Tuesday, March 3, 2015

The Colossal Failure of Buy and Hold

15 years later the NASDAQ finally got back to 5000.  This proves once again that markets  have big drops but they always get back to where they started.  Buy and holders might be taking a victory lap over this but they would be missing the point.  Anyone who had money in the NASDAQ 15 years ago and didn't sell is back to where they were---their money is back but they will never actually recover because of the opportunity cost.

For example, lets say you have two investors, investor A and investor B.  Investor A put $1mm into a NASDAQ index fund at the top of the market.  Investor B put $1mm into some investment that averaged 5%/yr.

Today investor A has his money back, his account is worth approximately $1mm.  Investor B doubled his money, he has a little over $2mm.  If both investors are able to earn 5%/year over the next 15 years they will both double their account values.  Investor A will have $2mm 15 years from now and Investor B will have $4mm.   The longer out you go the bigger the gap.

The real problem with buy and hold is not that markets don't come back from losses, they do.  The problem is that investors can never get back the lost opportunity cost as the losses take so long to recover from.

Friday, February 27, 2015

What is the Best Approach to Tactical?

Tactical Asset Allocation (TAA) is not a one size fits all, there are a lot of ways to implement a tactical strategy----relative strength, momentum, trend following, sector rotation, fundamentals, valuation, etc.   Practitioners of TAA will often argue that their way is better than others for whatever reason.  In 2014 many tactical managers struggled, particularly those who use any type of momentum analysis.  The reason was simple----even though the market closed up there was no momentum.  Does that invalidate decades of research proving that momentum works over every time frame and across assets classes?  Of course not.  Every investing approach cycles in and out of favor and every approach has it's kryptonite--- for momentum that is a choppy market.  Fundamental TAA strategies tend to be much slower to react so they would have done better last year.  Does that make them superior to momentum?  Of course not.  Fundamental TAA strategies just have different kryptonite.  Fundamentals often lag, meaning the market looks forward and predicts slower fundamental statistics before they happen.  Also, as John Maynard Keynes once said "Markets can remain irrational longer than you can remain solvent".

If different types of TAA strategies do well and do poorly in different markets that brings up an interesting idea----instead of trying to figure out what type of TAA methodology is best, investors should just combine multiple, uncorrelated methodologies.

Momentum should do well in a straight up or down market, but it should struggle in a choppy market and around equity peaks.  Momentum strategies typically would also not be able to participate in bear market rallies.  Counter trend strategies (buy into weakness and sell into strength) will tend to do well in choppy markets and around equity peaks but will lag in a straight up or down market.  Counter trend strategies can typically take advantage of of bear market rallies.  Fundamental strategies will typically do well in straight up or down markets but will be slower to react to a rally or a selloff.  Either type of strategy on its own would be powerful and should blow away buy and hold and MPT over time.  Combined they are much more powerful.

So which approach to tactical is best?  A combination of multiple, uncorrelated approaches.

Tuesday, February 24, 2015

Smart Beta Starting to Extend to Bonds

BlackRock is launching a new ETF on Thursday that is sort of a smart beta approach to bonds.  The ETF will use a mathematical model to try to have equal exposure to interest rate and credit risk.  You could argue that this is technically not smart beta depending on your definition, but this could be the start of new ETFs focused on the fixed income, especially as investors expect rates to rise which would hurt plain vanilla bond ETFs.  Like everything there are going to be some good and bad products launched.  We will need to do some more research on this strategy to see if we want to add this to our models.  On the surface I am not sure I like it that much, being tactical I would rather see  a product that shifted exposure from credit to interest rate risk tactically.  

We are also expecting to launch our own income ETF in the next couple of months.

Saturday, February 21, 2015

How To Top Money Market Yields

I have seen a bunch of stories in the media this week (I was quoted in a couple) talking about how investors should deal with low money market yields.  The advice was as to be expected----go into ultra short term bond funds and/or ETFs.  These funds typically yield under one percent, but that is better than zero, isn't it?  Maybe or maybe not.  First off you need to understand what money market funds are for, typically this is either:

1. Cash that you  might need very soon
2. Money that is allocated to cash tactically and could be re positioned any time to stocks or bonds
3. A small amount of cash to facilitate transactions, basically making sure you don't accidentally overbuy something.

In all of these cases you need easy and free access to your cash.  Ultra short term bond funds typically have restrictions on how often you can go in or out and ultra short term ETFs will typically have trading commissions, making neither choice a good substitute for cash.

We make use of ultra short term ETFs in our ETFs, primarily because we use cash tactically and we can buy and sell at institutional commission rates which are insignificant.  However, for individual investors these types of funds are typically a poor choice as they are not a substitute for what cash is used for and the yields, while better than zero, are still ridiculous.

Wednesday, February 18, 2015

Tactical Asset Allocation And a Positive Investor Experience



When doing any type of analysis it is always easier if your variables are static.  However, in real life most things are rarely static.  Take traditional risk tolerance and suitability for example.   In a buy and hold, asset allocation world a client would walk into an adviser's office and complete some sort of risk tolerance questionnaire that would place them in either a conservative, moderate, or aggressive category.  The adviser would then construct a portfolio based on the client's risk tolerance.  So for example, a client with a moderate risk tolerance might have a portfolio that is 60% stocks and 40% bonds.  In an up market they would get about 60% of the upside of the market and in a down market they would get about 60% of the downside.   If the investor was moderate all the time then this would probably work out ok, they would be satisfied with 60% market upside and would be ok with 60% market downside.  However, in real life risk tolerance is not static.  Investors by and large want relative returns in an up market and absolute returns in a down market.  Or said another way, in an up market an investor's benchmark is the S&P 500 and in a down market it is T Bills.  This moderate investor would be calling their adviser during a bull market looking for more exposure to gains and during a bear market looking for less exposure to losses.   Buy and hold has no answer to this except to tell the investor during the bull market that they can't have the gains and to tell them during the bear market that they have to have the losses.  This results in a poor investor experience.

Investor Experience

Advisers should strive to create the best possible investor experience for clients.  Investor experience encompasses risk tolerance, but it goes beyond that.  It is giving the investor the most return possible as an end result and making sure that they can tolerate the ride.  Too much risk and they will panic at some point.  Too little return and they will not be happy.  Because your moderate client is really looking for relative returns in an up market and absolute returns in a down market they will eventually have a poor investor experience, either by not making enough in an up market or losing too much in a down market.  

Tactical Asset Allocation as the Solution

Not only does your client's risk tolerance shift with the market, it should.  An aggressive investor shouldn't be aggressive during a 2008 type of market and a conservative investor shouldn't be conservative during a 2013 type of market.  In 2008 there was a ton of potential risk and not much potential return in the market.  In 2013 there was a ton of potential return and not much potential risk.  Tactical asset allocation (TAA) can be perfect for optimizing the investor experience by shifting allocations based on the risk and return in the market.  In an up market an investor who is moderate in the base case might move to moderate aggressive.  In a down market that same investor might move to moderate conservative or conservative.  TAA would be shifting the portfolio at the same time the investor's risk tolerance was shifting.  

Looking at investor experience, the more conservative investor judges investor experience by looking at volatility and drawdown first and return second.  The aggressive investors judges investor experience by looking at returns first and drawdown and volatility second.  Tactical asset allocation can provide drawdowns and volatility that would be acceptable for more conservative investors while providing return potential that would be acceptable for more aggressive investors.  

Tuesday, February 17, 2015

Why the S&P 500 Could Hit 2000

I was on CNBC last week talking about the possibility of the S&P 500 hitting 2000 over the next two weeks.

Pro: S&P at 2000

I got a little pushback even though a move to 2000 would only be about 4.6%.  Nobody can predict markets but they tend to move in predictable cycles.  Below is a chart of the S&P 500.  What is interesting as that four times since December the S&P has gone down to the 2000 level and bounced back.  You can also see a lot of support for the 2000ish level from September and October.


The S&P could very well rally here and never look back, but with turmoil still in Greece and Ukraine and uncertainty about what the Fed is doing, a move back to 2000 wouldn't be that strange.