Tag Archives: models

Tactical Allocation: The Best Asset Categories Now

Summary Tactical allocation strategies use relative strength rankings to select asset categories. They often have a filter excluding those which are technically in a bear market. Here is the list of asset categories passing such a filter now. Tactical allocation strategies aim at selecting assets based on a relative strength ranking. They can easily be implemented with ETFs. The set of assets may be global (main asset classes), focused on a specific asset class, on a geographical classification in equities (regions, countries), or on sectors. The relative strength ranking is generally based on price action and technical indicators (momentum, risk-adjusted performance, volatility). Tactical quantitative models are most of the time designed to detect and follow the trends. They often have a better risk-adjusted performance when they include market-timing rules excluding the assets that are in a bear market. All is about the definition of what a “bear market” is. Practically, we use moving averages. A bearish signal is posted when the price falls below a long-term moving average (for example 200 days, 10 months, 1 year), or when a short-term moving average (for example 1 week, 1 month, 50 days) falls below a long-term moving average. For some models, the signal must be confirmed during a number of days to limit the risk of whipsaw. I run several models of this kind. Here is the list of ETFs that still pass a double filter: last closing price and the 50-day moving average must be both above the 200-day moving average (date: 9/15 on close ). This double filter, named hereafter “no-bear” filter, is an example that does not correspond exactly to what I am using in the models, and global timing rules may also exclude all long equity ETFs in the list at some times. Moreover, models keep only the top-ranked ETFs regarding the relative strength factor. Global Assets model Possible Holdings: Dollar Index (NYSEARCA: UUP ), 7-10 year US T-bonds (NYSEARCA: IEF ), 20+ year US T-bonds (NYSEARCA: TLT ), emerging market bonds ((NYSEARCA: PCY ), (NYSEARCA: EMB )), international sovereign bonds ex-U.S. (NYSEARCA: WIP ), the U.S. stock market (NYSEARCA: SPY ), developed countries stock markets ex-U.S. and Canada (NYSEARCA: EFA ), Latin America stock markets (NYSEARCA: ILF ), Pacific region stock markets ex-Japan (NYSEARCA: EPP ), U.S. real estate (NYSEARCA: ICF ), commodities (NYSEARCA: DBC ). Passing the “no-bear” filter: none Equities by Countries model Possible Holdings: U.S., Canada (NYSEARCA: EWC ), Russia (NYSEARCA: RSX ), Japan (NYSEARCA: EWJ ) China (NYSEARCA: FXI ), Europe (NYSEARCA: IEV ), Sweden (NYSEARCA: EWD ), Germany (NYSEARCA: EWG ), Hong-Kong (NYSEARCA: EWH ), South Africa (NYSEARCA: EZA ), Indonesia (NYSEARCA: IDX ), Thailand (NYSEARCA: THD ), South Korea (NYSEARCA: EWY ), Taiwan (NYSEARCA: EWT ), Malaysia (NYSEARCA: EWM ), Vietnam (NYSEARCA: VNM ), Brazil (NYSEARCA: EWZ ), Mexico (NYSEARCA: EWW ), Chile (NYSEARCA: ECH ), Colombia (NYSEARCA: GXG ), Peru (NYSEARCA: EPU ). Not all countries ETFs are included in the model for various reasons (liquidity, correlations). Passing the “no-bear” filter: none. U.S. Sectors and Industries Possible Holdings: Utilities (NYSEARCA: XLU ), Energy (NYSEARCA: XLE ), oil & gas exploration and production (NYSEARCA: XOP ), Financials (NYSEARCA: XLF ), healthcare (NYSEARCA: XLV ), Industrials (NYSEARCA: XLI ), technology (NYSEARCA: XLK ), Consumer staples (NYSEARCA: XLP ), home construction (NYSEARCA: ITB ), biotechnology (NASDAQ: IBB ), REITs , retail (NYSEARCA: RTH ), semi-conductors (NYSEARCA: SMH ), MLPs (NYSEARCA: AMLP ), internet (NYSEARCA: FDN ), solar energy (NYSEARCA: TAN ). Not all industry ETFs are included in the model because of liquidity filters, redundancy or other reasons. Passing the “no-bear” filter: FDN (internet), IBB (biotechnology), RTH (retail), ITB (home construction). Bond model Possible Holdings: core U.S. aggregate (NYSEARCA: AGG ), PIMCO total return (NYSEARCA: BOND ), Convertibles (NYSEARCA: CWB ), high yield (NYSEARCA: JNK ), 1-3 year T-bonds (NYSEARCA: SHY ), 3-7 year T-bonds (NYSEARCA: IEI ), 7-10 year T-bonds , 10-20 year T-bonds (NYSEARCA: TLH ), 1-5 years corporate bonds (NASDAQ: VCSH ). Passing the “no-bear” filter: ( SHY ), ( IEI ) (1-7 year T-bonds), ( VCSH ) (1-5 years corporate bonds). Conclusion The asset categories that still look good now from a tactical allocation point of view are short-term bonds (U.S. government and corporate, under 7 years of maturity) and equities in a few U.S. industries: internet, biotechnology, retail, home construction. Please note that these tactical allocation models are not a part of my subscription service , which is focused on a 20-stock defensive portfolio with hedging tactics based on a systemic risk indicator. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I short the S&P 500 for hedging purposes.

The Importance Of Your Time Horizon

I ran across two interesting articles today: Both articles are exercises in understanding the time horizon over which you invest. If you are older, you may not have the time to recover from market shortfalls, so advice to buy dips may sound hollow when you are nearer to drawing on your assets. Thus the idea that volatility, presumably negative, doesn’t hurt unless you sell. Some people don’t have much choice in the matter. They have retired, and they have a lump sum of money that they are managing for long-term income. No more money is going in, money is only going out. What can you do? You have to plan before volatility strikes. My equity only clients had 14% cash before the recent volatility hit. Over the past week I opportunistically brought that down to 10% in names that I would like to own even if the “crisis” deepened. That flexibility was built into my management. (If the market recovers enough, I will rebuild the buffer. Around 1300 on the S&P, I would put all cash to work, and move to the alternative portfolio management strategy where I sell the most marginal ideas one at a time to raise cash and reinvest into the best ideas.) If an older investor would be hurt by a drawdown in the stock market, he needs to invest less in stocks now, even if that means having a lower income on average over the longer-term. With a higher level of bonds in the portfolio, he could more than proportionately draw down on bonds during a crisis, which would rebalance his portfolio. If and when the stock market recovered, for a time, he could draw on has stock positions more than proportionately then. That also would rebalance the portfolio. Again, plans like that need to be made in advance. If you have no plans for defense, you will lose most wars. One more note: often when we talk about time horizon, it sounds like we are talking about a single future point in time. When the time for converting assets to cash is far distant, using a single point may be a decent approximation. When the time for converting assets to cash is near, it must be viewed as a stream of payments, and whatever scenario testing, (quasi) Monte Carlo simulations, and sensitivity analyses are done must reflect that. Many different scenarios may have the same average rate of return, but the ones with early losses and late gains are pure poison to the person trying to manage a lump sum in retirement. The same would apply to an early spike in inflation rates followed by deflation. The time to plan is now for all contingencies, and please realize that this is an art and not a science, so if someone comes to you with glitzy simulation analyses, ask them to run the following scenarios: run every 30-year period back as far as the data goes. If it doesn’t include the Great Depression, it is not realistic enough. Run them forwards, backwards, upside-down forwards, and upside-down backwards. (For the upside-down scenarios normalize the return levels to the right side up levels.) The idea here is to use real volatility levels in the analyses, because reality is almost always more volatile than models using normal distributions. History is meaner, much meaner than models, and will likely be meaner in the future… we just don’t know how it will be meaner. You will then be surprised at how much caution the models will indicate, and hopefully those who can will save more, run safer asset allocations, and plan to withdraw less over time. Reality is a lot more stingy than the models of most financial Dr. Feelgoods out there. One more note: and I know how to model this, but most won’t – in the Great Depression, the returns after 1931 weren’t bad. Trouble is, few were able to take advantage of them because they had already drawn down on their investments. The many bankruptcies meant there was a smaller market available to invest in, so the dollar-weighted returns in the Great Depression were lower than the buy-and-hold returns. They had to be lower, because many people could not hold their investments for the eventual recovery. Part of that was margin loans, part of it was liquidating assets to help tide over unemployment. It would be wonky, but simulation models would have to have an uptick in need for withdrawals at the very time that markets are low. That’s not all that much different than some had to do in the recent financial crisis. Now, who is willing to throw *that* into financial planning models? The simple answer is to be more conservative. Expect less from your investments, and maybe you will get positive surprises. Better that than being negatively surprised when older, when flexibility is limited. Disclosure: None

Shock And Horror: Passive Hedge Funds

An academic article entitled “Passive Hedge Funds” has recently attracted quite a lot of comment in the Financial Times, Bloomberg, and on a variety of websites. Those whose ambition in life seems to be to discredit hedge funds and their managers at every turn have, of course, latched onto it. But the paper’s title is tendentious, its argument familiar and in some places flawed, and its conclusions really quite anodyne. Investors seeking hedge fund-like exposure through liquid alternatives will find that some products are similar to those described in that article; they should examine them very carefully before investing. The purported humor of math jokes often depends on the technical use of a term that has other, more familiar meanings. Thus, my college roommate’s knee-slapper about how every integer is interesting relied on a definition of ‘interesting’ as ‘having a unique property.’ The joke took the form of a mathematical induction: 1 is the multiplicative identity, 2 is the only even prime, 3 is the lowest true prime, 4 is the lowest perfect square… so if there is an uninteresting integer, it is interesting, because it is the lowest one. Maybe you had to be there. I am reminded of this moment of boundless mirth by a paper entitled ” Passive Hedge Funds ,” by Mikhail Tupitsyn and Paul Lajbcygier. This title has, inevitably, attracted comment, including headlines such as “Study: Hedge Funds Don’t Do S**t, Suck” (gawker.com) or, with less sophistication and élan, “New Study Argues Hedge Funds are an Even Worse Scam than We Thought” (vox.com) and even more prosaically, “The Case Against Hedge Fund Managers” (ai-cio.com). With the apparent exception of the latter, these commentators were so enamored by their deeply considered wisdom that they clearly felt no need to read the paper. Because its authors are quite explicit about their idiosyncratic use of the term ‘passive.’ They even put scare-quotes around it. The commentators just missed the punchline. It is hard to dispute Humpty Dumpty: “When I use a word, it means just what I choose it to mean ─ neither more nor less.” Since they take pains to explain what they mean by it, I have no argument with the authors’ use of ‘passive.’ They might have used ‘hippopotamus,’ which is more euphonious, but lacking poetic souls, they chose ‘passive,’ and missed the opportunity for a great title. The sense in which the authors use ‘passive’ to describe hedge fund return patterns is that they have linear correlation to hedge fund β. The crux of their argument is that “A manager with genuine investment skill should not only have “passive” linear risk exposures to alternative risk factors ( i.e ., alternative beta) but should also produce enhanced returns through nonlinear ‘active risk exposures.'” This is contentious, as will be seen below, but it is simply posited as a truth rather than justified. Was their choice of ‘passive’ tendentious and self-promoting? Of course: how else would a postdoc and an associate prof at Melbourne’s #2 university get noticed in the Financial Times or Bloomberg, let alone a temple to the Muses such as gawker.com? Was it helpful? Our commentators’ complete failure to understand the authors’ intent makes it rather obvious that it was not. The Tupitsyn and Lajbcygier article is, as their review of the literature makes clear, one of a long line of academic studies that propose models for hedge fund returns. Even critics more competent than our commentators tend to latch onto these studies as “proof” that hedge funds offer little value-added. But anything can be modeled ─ conventional mutual funds, sunspot frequencies, even (allegedly) the earth’s climate. Problems arise when, as Emanuel Derman and others have noted, the models are mistaken for reality. And hedge fund β ─ against which the authors argue hedge fund managers fail to add value ─ is, at best, a very peculiar concept, and arguably a spurious one. On consideration, the authors’ argument begins to look strangely circular: hedge funds fail to add value relative to metrics that derive from their own returns. This is something like arguing that I am a lousy swimmer because I am unable to swim faster than myself. I may well be a lousy swimmer, but comparison with my own performance will not establish that. A good portion of Tupitsyn’s and Lajbcygier’s analysis is devoted to returns on hedge fund indices. In choosing these as a database, they, like many before them, commit the fallacy of composition. The fact that you can calculate a mean return from a pile of reports does not indicate that there is such a thing as an average hedge fund: it is not only possible, but likely that none of the funds analyzed exhibited the mean return. Further, there is no reason to expect continuity from one time period to another: a fund whose return was close to the center of the distribution in one period may be an outlier in the next. Hedge fund returns are widely dispersed both synchronically and over time, so that the value of hedge fund indices is pretty much restricted to service as performance metrics for specific time periods. The standard error of the mean = s/√n, where ‘s’ is the σ of the population and ‘n’ is its size. Obviously, the error is significantly higher and thus the epistemic value of the mean significantly less, the more dispersed the population is. Given the wide dispersion of hedge fund returns, the value of their average is largely restricted to the bragging rights it gives to marketers fortunate enough to work for funds that have outperformed it. The authors are aware of these limitations, and devote some analysis to the returns of individual, real world funds. They find that most funds have strong linear exposures to familiar factor influences on investment returns. They conclude that “The nonlinear risk is more pronounced in arbitrage styles and styles following multiple strategies, and it is weaker in directional styles.” This should hardly be surprising ─ arbitrage is inherently non-linear ─ and it is not at all clear why the presence of linear risk in other sorts of strategies should somehow suggest dereliction of duty on the part of their managers. If, for example, a dedicated short fund carried no (negative) equity exposure, its investors would certainly have reason to object! Admittedly, fewer long/short funds make use of their ability to add value by adjusting their net exposure than might be expected, and with relatively stable long/short ratios, their exposure to equity risk factors would, of course, be linear. The same would be true of any long-only equity fund, and would certainly not attract criticism. In fact, long/short funds have increasingly tended to pursue a trading-oriented (“risk on/risk off”) response to changes in their risk perceptions in place of making changes to their short positions. As a group, hedge funds provide us with ample reasons to criticize them. Despite declining over the last few years, fees are in most cases still too high for the service provided. Lack of transparency inhibits rational analysis and portfolio construction, while providing a breeding ground for a wide range of abuses and sharp practice. The artificial mystique that this opacity fosters is repulsively reminiscent of Ozma of Oz. However, neither an adolescent potty-mouth nor accusations of fraud are not needed to make these points forcefully and to draw the appropriate conclusions for investors. Nor are “discoveries” that hedge fund α is not a matter of otherworldly powers to bend the laws of economics to the manager’s will ─ that their skills might be very similar in both nature and quantity to the skills that conventional portfolio managers exhibit. Tupitsyn and Lajbcygier have made a small contribution to the growing literature on hedge fund replication ─ nothing less, but certainly nothing more. Theirs is only one approach to hedge fund replication, and to my mind a less than satisfactory one. Factor replication is an inherently backward-looking approach to modeling, and when applied to the return streams from hedge funds, likely to result in some rather peculiar portfolios. A technique that I suspect has much more promise is the creation of robo-managers ─ algorithmic trading techniques that mimic the trading strategies hedge funds are known to pursue. Many hedge funds, particularly CTAs, are already effectively automated. While it is illegal to steal their code, it is possible to imitate it based on an analysis of their returns. In considering an investment in liquid alternative funds, many of which are “quantitatively-driven” in ways that are rarely specified explicitly and require research to understand, the nature of the security selection technique should be given careful consideration. Approaches similar to that of Tupitsyn and Lajbcygier are worth a look, but may not deliver all that they promise; the source of the factor exposures they purport to imitate must be investigated. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.