminum sanctions will be postponed, it does not seem to me like a real trade war is forthcoming. I am adding Cybersecurity and Blockchain at minimal exposures. Let’s see what they can do.
  • Increase Low Volatility High Yield and add Late Cycle, Stagflation. I like what I’ve seen so far in the low vol high yield theme, and am getting convinced this one will help to soften the blow and build up a buffer for the next market downturn, all the while generating decent returns. Best of both worlds. I am adding a significant bit of exposure to the Late Cycle and Stagflation themes, which should play into the current market environment quite well.

Cybersecurity as an investment theme

Digital crime is no longer just the domain of individual hackers operating from murky basements. These days many countries have entire cyber armies that stand ready to go to war, and every target whether corporate, governmental, military or civilian seems fair game. As does every piece of crucial infrastructure they can get their hands on via digital means or otherwise.

Countries are fighting wars with drones and robots, and the devices we use in our daily lives are becoming increasingly connected to the internet(Internet of Things) which makes it possible to weaponise them. Cyber crime, data theft and online manipulation is on the rise and can do physical, political and economic damage.

Long story short, the need to protect all of this crucial digital infrastructure is ever growing and governments, companies and individuals will be willing to pay for products and services that offer security. As we hook up more and more of our lives to the internet, that need will only grow, and many companies are stepping into the gap. Investing in firms that provide data protection, firewalls, anti-virus and other cybersecurity should provide solid long-term returns as their products and services become a necessity.

Portfolio construction: two ETFs

CategoryNameIDTERAlloc %
ETFFirst Trust Nasdaq Cybersecurity ETFCIBR0.60%50.0%
ETFETFMG Prime Cyber Security ETFHACK0.60%50.0%

Risk level: high / diversification: low

  • Dividend yield: 0.1%
  • Ex-ante predicted volatility: 13.9%
  • 1 year 95% Value-at-Risk: –23.3%
  • Scenario 2008 Lehman Brothers default period: -24.7%
  • Scenario Interest rates +100bps: +9.8%
  • Scenario 2008-2009: -8.0%
  • Scenario 2010 onwards: +201%

Stock markets will crash: how to prepare your portfolio for the inevitable

The yield curve has been rising, but (with exception of the last several days), short term rates have been moving up faster than long term rates. A flatter and perhaps at some point inverted yield curve has typically preceded a recession, as it implies that long-term views of the economy are becoming less rosy.

At the same time P/E ratios of stocks are getting close to all-time highs and commodity prices are rising sharply, which in the past has generally been followed by a recession. In the mean time the Federal Reserve is reducing their balance sheet and draining liquidity from the market.

As of writing, the S&P 500 has again turned officially negative for the year while volatility is higher than it has been for years. European and Japanese stocks are moving right along while emerging and frontier markets are still bucking the trend but also heading in the same direction. Not to sound gloomy but we may be working up to a period of sharply lower returns. How can an investor adjust their portfolio to cope?


Year-to-date stock returns on S&P, Nikkei, Hang Seng, Eurostoxx 50, Emerging and Frontier markets


The US Treasury actives curve, between now, December 2017 and December 2016


Spread between 2 year and 10 year US Treasuries

Crude oil during the previous two crises vs today

S&P500: The run up to the previous two market crashes vs today

What are the risks on the horizon?

I believe we will be going through two distinct periods. First there will be a time of sharply higher interest rates and commodity prices. Meanwhile equity markets start moving sideways as positive earnings surprises fail to excite, and the positive sentiment around their generally good results has to contend with worries about what is to come. Secondly, there will be a time of sharply negative stock returns as a recession brings things back to earth.

In the first period you will want little fixed income exposure except very short maturity and higher yielding bonds. You can complement that with some commodities and selective equity exposure. The latter can for instance be to high yielding stocks, or themes, countries or sectors that still have some life in them or are in an earlier part of the cycle.

In the second period you will want practically no equity exposure at all, keep a significant part of your portfolio in cash and complement that with long maturity fixed income and safe haven assets like gold. You will also be looking to buy the dip.

I believe we have now entered the first period. How long it will last is uncertain, but if the previous two market crashes (2000 and 2008) offer any guidance for the future, we are probably looking at anywhere between 9 months to 18 months (note that the 1989 crash actually happened in a much shorter time span but we are going to work off the assumption that we will face something more similar to 2000 or 2008).

That means that potentially until year-end or even summer 2019 there could be positive returns to be had, but you need to be selective.

How to modify your portfolio

At this point we want to be cautious. But we also don’t want to stand on the sideline until the middle of 2019 if select sectors of the market deliver healthy returns before then. To avoid getting caught out by rising interest rates we will want to reduce our fixed income exposure today and shift into more defensive, less volatile or higher yielding stocks. In addition, some commodity exposure is probably warranted.

Next, over the next 6-9 months or so we want to gradually adjust the portfolio to be recession-ready. That means at least reducing the most risky equity exposure, reducing commodity exposure and adding cash. Once interest rates are sufficiently high it may be a smart move to increase fixed income exposure.

How my model portfolio looks and what changes will be needed

CategoryNameMax% alloc*Alloc% todayAlloc% in 6 monthsDifference
Total portfolio100.0%100.0%
Lower RiskRising interest rates12.5%10.0%10.0%0.0%
Lower RiskThe next market crash20.0%5.0%8.3%+3.3%
Lower RiskLow volatility high yield11.7%5.0%11.7%+6.7%
Higher RiskRobotics / Automation9.4%5.0%2.5%-2.5%
Higher RiskWater scarcity9.9%10.0%6.3%-3.7%
Higher RiskGlobal tourism8.1%2.5%1.4%-1.1%
Higher RiskFrontier Markets11.9%5.0%0.0%-5.0%
Higher RiskHealthcare Innovation14.0%12.5%5.0%-7.5%
Lower RiskCore Bond9.0%5.0%1.0%-4.0%
Higher RiskCore Equity46.7%27.5%24.0%-3.5%
Higher RiskClean Energy16.4%5.0%2.5%-2.5%
Higher RiskUrbanisation12.6%2.5%1.4%-1.1%
Higher RiskModern Agriculture12.8%2.5%0.9%-1.6%
Higher RiskTrade wars14.0%2.5%0.0%-2.5%
Higher RiskLate Cycle16.1%0.0%7.5%+7.5%
Higher RiskStagflation17.3%0.0%2.5%+2.5%

* Refers to our position sizing methodology


  • Longer term themes. 45% of the portfolio is currently invested in longer term themes such as healthcare innovation, water scarcity, robotics, clean energy, tourism, urbanisation, modern agriculture and frontier markets. Some of these themes are less diversified and their constituents overvalued. For instance the ICLN ETF in Clean Energy has a P/E of 106 while the HEAL ETF in Healthcare is as high as 102. This clearly needs to be lowered. 6 months target: 20.0%. Since this is a thematic portfolio, we keep exposure to our conviction themes at all times, and once themes become significantly undervalued we want to move back in and pile up the allocation.
  • Core equity and bond. 32.5% of the portfolio is in the core equity and bond themes. Both carry higher risk from emerging markets, while the core bond theme has relatively high interest rate sensitivity. I will reduce their combined allocation to 25.0%
  • Short-term themes. 17.5% of the portfolio is currently in themes that play in on rising interest rates, a market crash and trade wars. These will be gradually raised to 28.3% as risks intensify. The Late Cycle and Stagflation themes are added into the mix
  • Low vol high yield. 5.0% of the portfolio is invested in the low volatility high yield theme. This theme has been holding up well and would likely add diversification in any crash, and I will increase it to 11.7% (its maximum allocation per our sizing methodology)
  • Cash. The remainder of the portfolio will be held in cash

Investing to benefit from the dawn of Eurasia

One of the excellent books I am reading at the moment is Dawn of Eurasia by Bruno Maçães, a former Portuguese minister and current political scientist*. The main premise of the book is essentially that the idea of Europe as a distinct entity from Asia is merely a historical construct, and that the new world order that is coming about – aided by the fall of the wall and the opening up of China – is essentially a Eurasian one.

* note this is not a sponsored post in any way shape or form!

While many of us tend to think of “Americanisation” when we think of “globalisation”, Maçães instead views the future of globalisation as being defined by developments on the landmass that spawned almost all of the world’s great civilizations. In that new world order, the balance between Russia, China, India, the European Union and Middle East will shape much of the world affairs in the future.

Meanwhile, the preeminent power of today, the United States, is increasingly redefining itself as being somewhere in the middle of both sides. Maçães views events like the election of Donald Trump, Europe’s refugee crisis and Brexit through this lens.

Russia, with its Eurasian Commonwealth of Independent States, and China with its Belt and Road initiative have been somewhat faster than many Europeans to see the bigger picture. Particularly the latter, functioning as “new Silk Road” is a project that spans 68 nations that are home to some 62% of the world population and aims to invest in infrastructure, roads, railways, ports and so on, thereby enhancing Eurasian economic cooperation.


If this all plays out, investors can obviously profit from increasing trade and prosperity throughout the wider region.

Infrastructure projects that are part of China’s Belt and Road initiative will bring direct benefits to places in China and Central Asia like Kazakhstan, Kyrgyzstan and Uzbekistan as they become more linked together and economies start integrating closer. Not only will the European Union be integrated internally, it in itself will start seeking closer integration with other powers.

While there are plenty of flash points and geopolitical issues that remain unsolved (Ukraine, Taiwan, Kashmir, the South China Sea to name just a few), potentially that integration will create a truly win-win situation where all countries involved can prosper.

Portfolio construction: Eurasian stocks and infrastructure

  • The constructed portfolio consists for 70% of stocks from China, Europe, Russia, Pakistan, Kazakhstan (through Depository Receipts listed in London) and ASEAN, coupled with some Indian infrastructure
  • The remaining 30% is filled with the KraneShares One Belt One Road ETF which invests in the primary countries and sectors involved with the initiative: mainly energy, utilities, industrials, materials and financials
CategoryNameIDTERAlloc %
One Belt One RoadKraneShares MSCI One Belt One Road ETFOBOR0.79%30.0%
RussiaVaneck Vectors Russia ETFRSX0.62%15.0%
ChinaiShares China Large Cap ETFFXI0.73%10.0%
EuropeiShares Core MSCI Europe ETFIEUR0.10%5.0%
India infrastructureColumbia India Infrastructure ETFINXX0.85%10.0%
PakistanGlobal X MSCI Pakistan ETFPAK0.91%10.0%
KazakhstanHalyk Savings Bank of Kazakhstan GDRHSBK2.5%
KazakhstanKcell JSC GDRKC1A2.5%
KazakhstanKazMunaiGas GDRKMG2.5%
Central AsiaCentral Asia MetalsCAML2.5%

Risk level: high / diversification: low

  • Dividend yield: 2.5%
  • Ex-ante predicted volatility: 11.2%
  • 1 year 95% Value-at-Risk: –15.6%
  • Scenario 2008 Lehman Brothers default period: -18.6%
  • Scenario Interest rates +100bps: +1.8%
  • Scenario 2008-2009: -23.3%
  • Scenario 2010 onwards: +88%

Model Portfolio review (first half April 2018): the core portfolios underperform

  • MTD portfolio performance: +0.15% (+0.28% since inception)
  • MTD benchmark performance: +0.47% (-0.33% since inception)
  • Net performance: -0.33% (+0.61% since inception)

Theme returns and model allocation

2018-04M theme returns

2018-04M allocation

2018-04M model contributors

Markets recap

On month to date basis, the S&P500 is up +0.66% while crude oil is up +3.77% and US 10 year yields are up +9bps to 2.83%. Meanwhile emerging market bonds are down -0.66%. The dollar was flat against the euro and a bit stronger against JPY (+1.0%). Finally, the VIX index has come down to about 17% as of yesterday’s close.

There have been worries about a potential trade war between China and the US, but after soothing words from both sides the bulls returned to the market. Having said that, Donald Trump just ordered attacks (supposedly a one-off) on Syria in retaliation for Assad’s use of chemical weapons, and Russia has vowed to retaliate. The general risk-on mood may sour in the last two weeks of the month depending on how this all plays out.

Notable portfolio underperformers

Core equity (27.5% allocation). Returned -0.07% vs +0.68% on Vanguard Total World. Non-US developed market stocks did better than the Total World index (which itself is 35% part of this theme), but emerging market stocks and frontier markets are getting hammered this month on worries around trade wars.

Core bond (5.0% allocation). Returned -0.33% vs -0.15% on Vanguard Total Bond Mkt. Given the rally in US rates, international diversification to developed markets worked out well, but the inclusion of 25% EM bonds in the portfolio hurt. Notably bonds of Russia (~5% of the index our EM bond ETF tracks) took a hit as the US imposed new sanctions.

Global tourism (2.5% allocation). Returned -2.20%. In the portfolio of 9 equal-weighted tourism related stocks, CTrip, Carnival and Wyndham each sold off -4% to -6%. It is easy to see that the airline stocks in the portfolio (RyanAir and Singapore Airlines) would sell off on the higher oil prices, and perhaps that sentiment resonates throughout the sector.

Notable portfolio outperformers

Clean energy (5.0% allocation). Returned +2.31%. A lot of that was driven by the second biggest holding in the ETF, Huaneng Renewables, to return nearly +11% MTD based on several rating upgrades from analysts.

Modern agriculture (2.5% allocation). Returned +1.22%. Mostly due to +2.3% on FTAG (First Trust Index Global Agriculture ETF). Within that index, Monsanto and Bayer AG are the two largest constituents forming 20% of the total and each returned +8% on the news that Bayer will be allowed to buy Monsanto by the US Department of Justice.

Urbanisation (2.5% allocation). Returned +1.20%. Mostly on the SPDR Metals and Mining ETF (XME) which returned +4.4% in the month. Alcoa, the largest holding in the ETF at over 5%, returned +22% as the price of aluminum shocked upwards after the US imposition of sanctions on Russia, targeting Rusal.

Thoughts on the portfolio going forward

I want to say I am 100% happy with my portfolio but to be honest at the moment I am not. Core equity and core bond have significant portions invested in emerging markets which over the longer run (I am talking about years) should really aid outperformance, however I am getting the feeling that we are working up towards major market turmoil and I am not sure if I want to stick with these allocations while going through that. It is a pity that I don’t rebalance intra-month because otherwise I would probably want to make some changes today.

I am still pondering over it, but for the moment I am also considering to reduce allocation to core equity (-5% or more). Also I am intending to reduce healthcare and robotics by as much as 5% to 10% as while I believe in the themes, a lot of the companies in the underlying ETFs seem quite overvalued from a P/E point of view. They will work, but not in the months where it all comes crashing down. To replace that allocation, I will likely add money in themes like Low Vol High Yield and Late Cycle.

Late cycle investing: where to put your money at the tail end of the expansion

We are still in the expansionary phase of the business cycle, a place we have basically been in since June 2009. And although the old adage goes that “bull markets don’t die of old age”, most would agree that we are now in or at least nearing the tail-end of the cycle. That is typically associated with an overheating economy that faces tightening monetary conditions and credit availability, slowing productivity and GDP growth that begins to stall. Not great news, all in all.

With interest rates going up and economists anxiously looking at economic data to spot either a pick-up in inflation or slowdown in the economy, stocks have been showing the first real signs of bull market fatigue in early 2018. They recently broke through their 200 days moving average for the first time in 2 years.

Once the bull market ends and things turn down, there won’t be many places to hide except for cash, gold and treasuries (and maybe, just maybe a select few consumer staples stocks). But calling the end of the rally has been unsuccessful for many, and DT’s fiscal stimulus plans may yet extend things for quite some time to come. Until it all comes crashing own there may still be decent returns to be found in certain places of the market. Here are three investments you could consider.

#1 Non-US equities

While the US may be nearing the end of the good times, in Europe and many emerging markets, the expansion is still very much going on. Europe in particular seems a step behind the US in terms of the business cycle, having been slower to recover from the previous bear market. With still low inflation and interest rates, and growth having missed out on the strength of the recovery that the US saw post crisis, European equities should have some room to run still. Emerging markets have also been showing notable resilience to recent US-led market volatility. Investing in these two markets may yet yield good results, bar a total systemic crash like we saw in 2008.

#2 High quality stocks and specific sectors

Defensive sectors like utilities, healthcare, energy, and consumer staples would generally be expected to perform better than their cyclical peers in this period. Also more generally, companies with stronger balance sheets (which tend to pay higher dividends) will be expected to stand firm while their more speculative peers take the brunt of the initial hits.

#3 Commodities

A key aspect of the late business cycle is that inflation should start picking up. Inflation-sensitive sectors like energy and commodities are expected to outperform off the back of this.

Portfolio construction: cash, commodities, non-US and high quality stocks

  • The suggested portfolio contains a lot of cash to cushion the blow that a recession will undoubtedly deal the markets at the end of it
  • Until then, commodities, European and Asian equities as well as high quality US stocks should be expected to perform better than the market as a whole
CategoryNameIDTERAlloc %
Asia equityiShares MSCI All Country Asia ex Japan ETFAAXJ0.69%10.0%
Europe equityiShares MSCI Eurozone ETFEZU0.48%10.0%
High dividend low volLegg Mason Low Volatility High Dividend ETFLVHD0.27%20.0%
CommodityiShares Commodities Select Strategy ETFCOMT0.48%30.0%

Risk level: low / diversification: high

  • Dividend yield: 2.6%
  • Ex-ante predicted volatility: 5.7%
  • 1 year 95% Value-at-Risk: –8.8%
  • Scenario 2008 Lehman Brothers default period: -11.6%
  • Scenario Interest rates +100bps: +1.7%
  • Scenario 2008-2009: -5.8%
  • Scenario 2010 onwards: +55%

Position sizing using the Kelly criterion: weighing upside potential against downside risk

One of the bigger worries around thematic investing is that investors may end up mistaking fads for investment themes. An ill-informed thematic investor in 1999 might have been convinced that putting most of their money in Dot com stocks would absolutely future-proof his portfolio, for instance. His or her money would have vanished into thin air.

Our approach is different, as in the model portfolio we generally pick themes that are underpinned by plenty of research and strong and obvious social and economic undercurrents. Things like water scarcity or healthcare innovation, where it is obvious that growing demand for water and healthcare as the world’s population ages and its middle class grows, is not just going to stop from one day to the next.

As a counter example, while we don’t necessarily believe that Blockchain is a fad, for the time being we are holding back from allocating to it as we cannot quite see the end game there yet.

Our approach: Marrying the quantitative to the fundamental

Fundamentally, we are sure that the themes we select are not fads and believe that all themes we invest in have strong return potential above the broader market in the longer run.

But besides being picky as fundamental theme investors, we also believe in marrying the fundamental to the quantitative. Before allocating to any theme, we perform thorough risk analysis on it, and use the output to make informed allocation decisions.

We do this because we know that despite having high conviction on a theme, putting all of our eggs in one basket and getting it wrong (like people got the Dot com bubble wrong), can derail an entire portfolio for the longer run:

  • If you lose -20% in a year, it takes a +25% gain to recover from your loss
  • If you lose -40%, it takes +67%
  • If you lose -60%, it takes +150%
  • If you lose -80%, it takes +400%

To avoid that, we emphasise downside risk management and enforce a position sizing strategy that caps any theme investment at 20%, and further limits that for themes where the downside risks outweigh the upside benefits.

Sound risk management: position sizing using the Kelly criterion

Having a position sizing strategy means setting an objective guideline for the size of every holding in your portfolio. It helps to decide how much to allocate to a certain position (or in our case, theme) and builds a diversified portfolio. That limits the risk of ending up with large and unrecoverable losses.

We apply a custom derivation of the Kelly criterion, a concept from probability theory that has many applications (notably in gambling and trading/investing). The Kelly criterion takes as inputs the win probability and expected returns when winning or losing in order to give you a suggested amount to “bet” on a certain trade. Specifically:


where f* is the suggested allocation, b is the expected return on success, p is the probability of success and q is the probability of losing it all (100%). So in an example where your expected return is 20%, the probability of achieving that is 90% (and the probability of losing it all thus 10%), Kelly would suggest a maximum allocation of 40%.

Typically that amount is then further constrained by setting a maximum allocation on each trade in the portfolio of say 10%, then multiplying that by the Kelly criterion result (the above example would get an allocation of 4%).

At its essence, this is a clever way to distinguish attractive from less attractive investments and allocate accordingly. The Kelly criterion will suggest betting more money on something if:

  • The likelihood of winning is higher
  • The payoff when winning is higher
  • The losses when losing are lower

Our derivation of the Kelly criterion

The above is more of a gambling approach, but there are obvious ways to incorporate it into portfolio management. We take a custom approach and use two analytics from the Bloomberg PORT risk model for every theme:

  • For the expected return in a positive scenario, we take the annualised returns in the 2010-2018 scenario. This was an extremely long-running bull market, and using Bloomberg’s risk model we calculate a hypothetical return based on the portfolio’s factor exposures and factor returns during the period. It should give a decent idea of how well each theme could be expected to do over the longer run, suggesting for instance that our Brexit theme would return some 5.0% annualised, while the Space race theme could earn as much as 16.5%
  • For the expected return in a negative scenario, it takes a similar approach but this time for the years 2008-2009, or the worst global financial crisis that many of us can remember.

We furthermore set the probability (rather subjectively, but uniform for all themes) of the positive scenario occurring at 82.5%, while the negative scenario gets a probability of 17.5%.

For each theme we work with a maximum allocation of 20%, with exception of the core bond and core equity portfolios for which we work with 25% (core bond) and 75% (core equity). All in all that gives us the following sizing function:

Max. position size = 20% *

[ ((82.5% * 2010-2018 return) + (17.5% * 2008-2009 return)) / 2010-2018 return ]

For instance, if the expected payoff on the Space Race theme over 2010-2018 would have been +250% (annualized from December 2009 to March 2018 that makes about 16.5%) and its return in 2008-2009 would have been -50.7%, our rule suggests a maximum allocation of:

20% * [((82.5% * 16.5%) + (17.5% * -50.7%)) / 16.5%] = 20% * 28.7% = 5.7%.

Had the downside loss been cut in half (-25%), we could have put 11.2% in it.

That gives the following maximum figures for the currently covered themes:

CategoryName2008-20092010-2018Max alloc.Kelly % max
Higher RiskHard Brexit-7.7%+49%20.0%11.1%
Lower RiskRising interest rates-8.2%+78%20.0%12.5%
Lower RiskThe next market crash+9.4%+37%20.0%20.0%
Higher RiskTrade wars-5.7%+87%20.0%14.0%
Higher RiskStagflation+2.1%+109%20.0%17.3%
Lower RiskLow volatility high yield-16.8%+158%20.0%11.7%
Higher RiskRobotics / Automation-25.9%+167%20.0%9.4%
Higher RiskWater scarcity-21.2%+140%20.0%9.9%
Higher RiskGlobal tourism-33.7%+192%20.0%8.1%
Higher RiskFrontier Markets-14.8%+142%20.0%11.9%
Higher RiskHealthcare Innovation-10.5%+211%20.0%14.0%
Lower RiskCore Bond-3.4%+11%25.0%9.0%
Higher RiskCore Equity-12.8%+137%75.0%46.7%
Higher RiskBatteries-21.7%+156%20.0%10.2%
Higher RiskBlockchain-24.9%+173%20.0%9.8%
Higher RiskFintech-27.5%+213%20.0%10.1%
Higher RiskSpace Race-50.7%+250%20.0%5.7%
Higher RiskClean Energy-0.2%+101%20.0%16.4%
Higher RiskMillennials-30.9%+167%20.0%8.0%
Higher RiskUrbanisation-12.2%+133%20.0%12.6%
Higher RiskModern Agriculture-13.4%+169%20.0%12.8%
Higher RiskSelf-driving vehicles-13.7%+192%20.0%13.1%
Lower RiskPost Trump Administration-8.7%+50%20.0%10.5%
Higher RiskEmerging Markets-5.1%+110%20.0%14.6%

After Donald Trump Leaves: Investing in a Post Trump World

The day of Donald Trump’s election back in November 2016 was quite a fascinating day to watch the markets (come to think of it, the whole second part of that year from June to November was a rollercoaster). Markets initially did not like the news much at all, then at some point during the day the tide turned and everything started rallying: US dollar, stocks, interest rates. That did not stop for quite some time.

It wasn’t so much that markets suddenly turned sanguine about all of the perceived bad aspects of a DT government. The worries about trade disruption and alienating allies were still there. But the prospect of a pro-growth government controlling all three branches had investors salivating and became the overbearing driver of returns. Corporate tax cuts, infrastructure spending, reducing regulations…

But lately the Trump trade has turned upside down

As of late, there is a real sense that that is changing and the worries are gaining the upper hand. The main culprit for the markets unease since early February have been Trump’s tirades on trade, blaming anyone from Mexico to JapanCanadaChina and the European Union for taking unfair advantage of the United States. These countries together represents two-thirds of all of America’s foreign trade and much of its exports.

On top of all this there are the worries about Mueller’s Special Counsel Investigation and whether any of it could eventually lead to impeachment. And don’t forget that by 2020 Trump faces new elections anyway.

So… Does this kill the market?

I read a quote from one portfolio manager in Australia this week proclaiming that the tweet-driven market was driving him insane and he was considering offloading all his US stocks. We are indeed in new territory here and I do wonder if there comes a point where Trump’s playing with the market ends up killing the bull market as a whole. US economic data tells us otherwise, but at some point something will give, right?

Long story short, Trump may be with us for quite some while, or his days may suddenly be numbered. How to invest for when that moment comes around? I see four main themes playing out.

#1 Long US dollar, short euro and yen

When Trump was elected, the US dollar initially rose from 98 to 103 (+5%). Since then however, it has been on a steady downward trend and only as of late seems to have potentially found a bottom around 90 (-8%). What gives?

The Trump “reflation” trade initially made the dollar stronger, but since then I have long suspected that the US administration has deliberately talked it down. While the longer term US government policy is still for a stronger US dollar (as that has certain benefits), in the short term a weaker dollar may help to “rectify” the trade imbalances the United States faces with other blocs and nations. Treasury Secretary Mnuchin seems to think so.

So it is ironic that while we expected a period of US dollar strength after Trump’s election, in fact that period may arrive after he steps off stage, as US economic policy returns to orthodoxy. The euro and Japanese yen are both at relatively strong point vs. the dollar compared to recent levels, so I would short them against USD.

#2 Long Mexican peso

In the run-up to the US election in 2016, Mexican peso declined to nearly 22.0 versus the US dollar. It has since recouped quite a lot and is back around 18, but many economists say its fair value should be closer to 15 or 16. A lot of the worries that have plagued MXN are likely to resolve itself when the new NAFTA deal comes into play, but it may take Trump fully stepping off stage for Mexican peso to regain its strength.

#3 Long US treasuries

Treasuries have become weaker as the rate hiking cycle has continued. Inflation levels are still expected to rise, since we are likely to be at full employment (and throwing fiscal stimulus at the economy at the same time), and on the back off that this trend should keep going for a bit.

At the same time you have to wonder when the next serious market downturn will take place and what is going to cause that. Or even how that is going to impact the position of “Mr Stock Market” Donald Trump. At that point we may reach the peak of this rate hiking cycle and things could turn around, or a flight to quality may raise treasuries all by itself.

#4 Long China and Europe stocks, neutral US equities

There are some reasons to suspect that China and European stocks will outperform their US peers in the event of Donald Trump stepping down. In both cases it will likely remove an irritant to their global trade ambitions, while in Europe’s specific case a weaker euro would likely be good for European stocks.

Portfolio construction: long USD and MXN, long treasuries and EU/China stocks

  • The model portfolio contains some 40% in currency positions, consisting of long USD and long MXN. The remainder is filled up by 20% US treasuries and 40% European and Chinese stocks
  • The volatility on this portfolio is some 6.4%, which is marginally higher than our Core Bond portfolio (4%). Both in terms of upside potential as well as downside potential this portfolio should be able to do well in the specific scenario it is designed for. In case the scenario does not exactly play out as envisioned, long stocks, long EM currencies and long USD should be able to balance things out quite neatly
CategoryNameIDTERAlloc %
Short EURProshares Short Euro ETFEUFX0.95%10.0%
Short JPYETFS Short JPY Long USD ETFSJPY0.39%10.0%
Long MXNMXN cashMXN-20.0%
US TreasuryiShares 20+ Year Treasury Bond ETFTLT0.15%20.0%
China equityiShares MSCI China ETFMCHI0.64%20.0%
Europe equityVanguard FTSE Europe ETFVGK0.10%20.0%

Risk level: low / diversification: high / allocation: 0%-10%

  • Dividend yield: 2.3%
  • Ex-ante predicted volatility: 6.4%
  • 1 year 95% Value-at-Risk: –9.5%
  • Scenario 2008 Lehman Brothers default period: -10.0%
  • Scenario Interest rates +100bps: +0.1%
  • Scenario 2008-2009: -8.7%
  • Scenario 2010 onwards: +50%
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The five big worries currently plaguing the stock market

People don’t like things they don’t understand, and we like to have an explanation for everything that happens. The same holds true for financial markets. Not a day goes by that financial journalists do not provide a general narrative for what is going on. Here’s a random take for yesterday:

After the worst three months for global stocks in more than two years, the second quarter has started on the back foot as trade tensions fester and technology shares get slammed. The risk-off mood comes as investors prepare for earnings season. They still anticipate a strong showing, but will be watchful for any more signs of a slowdown in the synchronized global expansion (Bloomberg markets wrap)

I am much like them and watch financial markets intensively every single day. Two of my screens at work have no other function than showing me a collection of some 48 intraday Bloomberg charts depicting everything from global currencies to global stock markets, commodities, credit indices and interest rates. Other screens show me news headlines and yet more flickering numbers. And all day long I’m surrounded by people who do the same and chat about what they see. I find it truly fascinating to see how news can hit the market and what direction asset prices trend in.

Even more fascinating are trend breaks, i.e. the euro structurally weakened any time there was a reason for US interest rates to go up until mid-2017 (which makes sense from a basic economics point of view). Since then there has been a total trend reversal and now the initial response is often for the euro to strengthen. But I digress.

Based on what I see and hear, here are the five things that I think are currently really driving markets. Call it my H1 2018 market narrative, if you will.

#1 Markets are looking for signs of the next recession

Despite recent sell-offs, we are still in the middle of one of the longest historical bull runs for equity markets. Calling the top has been a fairly unsuccessful endeavour over the past years, but there is an overbearing sense amongst many that this cannot go on for much longer.

At the moment all the economic data is looking rosy (dare I say goldilocks). Add to that DT’s fiscal stimulus and the fact that stocks in places like Europe and emerging markets are still relatively cheap or at least not overvalued, should provide enough steam to keep things going.

But at some point it will end, and everyone involved in finance is looking for cues on when, what and how. That exacerbates asset price fluctuations. In many ways, all of the items that follow should be seen in that light.

#2 Donald Trump. Period

There was a brief period after the US election in 2016 when markets where enchanted by the new president as they rallied around the “Trump trade”. That was basically a result of markets rejoicing over his business credentials and expected tax cuts and pro market policies.

But today I read “this is now Trump’s market” in an entirely different tone. Whereas in 2017 his tax cuts and pro-business image helped to stimulate markets through some tough times (threatening the destruction of North Korea and Seoul was a blip on my screens), in 2018 that seems to have played out. At times, DT seems to turn outright hostile to the markets when talking about implementing tariffs on foes and allies alike, ripping up NAFTA and bashing Amazon to settle a personal feud. It is truly unsettling.

#3 Interest rates and inflation

Rising interest rates has been a narrative in the market for quite a while now. While this has typically been a worry associated with fixed income, early February was the time things really spilled over into the stock market. And not just a little bit, it was also the first moment in about two years time that markets truly started selling off.

At that time, a consumer prices report that showed a larger increase in prices than expected, which raised fears of fast and furious increases in interest rates. Higher interest rates will make stocks relatively less attractive than bonds, while hurting the profit margins of companies, hence the sell-off.

Lately interest rates have trended down slightly on general risk-off sentiment, but expect these worries to come back at the slightest hints of more inflation than previously expected. Speaking of inflation, tariffs can cause that..

#4 Wars and trade wars

The US President spent much of 2017 focusing on North Korea. Tweeting about fire and fury and destroying North Korea, all the while boasting about nuclear buttons does not make for a comfortable backdrop when investing into stocks or other assets. More recently, DT has fired several of his advisors and replaced them with hardliners, notably John Bolton (of George W Bush and Iraq war fame). That begs the question of whether Iran is now going to find itself in the crosshairs.

At the same time, Trump is talking about ripping up NAFTA and imposing technology and steel tariffs on the EU and China. So far the tit for tat has not been that detrimental to the real world, though it has hurt market sentiment. If it starts to show up in GDP figures, this becomes a whole different ball game.

#5 Technology and FAANG selloffs

In the more recent sell-offs, technology and particularly the FAANG stocks (Facebook, Apple, Amazon, Netflix and Google) got hard hit. And not only them, Twitter was down double digits during a single day last week and practically nothing in the sector got spared. In many ways, the worries about trade friction with China are what brought down the sector, but DT’s feud with Amazon and worries about Facebook’s privacy issues (with increasing scrutiny and regulation of the sector undoubtedly coming up) added to that.

How to invest in the battery revolution

Batteries are currently the bottleneck of many technologies. You have a phone, but after using it for half a year its battery percentage says 36% at 5PM, when you still have a long evening ahead of you. Your laptop battery used to last for five hours when you first got it but now can only go for two. Your smartwatch can barely last you a full day, and on that twelve hour flight your wireless headphones die eight hours in.

Consumer devices have become more compact over the years. Whereas a Nokia 3310 (yes, that Nokia) used to measure 22mm in thickness, the latest iPhones measure only 7-8mm thick. Battery technology has had to shrink down in size accordingly, and on top of that it has had to go from supplying power to small monochrome displays to now powering full-fledged computing devices with huge state of the art screens. Never mind powering lightweight sports cars.

Thus far the battery technology that is available in your average consumer electronics (typically Lithium-ion) has struggled to keep up with these developments. Should at some point the barriers to quick charging and longer battery life be broken however, battery technology would represent a great investment for the longer term.

What are the latest developments in battery technology?

Most devices you will have come across in an average household (and in its next door garage) over the last decades run off Lithium-ion batteries. There are many different types of Lithium-ion batteries, and without going into the technical stuff (you know, how electrons are moved from one end of the battery to the other between the anode and the cathode or positive and negative electrodes, ahem) suffice it to say that these have generally been found to be the most efficient type of battery. Though not without their issues, mainly in the area of safety.

Developments in battery technology all focus on increasing the density of the battery (more energy in less space), improving the battery life and safety. Because no one likes exploding batteries.

Currently there is no clear indication of which technologies are going to win out. There is ongoing research by the big technology companies into improving Lithium batteries, with Lithium-air or Lithium-sulfur as possible contenders to take Li-ion’s place in your phone. Other technologies like solid state batteries, Sodium-Ion or Aluminum-Air batteries look at replacing Lithium entirely, but that seems further off and is receiving less R&D spending. So far no successor has successfully been brought to the market yet.

Demand from all sides should make this a great longer term investment

Batteries go in practically anything, and crossing the hurdle to having longer lasting and faster charging batteries could literally change our lives. Whatever the new technology ends up being, once it ends up on the market there is sure to be enormous demand.

As we have outlined above, which technology is going to end up in your phone is harder to predict, but most currently see no real competition for advances in Lithium batteries. Moreover, if the last 25 years are any guide for the future, it appears that any changes will happen gradually than suddenly. If new advances come to the fore, existing battery manufacturers are likely to be quick to jump on it.

Portfolio construction: lithium and battery technology

  • This single ETF theme portfolio consists of the Global X Lithium and Battery ETF which tracks the Solactive Global Lithium Index. It invests into the full cycle of a battery: from miners (creating exposure to Lithium prices) to actual battery producers
  • The ETF contains allocation to predominantly the United States, Australia, South Korea and Japan (77%) in total
CategoryNameIDTERAlloc %
BatteriesGlobal X Lithium & Battery Tech ETFLIT0.76%100.0%

Risk, Diversification And Allocation

  • Risk level: high
  • Diversification: low
  • For risk and total return since initiation see Portfolios
  • Probability of this theme playing out in the next 3-10 years: 50%-50%

Portfolio Characteristics (Full Look-Through, From USD Perspective)

  • Dividend yield: 3.74%
  • Ex-ante predicted volatility: 15.8%
  • 1 year 95% Value-at-Risk: –22.2%
  • Scenario 2008 Lehman Brothers default period: -31.0%
  • Scenario Interest rates +100bps: +6.1%
  • Scenario 2008-2009: -21.7%
  • Scenario 2010 onwards: +156%


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