Wednesday, August 19, 2015

How Counter Trend Models Can Adapt to Changing Market Environments

Trend following methodologies attempt to buy into market strength and sell into market weakness.  Counter trend methodologies do the opposite, buying into market weakness and selling into market strength.  Trend following works under the premise that investments tend to trend over time and works best over intermediate term time frames (1-6 months).  Counter trend models work under the premise that over shorter time periods (daily to weekly) markets are dominated by noise, fear, and greed, causing them to overshoot to the upside and downside before snapping back to equilibrium.

Counter trend models can add needed diversification to tactical portfolios dominated by trend following models.  Trend following works extremely well in straight up or down markets, but doesn't work is well in choppy markets or equity peaks.  Trend following models also can't participate in bear market rallies.  Counter trend models don't work as well in straight up or down markets but do very well in choppy markets and equity peaks.  They can also participate in bear market rallies.  

The basic idea behind counter trend models is to use some measure to determine whether a market is oversold, overbought, or at equilibrium.  These could be static models that perhaps buy on n day lows and sell on n day highs or they could use some sort of dynamic logic.  Because markets are dynamic I have not seen static counter trend models work well over long periods of time.  Dynamic models are usually a much better option.  

There are two market factors that will determine how a counter trend model will react and perform, noise and volatility.  Noise is a measure of whether the market has a direction or not, while volatility measures the extent of up and down moves.  Market noise will determine how well a counter trend model will perform while volatility will determine what types of market moves a counter trend model will need for it to determine whether a market is overbought or oversold.  Counter trend models tend to work best in markets that are noisy and volatile.  They tend to work worst in markets that have low noise and high volatility (trend following models work best in this environment).   

So far in 2015 we have had an extremely noisy market with no direction, but volatility has been low.   In this environment---high noise, low volatility---an adaptive counter trend model wouldn't need large moves to determine whether the market is overbought or oversold and it could move in and out of noisy markets very frequently.  This is what we have seen in our counter trend models this year.  In a high volatility market, adaptive models would need larger changes to move in and out of markets.  

The Smart Beta Dilemma

The debate about whether smart beta strategies add value vs. market cap weighted indices will probably never end.  Smart beta strategies continue to launch with impressive backtested results that show outperformance over market cap weight.  The main questions revolve around whether those backtests are curve fitting and/or anomalies and whether that outperformance can persist.

If you are a long term buy and hold asset allocator then this presents a problem.  You are benchmarked against market cap weighted indices so any allocation to smart beta involves risk of underperformance.  You have to be sold on the backtest and the idea that any outperformance will be persistent.  If you are right you might add alpha, if you are wrong then you have a problem.

Tactical asset allocators don't have that problem.  Whether any smart beta idea is an anomaly or not isn't as relevant if you are not going to buy and hold something for ever.  The only relevant issue is whether or not a smart beta idea has periods where it outperforms a relevant market cap weighted index and how volatile that performance is.  Using relative strength or absolute momentum models of smart beta along with market cap weighted products allows the tactical investor to switch back and forth between smart beta and market cap weight (or cash in the case of absolute momentum).  Whether the outperformance will persist over the long term isn't relevant as long as it persists long enough for the tactical investor to make money and isn't so volatile that it moves down faster than a tactical model can exit.  

For the tactical investor, smart beta is another tool in the toolbox.  Maybe smart beta strategies are better than  market cap weighted indices, maybe they are not, but they do give tactical investors another set of assets to use in their models.

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.