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
Duration
% Decline
Time to Breakeven
Sept ’29 – Jun ’32
33 months
-86.7
25.2 years
Jul ’33 – Mar ’35
20 months
-33.9
2.3 years
Mar ’37 – Mar ’38
12 months
-54.5
8.8 years
Nov ’38 – Apr ’42
41 months
-45.8
6.4 years
May ’46 – Mar ’48
22 months
-28.1
4.1 years
Aug ’56 – Oct ’57
14 months
-21.6
2.1 years
Dec ’61 – Jun ’62
6 months
-28.0
1.8 years
Feb ’66 – Oct ’66
8 months
-22.2
1.4 years
Nov ’68 – May ’70
18 months
-36.1
3.3 years
Jan ’73 – Oct ’74
21 months
-48.2
7.6 years
Nov ’80 – Aug ’82
21 months
-27.1
2.1 years
Aug ’87 – Dec ’87
4 months
-33.5
1.9 years
Jul ’90 – Oct ’90
3 months
-19.9
0.6 years
Mar ’00 – Oct ’02
31 months
-49.2
4.7 years
Oct ’07 – Oct ’08
17months
-56.8
Unknown

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.

Correlation

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:

Category
2002 Return
2008 Return
S&P 500
-22.10%
-37.00%
MSCI EAFE (Foreign Stocks)
-15.94%
-43.38%
Morningstar Emerging Markets
-6.05%
-54.44%
Morningstar Large Cap Value
-17.21%
-35.85%
Morningstar Large Cap Growth
-27.83%
-41.47%
Russell 2000 (Small Cap)
-20.51%
-33.64%
Source: Morningstar.com

 

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

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.

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