Wednesday, July 29, 2015

Factor Return Dispersion

So far in 2015 we have seen much more dispersion in the return of different factors---low volatility, momentum, value, increasing dividends, etc.  As you can see from the chart below it didn't really matter what factor you chose in 2014, all of them did well, except for size (small cap).  This year has show much more dispersion, from momentum (MTUM ETF up 9%) to high beta (SPHB down 5.78%):

Factor ETF 2014 YTD 7/28/15
Value RPV 12.21% -3.17%
Momentum MTUM 14.62% 9.00%
Dividends NOBL 15.54% 0.81%
Quality QUAL 11.70% 4.41%
Low Vol USMV 16.33% 3.64%
High Beta SPHB 12.68% -5.78%
Size IJR 5.85% 1.68%
Standard Deviation of Returns 3.49% 4.91%

Source: Morningstar

We already have a factor rotation model in TUTT and will be expanding the universe and adding a bit of factor rotation to our Core Satellite Strategies to take advantage of this dispersion.  The Core Satellite Strategies will keep a fixed 60% allocation to factor/smart beta ETFs but now they will incorporate a rotation model that can take more advantage of dispersion among factors.

Friday, July 24, 2015

Factor Investing--The Future of Traditional and Tactical Asset Allocation

Traditional equity research has always thought that most of a portfolio's returns can be explained by the portfolio's asset allocation.  This has then been taken to mean how much is in specific investment styles---small cap stocks, large cap stocks, growth stocks, value stocks, etc.  Newer research now shows that investment results can be explained by certain factors that have outperformed the market over time.  A factor is any characteristic shared by a group of stocks that can explain their returns and risk. There are a number of different factors that have historically earned a risk premium---value, size, momentum, quality, low volatility, etc.

Value Factor---Stocks that have low prices compared to their fundamental value

Size Factor--Stocks with smaller market capitilizations

Momentum Factor---Stocks with higher price momentum

Low Volatility Factor--Stocks with lower volatility (Beta)

Quality Factor--Stocks with low debt, stable earnings, and other quality metrics. 

There is much speculation about why factor outperformance exists and whether it will persist.  The reason some factors tend to outperform can be easily grasped.  For example the value factor is most likely a combination of the fact that if you buy something at a lower price and hold onto it for a long time then it should do better then something you buy at a high price.  You could also argue that value stocks are riskier than growth stocks since they have a more uncertain future and markets compensate investors for taking more risk.  The size factor can also probably be boiled down to risk and also smaller stock have more room to grow then larger stocks.  Momentum comes down to investor psychology.  Investors tend to pile into what ever is going up, creating trends that persist.  The quality factor makes sense and companies with strong financials should do better than those with weaker financials.  I am not quite sold on the low volatility factor.

For practitioners who still follow a traditional asset allocation approach  this new research presents a way to take a flawed investment philosophy and make it less flawed.  Instead of trying to optimize  portfolios by investment styles you could optimize exposure to factors.  Investment styles will still have factor exposure but it will not be pure.  For example a market cap weighted index of value stocks will still hold some stocks that are more blends between value and growth.  If these historical factor risk premiums persist then a well thought out factor based portfolio should outperform style based portfolios.

For practitioners of tactical asset allocation factor investing provides another powerful tool.  Historically, many tactical strategies have focused on style or sector rotation as a way to be positioned in the strongest style or sector.  This type of analysis can be either combined or replaced by factor rotation to try to be positioned in the strongest factor.  If the academic research is right and stock market performance is driven by factors then this should be a much more powerful approach going forward as it will a purer approach to capturing whatever factor is currently in vogue.  Over time, factors have shown a great degree of cyclicality.  Each factor has had a least a two year or more period of underperformance vs. market cap weighted indices but they are not completely correlated from an underwater basis.  This cyclicality and lack of underwater correlation also lends itself well to a tactical approach.

Monday, June 29, 2015

I am Getting Sick of this Ongoing Greek Crisis

Back in the old days if you couldn't  pay your bills you went bankrupt.  The people who didn't do their due diligence and loaned you money would have to work it out in the courts.  Today the Fed and the ECB have gone so far down the bailout rabbit hole that nobody is allowed to go bankrupt.  This has probably been one of the reasons that the bull market has gone on so long and been so strong.  When you know that the central banks will bail everybody out then you can take a ton of risk and not have to worry about the downside.  But what happens when everyone takes a ton of risk for a long time?  The eventual crash gets really ugly.  Kind of reminds me of the mortgage crisis in 2008 and the tech bubble of 2000.  The ECB can keep kicking the can down the road on Greece but the road eventually becomes a dead end and you have to deal with the fact that structurally, the Greek economy is different, and at the end of the day they probably just can't pay their bills.   This has been going on now for a number of years and I am getting tired of it.  Letting Greece go under would create some short term volatility but that would eventually subside and we could get on with business as usual.  Investors would also be reminded that their is no such thing as risk free and that they still need to do their homework when decided what to invest in.  Short term there would be some pain, longer term things would be better.  Unfortunately, politicians think about the short term because of elections, and ignore the long term when they are likely to be out of office any way.  

Tuesday, June 2, 2015

A Disaster Waiting to Happen?

If you earn a state pension or live in a state that has a shortfall in their pension then you need to pay attention to pension obligation bonds.

Borrowing to Replenish Depleted Pensions

The idea is that a state issues bonds, borrowing money from bondholders, and invests the bonds in their depleted pensions.  To make the math work the pensions invest the money relatively aggressively and are projecting that they will earn more on the invested money than they will pay out on the bond interest.  If the next six years in the stock market look like the past six years then this will all end well.  If they don't, then it could make a bad problem really bad.  Kind of like what happens when you borrow from one credit card to pay off another credit card---usually things don't work out that well.

Nobody knows what the market is going to do, but we can learn a lot from history and at least judge the odds of this strategy being successful.  Looking at current stock market valuations based on historical standards, whenever US markets have been at this high a valuation the next 10 years have been mediocre at best.  One of the times when people start bringing out the this time is different argument they will be right, states better hope this time really is different.

Wednesday, May 13, 2015

Targeting Portfolio Volatility

Volatility is an important factor in designing portfolios for clients.  First off, volatility tends to be negatively correlated with returns, meaning when volatility of an asset increases returns tend to decrease.  Second, volatility can hamper the "investor experience".  We have talked about the idea of optimizing investor experience in the past.  It basically means that at the end of some horizon the investor has earned as much as reasonably possibly while being able to tolerate the ride.  When volatility is high the ride is bumpy and becomes much less tolerable.

In traditional portfolio construction volatility is assumed to be static, today's volatility is tomorrow's volatility.  So an investor might construct a 60/40 stock/bond portfolio, using the bonds to dampen volatility.  That same investor might be willing to assume more volatility than a 60/40 portfolio would deliver in a stable environment but not willing to assume the level of volatility the same portfolio would have during a volatile environment, so the 60/40 represents a compromise.  This compromise causes the investor to not make as much as they could during a low volatility period and causes the investor to experience more volatility than they are comfortable with during a highly volatile period.  This eventually leads to a poor investor experience.

Targeting portfolio volatility is a much better approach.  For example, in the same 60/40 portfolio the stocks would be more volatile than the bonds.  Assume you want to target an annualized level of volatility, for example 12%.  During times when stocks are not volatile the percentage of stocks would increase vs. bonds.  During times when stocks are volatile their allocation would decrease vs. bonds.  Instead of a static portfolio the investor would have more in stocks during low volatility environments, setting them up for more potential returns, and would have less in stocks during high volatility environments, lessening the bumpiness of the ride and perhaps avoiding major drawdown.

Wednesday, April 15, 2015

The Biggest Mistake Investors and Advisers Make

Study after study of the money managers who have had the best long term performance shows the same thing----while the money managers made a lot of money over time, the average client lost money.  This isn't some sort of Ponzi scheme, it is because investors and advisers tend to buy into money managers or strategies when they are doing well and sell out when they are doing poorly.

Wall Street does a good job of hammering home the point that past performance doesn't predict future results.  Regardless of how bold that statement is on every marketing piece people still believe the most recent investment past will equal the future.  Last year's top money manager or strategy will be next year's top performer.  Last year's bottom performer will be next year's bottom performer.  This ignores two basic facts about how markets work----investment strategies cycle in and out of favor and everything eventually mean reverts.

It is no secret that investment styles and strategies cycle in and out of favor.  In the asset allocation world there are times when value outperforms growth and times when growth outperforms value.  There are times when small stocks outperform large stocks and times when large stocks outperform small stocks.  In the tactical world there are times when momentum strategies do well and times when the don't.  There are markets that are perfect for counter trend strategies and markets that aren't.  The best investment strategies might crush whatever benchmark you use over time, but day to day, week to week, month to month, there will be times it underperforms.  If investors are constantly getting out during the underperforming periods they usually get out of one strategy at the wrong time and into another at the wrong time.

Investments are also mean reverting.  What goes up big eventually goes down to more normal levels. This happens over and over again with asset classes and strategies---Gold, Apple, Biotech, Japan, etc. Investors always like to buy into what is hot.

We see this in our investment strategies, most new client money flow goes into whatever strategy has had the best recent performance.

I get it, it is much easier for someone to reconcile buying into what is hot than it is to buy into what is not.  But if you constantly rotate from what isn't  hot to what is then you are asking for mediocre investment results at best.  Instead of focusing on buying past performance focus on buying into a process that should produce the best results (tolerable volatility and the best possible returns) going forward and stick with it through the inevitable ups and downs.