3 Innovative Features

The Lumen Global Value Compass

The Lumen Global Value Compass is an original application of the most basic law of finance: The monetary value of any investment is equal to the sum of the future cash flow discounted back to present value. The discount rate used in the discounting calculation is equal to the expected future return of the investment.

Using live unaltered market data, a Discounted Cash Flow construct, and complex reverse engineering techniques, the Compass extracts the future expected return implied in the market price.  Notwithstanding the complexity of this algorithm, the true prodigy of our Compass is to derive this metric without applying theoretical and practically flawed models (i.e. the Capital Asset Pricing Model, or the CAPM based on unrealistic assumptions nullifying the results), and without applying subjective forecasts distorting the exercise. Our resulting metric is unbiased (not subject to assumptions and forecast), universal (comparing on the same basis stocks, bonds, real estate, commodities, and any other investment), and, crucially, forward-looking.

Using this single, universally comparable, and most importantly market-implied (objective!) metric, the Compass is uniquely capable to rank value in real-time across the entire global capital structure and at a granular level, i.e., the Compass works as a global GPS of value across asset classes (bonds, stocks, real estate, commodities, etc.), countries, markets, sectors, industries, styles (value, growth, dividend, volatility, small caps, etc.), individual securities and, most relevant currently, all ETFs!

This unique, exhaustive, and detailed real-time “map of expected returns” is a quantum leap compared with the practice of using historical returns (the rearview mirror!), or worse yet, using pseudo, non-comparable variables (e.g. stock multiples vs. yield-to-maturity) to rank or pick alternative investment opportunities. Thus, the Compass is an invaluable tool, empowering the user at all levels of investment expertise to identify and originate investment idea and strategies …  or the building block of professional, active, and profitable asset allocation.

The Black-Litterman Model – Lumen’s Proprietary Version

Lumen has developed a modified and enhanced version of the Black-Litterman model, solving both the well-known conceptual and operational flaws of this popular portfolio construction tool. While retaining the brilliant construct of the B&L, our proprietary application generates equally intuitive and coherent portfolios but with much-enhanced risk attributes and better performance results relative to the original version.

Traditional portfolio construction theory touted by H. Markowitz or Modern Portfolio Theory (MPT) is notoriously impractical. While preaching diversification, this process often results in corner solutions, i.e. put all your eggs into one basket. The remedy has been to arbitrarily impose minimum and maximum limits of exposure in each asset considered in the portfolio thus invalidating the entire exercise.

B&L came out with an ingenious process: rather than “sanitizing” the output with arbitrary limits, they enhanced the input or the expected returns for the assets considered. That is, instead of using historical returns (or simile), B&L uses as expected returns for the asset considered a complex  (Theil Mixed Regression Estimator) weighted average of a) subjective views (or individual expectations), and b) expected returns implied by the market. The idea is that if the portfolio must be tweaked (i.e. arbitrary min/max as in the MPT), then might as well tweak it with subjective views, albeit and especially if the subjective element is “normalized” by the market-implied expected return. The results are portfolios that are more intuitive (i.e. reflecting subjective views and strategies) and therefore diversified based on expectations instead of arbitrary limits. For the special case in which one has no subjective views, the model falls back to simply buying the market (passive portfolios).

Notwithstanding the brilliant construct, the B&L model however has a conceptual flaw and an operational one. The market-implied expected return is calculated by conceptually applying and operationally reverse-engineering the Capital Asset Pricing Model (CAPM) a notoriously flawed theoretical pricing model nullified by highly unrealistic assumptions. In addition, the model requires the precise tally of the (theoretical) global market capitalization, i.e. making the actual calculation totally impractical, or imprecise or both.

Lumen has successfully solved these shortcomings by using the market implied expected returns calculated by the Lumen Global Value Compass, i.e. no flawed theoretical model and nullifying assumptions, and no need to calculate (guess) a global market capitalization and invalidating the exercise in the process. The results have been impressive: in all cases our version of the B&L modified by using the Compass market-implied returns always generates portfolios which are not only even more intuitive and coherent than the original model, but also boasting substantially better performance attributes (see Portfolio Construction and Global Asset Allocation: A Practitioner Solution to a Black-Litterman Flaw by Simon E. Nocera.)

Lumen’s proprietary version of this most acclaimed model is particularly effective in building portfolios that can cast a very wide net capturing any global and granular investment opportunity, thus matching any (as in ALL) individual investment and risk tolerance profile, and uniquely delivering truly customized solutions.

Portfolio Risk Management Philosophy

We subscribe wholeheartedly to the tenet that financial risk is the possibility of a permanent loss of capital. And a loss of capital is often due to a lack of intrinsic value. That is, for us, true financial risk is conceptually the reciprocal of intrinsic value, i.e. zero intrinsic value is fundamentally equal to one hundred percent risk! Quite different from the widespread practice of confusing risk with volatility and, worse, precisely measuring it with the statistical standard deviation.

Accordingly, we do not see portfolios as “volatility machines” and do not attempt to manage the (random) future by using the rearview mirror. We subscribe instead to the practice of managing risk by diversifying portfolios across intrinsic value, something all investor professionals ought to be able to assess … without relying on the rearview mirror! That is, we rather use our investment expertise to assess fundamental (intrinsic) value instead of speculating on volatility … not just a philosophical distinction, but a practical guide!

In practice, our process translates into using state-of-the-art quantitative tools (Value at Risk,  Conditional Value at Risk, Monte Carlo simulations, Principal Component Analysis, etc.) to fulfill one crucial task: measure the probability that the value implied in the portfolio will meet a specific goal, e.g. a targeted percentage return, a dollar amount, a return relative to a benchmark, etc. The reciprocal of this probability (value) is equal by construction to the probability of … a permanent loss of capital!