Monday, December 30, 2013

Deep Risk

William Bernstein just wrote a book called "Deep Risk: How History Informs Portfolio Design".  I haven't read the book but in the January issue of Financial Planning magazine there is an article talking through the concepts.  Bernstein defines deep risk a negative real (inflation adjusted) return over a 30 year period.  This can be caused by four things---inflation, deflation, confiscation, and devastation.   According to the article the only area that an investor should have constant protection against is inflation, the other risks are too low in probability and/or have a high cost of insuring against them.  This is a better idea than the permanent portfolio concept of having fixed allocations to things like gold, silver, treasuries, real estate, stocks, etc.  but it is still flawed.  Bernstein argues that to protect against inflation investors should own global equities, commodity producing stocks, gold, and tips.  These assets may protect against inflation but they can also do poorly in other environments, like gold did in 2013.  

We know that markets will go up and down, interest rates will go up and down, inflation will do up and down, commodity prices will go up and down, etc.  We just don't know when.  Having fixed allocations to protect against any of these risks is like using a sledgehammer to kill a bug--it may work but it is overkill and can cause collateral damage.  None of these markets events happens overnight.  If you keep in harmony with market trends you will automatically adjust your portfolio to be responsive to anything that could and will happen.

Friday, December 20, 2013

Gold Set For First Annual Loss in 13 Years

Just read an article in the WSJ this morning about how Gold is down 29% YTD and is set for its first annual loss in 13 years.

Can't help but remember all the people who told me how Gold was a sure thing or how Gold never went down.  The lesson here is pretty simple---don't get caught up in all the fundamental reasons why something should go up or down and don't get caught up in the sales sizzle of people who have a vested interest in trying to get you to buy something.  All of that stuff is rarely right, the market is always right.  Follow the trends and counter trends and you will be ok.  There will be a time when it makes sense to buy Gold again but don't try to pick the bottom, you may get lucky here and there but that is rarely a winning strategy.

Tuesday, December 17, 2013

Outlook for 2014

As we get closer to the new year, my inbox is starting to get flooded with different market outlooks for 2014.  Because of this I thought I would chime in with my own outlook:

1. Most of the outlooks that come out will be completely wrong so I will delete all of them immediately except for the ones that come with funny comics.

2. One or two will be right, not because the authors have any special insight, but for the same reason a broken clock is right twice a day.   With enough people making predictions, statistically speaking, one or two will guess right.

3. The one or two who guessed right will be paraded in front of the financial media as great experts.  The media will also probably ignore the fact that they probably guessed wrong every other year.

4. The US market will probably fall somewhere between up 35% and down 35%

5. It will be no easier to predict what the market will do (impossible) in 2014 than it is any other year.

6. Bonds will either be up or down

7. Markets will continue to move in recognizable trends and counter trends

8. Instead of trying to predict what the market is going to do investors will be better of investing with these trends and counter trends.

Thursday, December 12, 2013

Ultimate Success Formula

The two areas were people are given the most mis-information are nutrition and finance.   I was recently listening to an expert on nutrition who espouses a view that is far different than the mainstream and he recommending people use the following formula in trying to find out what works for them:

Step 1---Try what everyone says should work
Step 2---If it doesn't work then throw it out
Step 3---Try the opposite

This advice carries over to finance as well.  You tried the traditional asset allocation approach in 2002 and 2008, how did that work?  If it didn't work well then toss it and try the opposite.  The opposite of fixed allocations decided by your risk tolerance and age is to have flexible allocations determined by the market, or Tactical Asset Allocation.

Wednesday, November 27, 2013

Why traditional diversification is ‘downright dangerous’

Just was an article on and couldn't believe the title:

That is probably going to cost them some advertisers but a lot of the article actually make sense.  They quote Burton Malkiel, who wrote a random walk down Wall Street, which is basically the desk reference guide of the index and buy and hold crowd, as saying that because of what is likely to happen to bonds that the 60/40 portfolio is now dangerous.  

The only thing I take exception to in the article is this quote:

Any norm at all ignores another fundamental investing precept—that your allocation needs to change to suit your personality and stage of life—a more important concept now than 70 years ago, because people live longer and plan their own retirements.
Markets don't care about your personality or stage of life.  Your allocation should change based on the trends in the markets.

Saturday, November 23, 2013

A Broken Clock is Right Twice a Day

The Wall Street Journal had a story this morning about how stock market strategists are taking a cautious approach going into 2014.  That would matter if they could actually predict the market, which they can't.  From the story:

Wall Street strategists have a reputation for being stock-market cheerleaders, helping to boost sales of stocks at their brokerage firms. Since 2000, stocks have returned an average annual gain of 3.3%, well below the 10% predicted by strategists. And in every year they have predicted stocks would rise, missing all four down years. 
At the same time, however, stocks have outpaced analyst forecasts in seven of those years, with one year, 2005, in which forecasts essentially hit the nail on the head.

So, they missed all the down years and only really got it right in 1 of 10 years, a .100 batting average.  What about this year?

 Strategists had started off 2013 calling for a moderate rise in stocks, although the forecasts were for a better one than they are now expecting for 2014. At the beginning of 2013, the average forecast from strategists at 15 banks was for a 7.7% gain, which would have left the index at 1532, according to Birinyi.
Not even close.

Friday, November 22, 2013

Smart Beta

With the ever increasing popularity of ETFs it is not surprise that we are starting to see a whole new class of index products that are differentiated from the basic indexes that we are all used to, like the S&P 500.   Traditionally indices have been market cap weighted, meaning larger companies will have a larger allocation in the index.  I am sure there is a reason that indices started as market cap weighted, I just don't know what it is.  There is no rule that this is a better way, it just is what it is.   Now we are starting to see more and more "smart beta" products.  These ETFs slice and dice indices in a bunch of different ways, for example some equally weight all stocks in the index, others focus on low beta stocks, others focus on high beta stocks.  All will claim that their way is better than the standard market cap weighted index.  Maybe they are but a few things you need to be aware of in evaluating these products:

1. Wall Street lives on continual money in motion and continual selling of new products.  Once something becomes commoditized, like market cap weighted index funds (we don't need another S&P 500 ETF or another Russel 200 ETF for example) then Wall Street will come out with a new twist, not always based on what is better, but based on what it can sell.

2. We have tons of history through different market cycles on market cap weighted indices, we don't have it on smart beta.  Most of these products are developed through backtesting, which there is nothing wrong with, but done the wrong way can result in curve fitting (basically blindly finding something that beat market cap indices in the past and just assuming it will in the future).

We use some of these products and will continue to evaluate others so I do believe that they add some value to the current investment landscape, but just like with everything Wall Street comes out with investors need to tread with caution and do their homework.

Friday, October 25, 2013

NASDAQ 5000?

On March 9,2000 the NASDAQ closed over the 5,000 mark for the first time ever. The NASDAQ ended with its 15th record close that year, up 150.22 points to 5,047.39. Its low was on October 9, 2002 at 1,114.11---a 3944 point range between high and low.  Currently the NASDAQ is at 3928, a 71% retracement.  Historically, once an index retraces more than 68% of a move, it ends up retracing 100% of the move in the future. That could mean the NASDAQ reaching 5000, perhaps by mid 2015. 

Tuesday, September 24, 2013

Just Say No To Fixed Allocations

I got a real interesting question the other day from someone who wanted to know if Utility stocks were a good thing to buy if you expected a market crash.  Basically, if the market is going to crash would utility stocks do less bad than other areas of the stock market.  In a world where people have fixed allocations to stocks regardless of what is happening in the market this is a great question.  If you have to be invested in the market it makes sense to find those areas that will be hurt the least in a market crash.  But, why do you have to be invested in the market?  If the market does crash, which it will eventually because it always does every once in a while, then why try to find areas that will lose the least?  The better idea is to get out of stocks entirely and into cash or Treasuries and wait until the market starts going back up.

I am seeing the same thinking in the bond market these days.  Everywhere you turn there are articles on areas of the bond market that will be hurt the least when interest rates rise.  I saw one article that recommended short term Treasury ETFs like iShares 1-3 year Treasury (SHY).  A quick look on shows that SHY is yielding .27%, that's not even worth the effort it takes to push the enter button to enter a sell order.  The question should not be which area of the bond market to get into, it should be if you are getting out of bonds what do you buy instead?

Saturday, September 14, 2013

Mutual Funds Try Hard to Hide One Statistic

An RIA we work with shared a short article about how mutual funds try very hard to hide their maximum drawdowns which then makes it impossible to calculate their MAR ratios.  Maximum drawdown is your maximum peak to trough loss.  For example, lets say you put $100 into a mutual fund in January, in August it was worth $200, and then in December it was worth $110.  You actually made money for the year, you started with $100 and ended with $110, but it doesn't feel like it.  In August you had $200 and in December you had $110, you had a $90 drawdown which was 45%.  We have long believed that risk should be measured by maximum drawdown, not nebulous figures like standard deviation, but I have never seen anywhere where you can find drawndown numbers on mutual funds.  We even subscribe to the most sophisticated analytic package Morningstar has, we can run over 500 statistics on mutual funds, but I have never seen it report on maximum drawdown.

Why don't mutual  funds want you to know what their maximum drawdowns are?  Because the numbers look ugly.  From October 2007 to March 2009 the S&P 500 had a 60% drawdown.  Since most equity funds don't beat the S&P 500 it stands to reason that many were much worse.  It is much better marketing for them to show risk measures like standard deviation because most people don't understand that anyway, but they do understand a peak to trough of 60%.

In evaluating any investment the maximum drawdown can be used to calculate the MAR Ratio.  The MAR Ratio is simply the average annual return divided by the maximum drawdown.  For the past 10 years ended 9/13/13 the S&P 500 has an average annual return of about 7.36% with a maximum drawdown of 60%, that gives us a MAR ratio of .12.  If you were evaluating an investment that could return 7.36% on average but could also drop 60% at any time you probably wouldn't take those odds.  MAR ratios should be 1 at a minimum, so if an investment had a 60% drawdown it should have a 60% average annual return.  Now you understand why mutual funds don't want you to know about maximum drawdown and MAR ratio.

Monday, September 9, 2013

How Is This News?

Investors Bet on Battered Emerging Markets

The WSJ ran a story this morning quoting some large emerging market funds who are bullish on emerging markets.  What would you expect them to say?  If investors want to invest with style box money managers that is their choice but don't let what they say about their investment sector sway you in any way.

Money does go where it is treated best and it hasn't been treated well in emerging markets this year.  That being said, if this rally continues then at some point the US is going to start looking overvalued vs. emerging markets and you will see them catch up.  If the rally doesn't continue then emerging markets could get hammered some more.

Tuesday, September 3, 2013

Your Goals Don't Matter Agility Does

If you have ever talked to a financial planner before the process usually goes something like this:

Step 1:  Determine your goals

Step 2: Determine your risk tolerance

Step 3: Create a portfolio, within your risk tolerance, that is designed to achieve your goals.

Step 4: Help you stick with your portfolio through periodic re-balancing and telling you to hang on during market declines.

This sounds fine in theory, you have a goal or goals that you want to achieve and if you can design a portfolio that will give you the best chance of achieving them then what is wrong with that?

What is wrong of course is that the market doesn't care about your risk tolerance or your goals, it will do what it is going to do.  For example, lets say it is the year 2000 and you are 55 and want to retire in 10 years.  Some simple math tells you that you need to average 10%/yr in your portfolio to reach your retirement goal.  Anyone can design a portfolio for you that would have returned 10% over the past 10 years but that is meaningless for what it is going to do over the next 10 years.  In fact, you probably would have reached 2010 with about the same amount of money you started with, if you were lucky.  So in effect you are getting an asset allocation that a financial planner is guessing might have a chance to earn 10%, you are re-balancing to that allocation, and being advised to stick with it during market downturns.  

Agility Is What Matters

Would you ever write a business plan and stick with it no matter what?  No.  New opportunities and new threats always pop up, your business plan needs to be constantly updated to keep up with reality.  Why would you ever design an investment plan and stick with it?  In the above example, since I have no way of predicting what mix of assets will return 10%/year the best solution is to earn as much as possible while taking a risk level that you are comfortable with.  This requires agility and the willingness to respond to new opportunities like Bull Markets, and new threats, like Bear Markets.

Monday, August 26, 2013

Modern Portfolio Theory Works Just As Well as it Did in the 90's, Which is Not At All

One of the criticisms that I often hear about Modern Portfolio Theory (MPT) is that it doesn't work as well as it did in the 90's.  That is not true, MPT works just as well as it did at any time in history, which is not at all.  

The main idea behind MPT is that there is an optimum portfolio where the combination of non correlated assets creates an overall mix that can have a better risk/reward profile than the individual asset classes on their own.    From an academic standpoint MPT is very interesting because the optimum portfolio mix does exist.  The problem is that I can tell you what it was yesterday but I have no idea what it will be tomorrow, and that is where MPT becomes useless in real life.

In order to decide how much to allocate to each asset class you need to predict:

1. The future returns of each asset class
2. The future volatility of each asset class
3. The future correlation of each asset class

If you could accurately predict all three of those things then MPT would work great.  You would have predicted the crash in stocks in 2008 and the rise in bonds, along with the lack of correlation.  An MPT portfolio would then have 100% bonds and investors would have been protected.  Unfortunately, you can't predict any of these variables, making MPT interesting to study but of no practical use.

So why did MPT appear to work in the 90's?  Because anything that told an investor to buy stocks would have worked, I could have had a monkey throwing darts at an asset allocation chart and I would have made money.  That doesn't make it a valid strategy.

Thursday, August 15, 2013

The Glaring Flaw in Risk Parity

Was forwarded an interesting article from Bloomberg the other day about some of the struggles in risk parity strategies, particularly Bridgewater's All Weather.

This highlights the one glaring flaw in this approach---you are using past returns, correlations, and volatility to set allocations.  Interestingly, this is the same reason why Modern Portfolio Theory does not work.

To us risk parity can be improved in three ways:

1. Use maximum drawdown instead of standard deviation as a risk measure.  Nothing is perfect but clients tend to view risk more as drawdowns from a high water mark than day to day and month to month volatility.

2. Use methodologies instead of asset classes.  You can get a better idea of what to expect from a methodology, say momentum or counter trend, than you can from an asset class.

3. Using the above two methods can avoid having large fixed income exposure reducing or eliminating the need for leverage.

Friday, August 9, 2013

Conservative and Aggressive is Not An Asset it is a Methodology

I recently reviewed an investment portfolio for an 82 year old and his daughter.  It was the usual asset allocation mutual fund portfolio with the usual funds I normally see.  When we go the an emerging market bond fund his daughter was aghast because she thought there was no way an 82 year old should own this risky an investment.  She was partially correct.  At the time emerging market bond funds had moved from being in an uptrend to being in a downtrend.  Over the past three months they had been down somewhere in the neighborhood of 11%.  There is no way and 82 year old, a 65 year old, or a 25 year old should own emerging market bond funds, or anything else, that is in a downtrend like that.  On the other hand, prior to that, emerging market bonds had been in a steep uptrend.  I have no problem with anyone at any age owning emerging market bond funds when they are in an uptrend.

The point is that asset classes in and of themselves are not risky, it is how you use them that is risky.  In the hands of a buy and hold asset allocator emerging market bond funds are risky as they can go through periods where they lose a lot of money.  In the hands of a tactical investor then they are just another tool to shift money to when they are in favor.

Wednesday, July 3, 2013

A New Paradigm For Investing?

It wasn't so long ago that we had different asset classes that we could use in designing a portfolio.  Asset allocation did little, if anything, to protect from market declines, but you could use different combinations to tweak the risk vs. return of portfolios.  For example, you used to be able to add bonds to a portfolio to reduce risk, while also reducing returns.  Adding Gold or commodities used to also change the risk/return structure of portfolios.  You also used to be able to add international and emerging market stocks to increase returns and risk.  Now adding any of these assets just adds risk and reduces return.  This creates a problem for the asset allocator, when US stocks are the only game in town what do you do?  Do you keep fixed exposure to the other asset classes and just ride them down?  Do you have 100% stocks and hope that we don't have another bear market?  This new paradigm may just reverse itself, but if it doesn't asset allocators are going to have to think long and hard about new ideas in portfolio design.

Thursday, June 27, 2013

How Investors Can Achieve True Diversification

I just read a great article in Institutional Investor entitled How Investors Can Achieve True Diversification by Andrew Weisman.  Ironically he is from Janus which used to be the poster child for all of your eggs in one basket.  Subscribers can read the article here:

He argues the same thing about diversification that we talk about a lot---portfolios that appear to be diversified are really dominated by the same risk factor.  He talks about this in terms of institutional investors but the same ideas apply equally well to individuals.  He makes a couple of great points about portfolios and risk factors:

1. In a standard 60/40 stock/bond portfolio 97% of the variance can be explained by the stock allocation.

2. Many investors mistakenly assume that apparent diversification is actual diversification, that is because:

A. The stock part of a portfolio is obviously dominated by equity risk.
B. The bond part of the portfolio for most investors has moved out the risk spectrum in search of yield, resulting in bonds like high yield corporates that are dominated more by equity risk than duration risk.
C. So called alternative investments are extremely correlated to the S&P 500.  According to the article the HFRI Global Hedge Fund Index has been correlated versus the S&P 500 at a greater than .9 for approximately the past two years.

The cause of this lack of diversification is that institutional investors (and individual investors) have been trained to think of portfolio construction as a collection of assets, which concentrates portfolio risk into a single factor.

The solution that the author points out is simple, yet complex-----portfolio construction should not be by asset class, it should be by risk factor.

This is something we believe wholeheartedly.  In our shop we use different methodologies (counter trend and momentum), different time frames, and different asset classes in our models.

Wednesday, June 5, 2013

The Perils of Past Performance

PAST PERFORMANCE DOES NOT PREDICT FUTURE RESULTS.  That line is on every piece of investment literature that goes out to clients, they get it, but often times advisors don't.  Past performance of any investment or methodology is virtually meaningless, it tells you how something performed in the past, but not why it had that performance, which is the critical component in figuring out how something is likely to perform in the future.

Long Term Capital Management is a classic example.  A few years of great performance followed by kaboom.  Their performance came from a more sophisticated knowledge of arbitrage opportunities and more sophisticated systems.  It was only a matter of time before the rest of Wall Street caught up and those opportunities disappeared.

Asset allocation is another example.  From 1982-99 it did great, that didn't tell investors anything useful going into 2000-2002.  From 2003-2007 it also did great, that didn't help investors in 2008.  The real question is why did asset allocation do great?  It did great because the market was going up, since the market doesn't always go up, and since nobody can predict when it is going to go down, the past performance of asset allocation is useless.

The same issue can be found in backtesting tactical methodologies and systems.  We have a very successful counter trend system for Treasury Bonds.  However, adding an inverse side (betting Treasuries are going to go down) historically reduces returns and increases risk.  If I relied purely on the backtested results I would be tempted to remove the inverse side and have the system be long only.  We decided to keep the inverse side in because we asked why did the returns work out the way they did in the backtest.  The reason is because over the entire duration of the backtest Treasury Bonds were in a bull market.  However, even in this environment, the inverse side was still slightly profitable.  Will Treasury Bonds continue in a bull market?  Probably not.  Therefore, having an inverse side to the system would have hurt performance in the past but will probably help performance in the future.

Tuesday, May 28, 2013

All Investment Strategies Stop Working At Some Point

I was talking to an advisor earlier in the week about tactical asset allocation and he conveyed a story about how he had allocated money to a tactical strategy that stopped working.    Every investment strategy stops working at some point, either temporarily or permanently: Buy and Hold and asset allocation in 2002 and 2008, the legendary Bill Miller at Legg Mason in 2007, and yes, even a tactical strategy.

Market dynamics are constantly changing, it would be foolish to expect an investment methodology to work all the time in every type of market, or never just stop working.  How do you protect against this:

1. Use multiple, uncorrelated, methodologies.  We use intermediate term momentum analysis that buys into something when it is going up and sells when it starts to weaken, combined with short term counter trend analysis that buys when something is weak and sells when it is going up.  These methodologies do not move in the same direction at the same time and use completely different metrics.  If one stops working the others will not be impacted.  

If you insist on using some sort of buy and hold or asset allocation strategy you would need to combine it with a completely different return stream.

2. Define for whatever strategy you are using what ''stop working'' means.  For us, this is a strategy that doesn't perform as it should.  For example, a momentum strategy that doesn't do well in a market that is favorable for momentum or a counter trend strategy that doesn't do well in a market that is favorable to counter trend.

3. Understand that all strategies stop working at some point and constantly monitor everything for any signs that it is not working properly.

4. If you identify a strategy that is not working as it should figure out why and if it is temporary or permanent.  Err on the side of caution here.  Over the years I can think of two models we had that stopped working as they should.  They relied on inter-market relationships that had always been strong and ceased to be so.  We decided that these changes in the market dynamics were most likely permanent and took the models out of our strategies.

5. Most importantly, always be improving.  It is tempting to find an investment strategy with a great long term track record and assume it will continue, it won't.  Being static and/or relying on track records is a recipe for disaster.  Look at all the companies through the years that went out of business because they assumed that what worked in the past will continue (anyone interested in a buggy whip?) We are in a constant state of improvement.  There is always a better way to do what we do and I spend hours every day trying to find it.  When I do, then I try to find something better than what I just found.

Friday, May 24, 2013

Should You Invest in Frontier Markets?

I recently had an email exchange with a reporter about frontier markets (emerging, emerging markets).  He was writing a story about what markets investors should invest in.  My answer to him was none.  Not because there are not huge opportunities in frontier markets, but because of what could go wrong.  If you time it right (big if) you can make a lot of money buying the right frontier market at the right time. If you time it wrong you need to explain to clients why you lost a ton of money investing in some obscure country nobody has hear of.

I just read an interesting study done by CXO Advisory (link below but available to subscribers only)

They add a frontier market ETF (FRN) to a diversified portfolio.  What they found was that FRN slightly decreased returns over time and increased risk.  There are of course caveats here, the main one being that FRN hasn't been around for a very long time.   However, the point is that investors need to always make sure they look at the risks of whatever they are investing in before getting wowed by the potential returns.

Monday, May 20, 2013

7 TTM Investment Strategies Win Top Gun Award with PSN

Period Ending 3/31/13

Momentum Income (formerly Inst'l Income) 1 Stars Global Fixed Income Universe

Trend Aggregation Income (formerly Tactical Income) 1 Stars Global Fixed Income Universe

Trend Aggregation Absolute Return (formerly Balanced) 1 Stars Global / Intl Balanced Universe

Trend Aggregation Core (formerly Endowment) 1 Stars ETF Global Balanced Universe

Trend Aggregation Core (formerly Endowment) 1 Stars Global / Intl Balanced Universe

Momentum Core (formerly Multi-Strategy) 1 Stars ETF Global Balanced Universe

Momentum Core (formerly Multi-Strategy) 1 Stars Global / Intl Balanced Universe

Momentum Growth (formerly Capital) 1 Stars ETF Global Balanced Universe

Momentum Growth (formerly Capital) 1 Stars Global / Intl Balanced Universe

Momentum Absolute Return (formerly Institutional Balanced) 1 Stars ETF Global Balanced Universe

Momentum Absolute Return (formerly Institutional Balanced) 1 Stars Global / Intl Balanced Universe 

Friday, May 17, 2013

Gold's Allure is Starting to Fade

Just read an article in the WSJ this morning about Gold:

Up until recently the most frequent question I got from investors was what I thought about Gold.  The answer was the same then as it is now, if it is in an uptrend I like it, if it is in a downtrend I don't.

Gold's recent drop reinforces a number of key lessons for investors:

1. Assets that undergo parabolic moves (Gold, Apple, etc) almost always retrace most, if not all, of that move.  Therefore, having a herd mentality and buying into something like this once it has rallied a lot rarely makes sense.

2. Once everyone starts to accept that something is going to go up that is the top.  Gold's fall started when the consensus was that nothing would stop it from $2,000/oz.  Same thing with Oil a couple of years ago and Apple.

3. Investors believe that their most recent experience will continue.  I was told last year by someone in her 80's that gold ALWAYS goes up and has never lost money.  Same thing with people who are convinced bonds are conservative (30 year bull market about to end), normal stock returns are 30%/yr in 1999, etc.

4. Instead of trying to predict tops and bottoms and figure out why it is better to stay in harmony with the trend.  When gold was going up I liked it, now I don't.

Wednesday, May 1, 2013

Is The Economy Really Improving

Below is the replay from my appearance on Fox Business News yesterday about whether the economy is improving or not.

Is the Economy Really Improving

Monday, April 29, 2013

TTM Strategy Correlations

Morningstar recently put out a paper on global balanced managed ETF strategies.  In the paper they look at correlations between the managed ETF universe vs. a balanced buy and hold portfolio.  Our strategies took 3 of the top 10 spots in lowest correlation compared to the balanced benchmark:

Here is the benchmark that Morningstar used:

This highlights the difference between partially tactical strategies that are nothing more than traditional static asset allocation strategies that can move around a little bit, and fully tactical strategies.

Thursday, April 25, 2013

Another Example of Why Fixed Allocations Are a Bad Idea

Just read a good article in the Wall Street Journal about how poorly commodities have been doing:

Wheels Fall Off The Supercycle

This is just another example of why fixed allocations are a bad idea.  Commodities have been in a long bull market and unfortunately investors tend to believe that what has happened most recently will continue.  Now, most traditional asset allocation portfolios have some exposure to commodities.  I have no problem with commodities and no idea whether they will continue to decline or move up.  I just have a problem with fixed allocations to asset classes regardless of how they are doing.  A better idea is to own commodities once they start to trend upwards and don't own them as long as they are in a  downtrend.

Wednesday, April 24, 2013

One Reason We Don't Use Stops

False Rumor Causes Stocks to Plunge

I am often asked if I use stops to try to limit drawdowns.  In all of our testing we have found that every once in a while stops can help, but for the most part they don't.  Days like yesterday are another reason that stops can be problematic.  When the market briefly plunged it probably triggered a bunch of stops, causing traders to sell positions at a loss only to see the market rally moments later.

'Target' Funds Vulnerable to Rate Rise

Great article in the Wall Street Journal this morning on how target date fund investors could be at risk when/if interest rates increase.  Target date funds are supposed to get more conservative as you get older, the thinking being that the closer you get to needing your money the more conservative your investments should be.  This thinking has a number of major flaws:

1. What is conservative?  According to target date funds it is adding bonds because over the past 30 years bonds have gone up, and in years that stocks have done poorly bonds have done well.  So in the past bonds have been a risk reducer in portfolios, but if interest rates start to rise bonds will go down in value.  The true definition of conservative is whether or not you can lose money.

2. Your age and time horizon matter very little as to whether you should be conservative or not, what is going on in the market is much more important.  Nobody, regardless of age, should be trying to chase stock market gains during a market downturn like 2002 and 2008.  Just about everybody should be in stocks during a market upturn.  The key to safety is being in harmony with market trends, not pulling money out of stocks and shifting to bonds regardless of what happens in the market.

Monday, April 1, 2013

Asset Allocation's Ugly Side

I just read an article in the Wall Street Journal about how commodities have not done well this year in the face of the market rally.  Stocks, Commodities Break Up the Band

A traditional asset allocation portfolio would usually have an allocation to commodities.  It would also usually have an allocation to foreign stocks (emerging and developed) and bonds along with US Stocks.  

When an investor adds bonds to a portfolio they expect they will drag on returns during a market upturn.  They accept that for the supposed protection during market declines.  I have written in the past about how bonds are likely to go from being a risk reducer to a risk enhancer in portfolios so I won't rehash that here.  When they add commodities they typically hope that commodities will rise with stocks and might provide some protection during a market decline.  While US stocks have gone up quite a bit this year the traditional asset allocation portfolio is having some problems so far.  Here are the year to date returns of some ETFs that track these other asset classes:

Commodities---iShares S&P GSCI (GSG): .34%
Bonds- Barclays Aggregate Bond (AGG): .07%
Intl Developed- iShares MSCI EAFE (EFA): 3.73%
Emerging Market- iShares MSCI Emg Mkt (EEM): -3.56% 

S&P 500:   10.61%

Thursday, March 14, 2013

Fidelity's Deal With iShares is a Disaster For RIAs

Yesterday Fidelity supposedly upped the ante in the ETF war with Schwab and TD Ameritrade by expanding its commission free iShares lineup to 65 ETFs. Every article I have seen on this so far has lauded the move. For buy and hold retail investors who are looking for a place to build passive ETF portfolios then Fidelity's new offering might make sense, but for RIAs who use ETFs to manage money tactically this deal is a disaster.  What Fidelity has done is on the front end they have appeared to improve their program with the hopes that nobody notices that what they took away actually makes it much weaker.  We see three major problems with the deal:

1. They are taking 10 ETFs off the list as of 4/30. This could generate unnecessary capital gains from replacing those ETFs in client accounts.

2. They are replacing high trading volume ETFs with low trading volume ETFs.

3. They are charging short term redemption fees on ETFs held for less than 60 days.

Removing 10 ETFs

For some reason Fidelity has decided to remove 10 ETFs from its commission free lineup. This could create unnecessary capital gains for investors. For example, we currently own the iShares MSCI Emerging Markets ETF (EEM) in some clients accounts. Because we are tactical managers we could sell this ETF at any time. We bought it commission free with the expectation we would be able to sell it commission free. Now, as of 4/30 client accounts will be charged a commission when/if we sell. If we still own it on 4/29 we might be forced to replace it, and potentially generate capital gains, with the iShares Core MSCI Emerging Markets ETF (IEMG), which replaces it on the list.

Replacing high trading volume ETFs with low trading volume ETFs

Another problem with the 10 ETFs that Fidelity is taking off the list is that many of them are actively traded while many of their replacements are not.  For example, we often trade the iShares Russell 2000 ETF (IWM).  According to an analysis from BlackRock  IWM trades around $3billion/day so orders of pretty much any size should be able to be executed within the bid/ask spread.  Now IWM is being replaced with iShares Core S&P Small Cap (IJR).  This ETF trades an average of $65 million/day so larger orders would probably have to be done a few cents outside of the spread, costing us and clients money. 

Short Term Redemption Fees

Buried in the small print of this deal is that Fidelity will charge short term redemption fees on ETFs held less than 60 days.   Again, not a big deal for the buy and hold retail investor but for tactical managers this is a deal breaker.  We will often be in and out of ETFs within 60 days.  The back end charges could substantially eat into returns, especially for smaller accounts.  I can understand why actively managed mutual funds might want to scare off active investors with redemption fees but I can see no reason why Fidelity should care if RIAs don't hold an ETF for 60 days. 

To us, this looks like a decision made by the retail side of Fidelity with no thought to how it would impact the institutional side.  For buy and hold retail investors this could be an attractive offering.  For RIAs who are tactical or active and have decided to partner with Fidelity then this deal is a slap in the face.

Wednesday, February 13, 2013

Interesting Short Term Opportunity in Long Term Treasuries

I am not a trader or market timer, but if I was I might be looking at long term Treasuries right now for the following reasons:

1. Rates have backed up quite a bit as money has shifted out of bonds and into stocks based on the stock market rally and easing fears of a global meltdown.  Over the longer term we all know that rates at this level are probably unsustainable but in the short term we may be a little oversold.

2. Everyone and their mother expects a correction in stocks but they are all afraid to sell or go short because if stocks continue to rally they might miss it.  A safer bet could be taking a position in Treasuries, which would probably rally in the face of any major stock market correction, and if point 1 is correct, at least over the short term there is not a ton of risk to the downside in that trade.

We do have a small position in long term Treasuries in our Fixed Income models based on short term countertrends.

Saturday, January 26, 2013

Will investors ride bull market?

My bullish call on stocks at the end of 2012, so far so good:

This wasn't about predicting earnings, the jobless rate, etc.  Simply the market had been in a downtrend right after the election, it then began an uptrend in mid November.  Once stocks start an uptrend it is highly likely that the uptrend will last for a while.  Simple as that.

The Risk of Safety

Yet another article about the bubble in the bond market:

Most investors today have never seen a bear market in bonds, interest rates have been steadily decreasing since the early 80's so investors have come to look at bonds as "safe" and stocks as "risky".  True safety is being in harmony with market trends, in stocks and bonds, investing in an asset class when the rewards outweigh the risks and not investing in it when the risks outweigh the rewards.  With interest rates so low at best you are looking at earning just the coupon on bonds, at worst you are looking at capital losses when interest rates increase.   Not much reward there and a lot of risk, that is not my definition of "safety".

Wednesday, January 23, 2013

Machine Learning in Financial Trading

Just read an interesting article in Markets Media about machine learning in trading.  Our chief systems designer, Murray Ruggiero, wrote a book about this a while back regarding using neural networks---computer programs that learn and make predictions-- to trade.  To me, the most interestsing use of this technology is when to use trend following strategies and when to use mean reversion strategies.   Trend following strategies work best in trending markets while mean reversion strategies work best in choppy markets.  It is easy to figure out what type of market we have been in, but to be able to accurately forecast what type of market is likely in the future would allow the trader to find an optimal allocation between trend and mean reversion strategies. 

Friday, January 18, 2013

Some Common Sense on the 4% Rule

The 4% withdrawal rate in retirement has become the gold standard in financial planning.  Unfortunately, while it looks good in practice it might not work in real life (meaning the client could be at great risk of running out of money).  The logic beyond the 4% rule is that in retirement a client could withdraw 4% of their portfolio every year, for example a $1mm portfolio could sustain withdrawals of $40,000/year over the retirement period.  The problem with this is that you need a certain growth rate in the market and you need to avoid large losses to make this work and unfortunately the market doesn't really care what you need, it will do what it will do. 

The article above in FA  Magazine not only tackles this but also suggests one answer is to use tactical portfolios to avoid large drawdowns.

Wednesday, January 16, 2013

Simple Sector ETF Momentum Strategy

Just read a post on CXO Advisory (full post available to subscribers only):

Which tested a number of simple strategies to switch among different sector ETFs:

Materials Select Sector SPDR (XLB)
Energy Select Sector SPDR (XLE)
Financial Select Sector SPDR (XLF)
Industrial Select Sector SPDR (XLI)
Technology Select Sector SPDR (XLK)
Consumer Staples Select Sector SPDR (XLP)
Utilities Select Sector SPDR (XLU)
Health Care Select Sector SPDR (XLV)
Consumer Discretionary Select SPDR (XLY)

What they found echoes our research.  It is relatively easy to create a sector momentum strategy that beats the market but not by enough to really make it compelling, especially since there are many other momentum based strategies that do much better than sector momentum.  Here is their summary:

In summary, evidence from a limited sample period suggests that a simple sector ETF momentum strategy fares well compared to the overall stock market and adds some value to a simple (equal-weighted) diversification approach, but this added value may be dissipating.


Friday, January 11, 2013

The TTM Approach to Tactical Asset Allocation

Traditional asset allocation theory relies on a number of key tenets:

·         Markets can go down in value but they always come back.  Therefore, long term investors should not be concerned with market downturns.

·         Different asset classes (large stocks, small stocks, international stocks, growth, value, etc) are uncorrelated.  Therefore, spreading your portfolio among these different asset classes can produce higher returns with less risk.

·         Markets are unpredictable.  Therefore a passive approach is best.

Markets Don't Always Come Back Over The Investor's Time Horizon

Unfortunately, as many investors have discovered the hard way, these tenants do not hold up in real life.  Looking back over hundreds of years of data, whenever markets go down they do eventually come back.  However, that may not be over the investors time horizon.  Studies showing how markets react over time typically use periods of 70 years or more.  That is hardly relevant to most investors.  During such a long time there will be some ups, some downs, and some sideways movements.  The average investor who retires at age 65 might have a time horizon around 20 years.    If we look at the market over 10 and 20 year blocks the story is very different.   For example, from 1965 to 1982 an investor who bought and held the market would have made 5% total.  If he started with $100, he would have had $105 after 16 years.  More recently, if an investor retired on December 31, 1999 with $1mm and put it into the S&P 500, at the end of 10 years he would have $900,000 left.  If he had assumed a 10% return in retirement over a 20 year period then he would have to average 22%/year over the next 10 years just to get back on track.    If we assume he bought into the idea that he could withdraw 4% in retirement ($40,000/year) then the picture is even worse---his account would have shrunk to $484,000.  He is now at great risk for running out of money.  Over the same time period a $1mm investment in the NASDAQ on December 31, 1999 would have been worth $557,000 after 10 years.   

Below is a chart of the Bear Markets in the S&P 500 since 1929, their duration, the amount of decline, and how long it took investors to get back to even.

S&P 500 Bear Markets
% Decline
Time to Breakeven
Sept ’29 – Jun ’32
33 months
25.2 years
Jul ’33 – Mar ’35
20 months
2.3 years
Mar ’37 – Mar ’38
12 months
8.8 years
Nov ’38 – Apr ’42
41 months
6.4 years
May ’46 – Mar ’48
22 months
4.1 years
Aug ’56 – Oct ’57
14 months
2.1 years
Dec ’61 – Jun ’62
6 months
1.8 years
Feb ’66 – Oct ’66
8 months
1.4 years
Nov ’68 – May ’70
18 months
3.3 years
Jan ’73 – Oct ’74
21 months
7.6 years
Nov ’80 – Aug ’82
21 months
2.1 years
Aug ’87 – Dec ’87
4 months
1.9 years
Jul ’90 – Oct ’90
3 months
0.6 years
Mar ’00 – Oct ’02
31 months
4.7 years
Oct ’07 – Oct ’08

Source: Telephone Switch Newsletter, Summer 1992. Updated by the National Association of Active Investment Managers, Inc. through 2012.

One thing that this chart makes clear is that Bear markets are fairly common, very painful, and it can take a long time for investors to break even.  Between 1929 and 2008, there have been 15 bear markets with an average decline of 39%. During those 81 years, a new bear market began on the average of every five years, and lasted 18 months. After the bear market bottomed, omitting the 1929 crash, it took an average of 3.6 years just to break even.

Bear markets have a number of other consequences. 

·         While markets eventually come back, investors lose time and opportunity during them.  According to the National Association of Active Investment Managers over the past 70 years, the major indices spent nearly 60% of the time sitting out bear markets and then returning to earlier highs. Only about 40% of the time were real gains being made. 

·         Investors rarely buy and hold.  Instead, they tend to sell out when the pain of loss becomes unbearable, typically at, or near, market lows.  Then they tend to buy back in when the pain of watching everyone else make money becomes unbearable, typically at, or near, market highs.  According to Dalbar Financial Services for the period 1984-2003, the average return of the S&P 500 Index was 12.2%. Equity mutual fund investors during the period achieved an average return of 2.67%.  This is due to the average investor selling at lows and buying at highs.


Asset classes that may be uncorrelated during up markets tend to become correlated during down markets as investors sell everything in a panic.  Below is a chart of the returns of the S&P 500, international developed stocks, emerging market stocks, large cap growth stocks, large cap value stocks, and small cap stocks in 2002 and 2008:

2002 Return
2008 Return
S&P 500
MSCI EAFE (Foreign Stocks)
Morningstar Emerging Markets
Morningstar Large Cap Value
Morningstar Large Cap Growth
Russell 2000 (Small Cap)


A "diversified" portfolio of large stocks, small stocks, international stocks, emerging market stocks, growth, and value, would have offered no protection from bear market declines.

Markets Are Not Predictable But True Trend Changes Are Recognizable

Nobody can predict markets however there are a number of factors that investors can consider to put the odds in their favor.   There are five outcomes for investors in the stock market over any week, month, year, etc:

1.       You can make a lot of money

2.       You can make a little money

3.       You can be flat---not make any money, not lose any money

4.       You can lose a little money

5.       You can lose a lot of money

Fluctuations happen, so there is no way to avoid small losses.  However, large losses of the type that happen in Bear markets can be avoided.  True trend changes don't happen overnight, they take time to form.  While nobody can accurately predict Bear markets it is relatively simple to see a true trend change.  A change in trend may not persist and turn into a Bear market but it substantially increases the risk of large losses and limits the potential rewards. 

Putting the Odds In Your Favor

There are typically three types of markets:

1. Markets that go up in a fairly straight line (Bull Markets)

2. Markets that go down in a fairly straight line (Bear Markets)

3. Choppy markets that could go in either direction

In a traditional asset allocation framework the investor would treat each market the same.  He would ride the bull market up, he would ride the bear market down, and he would move up and down with the choppy market and hope that he ended up positive.   Using Tactical Asset Allocation (TAA), each type of market should be handled differently.   In Bull Markets, investors should be mostly, or completely in stocks.  In Bear Markets, investors should be mostly, or completely out of stocks.  In choppy markets investors should use a mean reverting or counter trend approach to make money from market overreactions.  This is where having a model based approach is key as it removes the emotion from the equation.  When stocks weaken then a momentum or trend following model based approach would move out of stocks into bonds and/or cash.  When stocks strengthen then a momentum or trend following model based approach would move back into stocks. 

How Markets Work

Markets are not efficient because they are traded by people.  People bring their emotions to their trading---greed, fear, and ignorance.  This creates a number of opportunities for profitable trades, including:

1. In the intermediate term assets that have gone up tend to continue to go up.  Basically, whatever is hot, stays hot for a long enough time to profit from it. 

2. In the short term markets overreact on the upside and downside and eventually snap back. 

At TTM we take advantage of both of these opportunities using momentum and counter trend analysis.

The TTM Approach

We use an objective allocation model that analyzes two categories of information:  momentum and counter-trends.   Momentum measures tell us the strength of stocks vs. bonds and which stock and bond sectors are the strongest.  Counter-trend analysis identifies possible short term market turning points and where the market may be overbought or oversold.  Momentum measures work best in straight up or down markets as in those environments a move down or up in stocks or bonds tends to be persistent.  Counter trend analysis works best in choppy, directionless markets. 


Momentum is the documented tendency of investments to persist in their performance. In other

words: stock, bond, commodity, or currency sectors that outperform during a given time period

tend to continue to outperform. More than 300 academic papers have been published illustrating

that momentum outperformance exists in just about every asset class.  We use momentum to decide how to allocate strategies among stocks and bonds and then to decide which stock sectors and/or bond sectors to include.

Counter Trend Analysis

Momentum based models work very well in straight up or down markets but tend to be much less effective in directionless markets.  They also will typically give some of their profits back at market turning points.  counter-trend analysis is equally as effective as momentum analysis but completely opposite in methodology.


Counter-trend trades are typically much shorter in duration than momentum trades and usually have a much lower win/loss ratio (winning trades are smaller and losing trades are smaller).   Counter-Trend models look to buy into oversold markets, expecting them to bounce back, and sell into overbought markets, expecting them to selloff.  Over the short term, markets are dominated by noise, fear, and greed.    This causes short term dislocations and deviations where market prices stray too high or too low and then snap back. 

Counter trend strategies can thrive in directionless markets and react quickly to major turning points.  They can be less effective during steady trending markets. 



Achieving Market Beating Returns with TAA

Most TAA strategies have the stated goal of beating the market over a typical market cycle (4-6 years on average).  They try to do this through a number of different strategies:

·         Apply a rotation strategy, sector, country, and/or style.  These managers will try to outperform by being in the right style, sector, and/or country.  Based on our research this is hard to pull off on a consistent basis and runs the risk of a situation where the market goes up but the sectors, styles, and/or sectors the manager is in do not. 

·         Create a portfolio of non-correlated asset classes.  Such a portfolio might have tactical allocations to US Stocks, Bonds, REITs, International Stocks, and Commodities.  This is also hard to pull off as by nature these asset classes tend to be uncorrelated and could drag on portfolio performance if one area is in a drawdown.

·         Buy individual stocks. This can work if the manager can consistently pick winners but this also exposes the investor to company specific risk (ie. AIG, Bear Stearns, Lehman, etc).

At TTM we take a multi-factor approach to try to beat the market:

1. Being heavily invested in stocks when our momentum models are positive

2. Being in the strongest market cap sector among large cap stocks, mid cap stocks, and small stocks.  Our momentum models determine which market cap sector has the strongest momentum.

3. Using counter-trend analysis to buy into short term lows and sell into short term highs.  This allows us to profit from short term market turning points and choppy markets.

4. Moving out of stocks and into bonds during times of market turmoil, protecting gains and avoiding losses.

5. Applying a prudent leverage factor during sustained uptrends.

How We Use Leverage

Leverage can sometimes have a negative connotation for investors and rightfully so.  Used inappropriately, leverage can increase portfolio volatility and magnify losses.  There are times when the risk of being invested in the market outweighs the rewards and there are times when the rewards outweigh the risks.   During times when market risk is low and potential rewards are high(during sustained market uptrends and when the market is oversold over the short term) then the use of leverage is warranted and can magnify returns without taking un-necessary risks.  During times when market risk is high and potential rewards are low (during sustained market downtrends and when the market is overbought over the short term) then the use of leverage is not warranted as it would increase risk and potential losses.

How We Hedge Market Risk

How we hedge against market risk during market downturns is more important than how we try to beat the market during upturns.  There are a number of ways tactical managers can use to hedge portfolios----moving to cash, moving to bonds, and/or using inverse funds.  We have chosen not to use inverse funds, we like making money when the market goes down but we are unwilling to take a chance of losing money when the market goes up.  We have developed a number of profitable tactical methodologies that use inverse funds but they are only right a little over 50% of the time, that isn't good enough for us.   Instead, we prefer to move to bonds if they are attractive, and cash if they are not.  For our bond allocation we have chosen long term Treasury Bonds and the Barclays Aggregate Bond Index as our preferred hedges.  While Treasuries are typically a great hedge to the stock market, they can also be quite volatile, so we have exposure to them but it is limited.  The Barclays Aggregate Bond Index gives us the ability to earn more than cash without the volatility in Treasuries.

Putting It All Together

It is clear that traditional asset allocation doesn't work.  Market declines happen too often, last a long time, and take too long to recover from.  Our approach offers the ability to profit in market uptrends while avoiding multi-month market declines.