In the wake of the Great Recession, much was written in the industry press and elsewhere about the failure of traditional tools and techniques advisors use to mitigate risk. Buying and holding a diversified portfolio didn't work very well; just about all asset classes fell in unison. Many critics contended that the Monte Carlo models used by advisors underestimated either the likelihood or the severity of a black swan event.
As a result of their recent experiences, advisors have been re-examining their long-held investment approaches. Many have concluded that a buy-and-hold strategy is no longer advisable. But those who previously held to the buy-and-hold philosophy are loath to be viewed as "traders" or "market timers." Rather than trading on short-term market gyrations, these advisors look for longer term trends they can exploit. This might be as simple as overweighting asset classes they view as undervalued and underweighting those they perceive as overvalued.
A significant number of advisors are giving more weight to intermediate and long-term economic trends as well. This is something institutional investors have done for years, but it is a relatively new phenomenon within the advisor community.
Econometric data can be used for two different and sometimes opposing reasons: Investors can use it to actively seek investment opportunity. They can also use it defensively as a risk management tool. Large institutions that have had access to econometric tools for years use them for both reasons. These tools typically start at hundreds of thousands of dollars and can go up to millions, which puts them out of the reach of advisory firms. Recently, though, a number of new technology products have been launched offering quality econometric tools at reasonable prices. One of the more ambitious of these new products is Hidden Levers (www.hiddenlevers.com), now in beta testing.
Hidden Levers is a financial technology company based in New York City. Their goal is to reveal the hidden links (or levers) between the economy and an investment portfolio. Hidden Levers does this by allowing advisors to create economic scenarios in order to gauge their impact on a given investment portfolio. The data can also be used to determine what investments are likely to perform best under a given scenario.
The founders of Hidden Levers, Praveen Ghanta and Raj Udeshi, know a thing or two about economics, trading and technology. Ghanta is a graduate of MIT, with bachelor's degrees in computer science and economics, and a master's degree in computer science. He has built credit derivatives and risk management systems for Deutsche Bank and participated in other econometric projects. Udeshi has a background in emerging markets sales and trading, as well as interest rate swaps, foreign exchange, inflation-linked bond swaps and foreign exchange options. Udeshi was previously a founding member of Xolia, a fin-tech startup whose decision-making technology helped users choose the right online broker, life insurance policy and credit card for their needs.
An Overview Of The Software
Hidden Levers is a Web-based financial technology platform that offers a great deal of functionality, but broadly speaking, it can be divided into two types of tools: those for research and those for risk management. The research tools will appeal primarily to stock pickers, but it can be useful to other people, too. For example, if you are running a core/satellite portfolio strategy, you might use the research section to develop ideas for the satellite portfolio.
Research
Within the research portion of the application, you find the "Macro Strategies List." The list contains macroeconomic ideas that the Hidden Levers team is currently following. When I logged on in mid-April, these included such topics as: "Japan Recovery Plays," "Long Oil Plays," "Long Gold Plays," "Rising Retail Sales Plays," "Short Dollar Plays" and "Short Euro Plays." For the commodities and currencies, an information box contained the one-year price trend for the commodity, as well as investments that could capitalize on a scenario.
In the Japan recovery, there is no "trend" to track, but there are recommended investments. Not surprisingly, one of those was the Ultra MSCI Japan Pro Shares (EZJ) a leveraged ETF designed to replicate twice the daily performance of the MSCI Japan index. Some of the other recommendations-including a Japanese Internet service provider, a credit services firm and a semiconductor firm-might not be so intuitive, however.
Hidden Levers allows advisors to create their own scenarios, too. One method is to click the "more ideas like this" link under a scenario. So, for example, if you want to use the screen Hidden Levers used for the long gold scenario, but apply it to agricultural commodities, you would select the more ideas link under "long gold."
This would take you to the screener page. From the drop-down list, you'd substitute agricultural commodities for gold and run the screen. When I tried it, three agricultural chemical companies came up as the top investment ideas. The screener displayed vital statistics like market cap, price to earnings, price to book, etc. Users can drill-down for more complete investment information.
The "Start Macro Trend Screener" link can also initiate screens. This takes you to the same screener we used in the last example, but no settings have been pre-selected. There are three steps to creating a screen. First, select a lever from the 40 or more available and indicate whether you want to screen for investments that are positively or negatively correlated with the lever. Next, you can limit your search to certain asset classes, sectors or countries. Third, you can limit the search to minimum and maximum market cap, P/E, price to book and other criteria. Then run the screen.
To analyze individual stocks, mutual funds or ETFs, go to the "Macro Profiles" area. Type a symbol into the box on the screen, and Hidden Levers arranges information in four quadrants on the screen. The upper left contains the macro profile. This shows economic levers correlated with the asset being analyzed that Hidden Levers believes have an effect on the asset's performance.
When I ran an analysis on Microsoft, the application indicated that the company was positively correlated with the S&P 500 and negatively correlated with the U.S. dollar index. In the lower left, the screen displayed a chart of Microsoft against the S&P 500. In the upper right is a detailed quote for the company based on the trailing 12 months. In the lower right, in the "advanced statistics" section, is additional information on the levers highlighted in the upper left.
These include the impact coefficient, standard error, R squared and the confidence level. You can expand this list to see the relationship between Microsoft and all the hidden levers. Sometimes, the regression analysis will show high correlations with other levers, but these levers were not flagged as causal by Hidden Levers' statistical and fundamental analysis.
Risk Management
The risk management section of the application is divided into four sections: "Scenarios," "Scenario Modeling," "Economic Modeling" and "Portfolio Stress Test." The first is an expanded list of the types of scenarios found under the "Macro Strategies" portion of the research side. When I logged on, there were more than 25 scenarios divided into six categories ("Trending Now," "Geopolitical & Worldwide," "Monetary & Banking," "Politics & Government," "Real Estate" and "U.S. Market & Economy.")
When you pick a scenario-for example, "Armed Conflict in Korea"-a page pops up with scenario impacts, scenario hedges and a button that allows you to run the scenario on a portfolio you've uploaded into the system. "Scenario Impacts" shows the estimated impact on the various hidden levers. If you want to adjust any of the estimates, you can do so using the sliders next to each value. Assuming you agree with the estimates, Hidden Levers suggests long plays and short plays for the scenario.
Recommendations in this case include going long gold and short restaurant stocks. To run a scenario on your portfolio, you select the portfolio and run the scenario. The resulting page displays the economic levers on the left and the portfolio holdings on the right. On the portfolio side, you can see the estimated impact on each holding, plus the total impact on the portfolio.
The "Scenario Modeling" section is just another way of reaching the "Scenario Analysis" tools mentioned above. Economic modeling allows you to select a portfolio and apply changes in one or more economic levers to the portfolio in order to determine the likely impact. For example, if I move the health-care inflation lever higher, as expected it will result in higher returns from the Vanguard Health Care mutual fund.
The portfolio stress test is designed to zero in on the scenarios that a given portfolio is particularly vulnerable to. Load a portfolio, run the stress test, and the application will display the scenarios that would do the most damage to your portfolio, including an estimated percentage decline, as well as economic indicators to watch that might indicate a likelihood of the scenario playing out. For example, if a double-dip recession would hurt the portfolio, I should probably keep a particularly close eye on the Consumer Price Index for urban consumers and commercial foreclosures and IT spending growth, according to Hidden Levers.
In addition, Hidden Levers offers an economic data center that displays all of the data that estimates are based on. This data is organized by type (currencies, economic indicators, etc.) and it can be viewed globally or by region. This portion of the program also contains a list of widgets. These widgets allow you to rapidly perform certain operations-for example, to chart an individual lever against a stock or chart one lever against another. More will be added over time.
How Does The Model Work?
In theory, Hidden Levers sounds great, but in order to be useful, it has to get the correlations between the scenarios, the hidden levers and the investments correct. This is a tall order. The firm uses statistical analysis and other tools to model these interrelationships across 100 economic indications, U.S. stocks, ETFs, mutual funds and 15 major currencies over a ten-year period.
A full explanation of the methodology is beyond the scope of this article, but in summary, Hidden Levers performs a regression analysis of each stock against the S&P 500 and each market indicator. Once the regression analysis is finished, they filter for lever relationships that are significant (according to their analysis) with at least a 95% confidence level. These are the results that drive the stock screener and scenario analysis. The Hidden Levers Web site provides a more detailed explanation of the econometric model.
Is It Accurate?
Since the application is still new, it is too early to draw any conclusions about the accuracy of the tool's predictions, but in principle, I like the idea of applying this sort of analysis to a portfolio. If nothing else, it forces advisors to look at portfolios through a prism they don't normally use. If Hidden Levers can really help advisors rapidly incorporate macro trends and economic indicators into their analysis, they will be doing the industry a major service. I particularly like the ability to stress-test existing portfolios against all scenarios and receive hedge suggestions to protect against major vulnerabilities.
Since this is a beta site, there are numerous minor annoyances. Some of the nomenclature could be improved. The labels are not really indicative to a novice user of what a tool does. At times, the site was a bit slow, but I suspect this will be addressed in due course. Currently, the universe of mutual funds and other assets is not complete, but Hidden Levers is adding data regularly.
Hidden Levers offers all users a 15-day free trial. After that, it costs $200 per month for the full professional version, or $50 per month for a plan that includes a subset of the features discussed above (see site for details).
For a limited time, Hidden Levers is looking for additional beta testers, and it is offering a special deal to readers of Financial Advisor magazine. Beta testers will receive 75% off the list price of the program for the remainder of 2011, and then 50% off for life thereafter. To sign up for this special offer, use the following link:
https://www.hiddenlevers.com/hl/user/signup?discountcode=PROBETA We believe that Hidden Levers, and others developing this type of software for advisors, are going to garner more attention in the months ahead. With the free trial offer and the special beta offer, trying Hidden Levers is now risk free. Check it out.