Thursday, March 26, 2015

How The Bull Market Might End

Yesterday I was on CNBC talking about how bull markets die slowly and how the sell off was not the beginning of the end, yet:

What yesterday might have been though is a sneak peak at what the end will look like.  In this Fed induced bubble bad economic news should be good as it means that Fed tightening will probably be pushed out.  When bad economic news is bad, then that is bad, because it means that the market thinks the Fed might be out of bullets.  If the Fed has exhausted their playbook and we are still headed towards a recession then we have a problem.  Over the past few years we have had a bunch of V shaped moves in the market, something knocks us down but we know the Fed has our back so the market rallies back up.  If we know the Fed has our back but we also don't believe they have any options left then one day we have a decline that doesn't rally back.

As I said on CNBC this bull market will die slowly, but all bull markets eventually die.  Investors who are prepared will be fine, those who have come to believe "this time is different" will get hurt like they always do.

Sunday, March 22, 2015

What is Better---Index Funds or Active Managers?

The active and passive investment shops always argue it out over what is better---active money managers or indexing.

I just read a paper from Vanguard that, as you would expect, makes the case for index funds:

The Case For Indexing

Put alongside the paper from Ted Theodore about there being better times to be active and better times to be passive it brings up an interesting idea:

Dig We Must

What if they are both right?  There are times when stocks are uncorrelated that a good stock picker (someone who is not just hugging an index) can add some real value.  There are also times when stocks are very correlated where it is much harder for an active manager to add value.   Given this, it is very easy for both sides to data mine and pick out the times when there way outperformed as proof that one way is better than another.

However, this argument ignores the 800 pound gorilla in the room about what happens when the market goes down?  Neither active stock pickers or passive indexes will protect investors from market declines.

The better approach could be twofold:

1. Instead of active or passive how about smart beta?  Smart beta strategies fall somewhere in between, they are passive because a computer is picking the stocks just like an index fund, but they have a semblance of being active because the portfolio manager is using some sort of formula other than simple market cap weighting to pick stocks.  The smart beta strategies out there today have all been backtested and show to beat the market.  Yes, I know that nobody has ever seen a bad backtest so time will tell whether these strategies are robust going forward.  We think they will be because we believe they benefit from a value and size effect which should persist.

2. You need a tactical overlay.  Smart beta may beat the market over time but it won't protect you when it crashes either.  A tactical overlay on top of a smart beta strategy makes smart beta smarter.

Friday, March 20, 2015

Is It a Stock Pickers Market or a Global Macro Market?

If you watch financial news enough you will hear someone come on and talk about how the current market is for stock pickers, but what does that mean?  Just watching the market day by day you see times when it seems like all stocks go up or down together and you also see times when there are a bunch of divergences.  It would seem to make sense that during times when stocks are moving together that there isn't a ton of value trying to pick individual stocks.  On the flip side, it would seem that during times when there is a lot of divergences between stocks that stock picking would have much more value.  As a money manager we have individual stock strategies and strategies that just buy broad market based ETFs.  If we could identify times when our stock strategies were likely to outperform and times when it made more sense to concentrate on broad markets, that could be very useful.

Ted Theodore over at QAS just wrote a real interesting piece on how to measure this.

ETF Strategist-Dig We Must

Saturday, March 14, 2015

Why Smart Beta Strategies Work---It's Not What You Think

Smart Beta strategies are hot.  Go to any ETF conference and the majority of presentations will be about Smart Beta.  Smart Beta is any type of indexing methodology that is not market cap weighted, in an index like the S&P 500 companies are weighted by how large they are.  A Smart Beta approach to the S&P 500 would weight companies differently---equal weight, fundamental weight, low beta, high beta, etc.

It makes sense that Smart Beta is hot right now, ETFs are the future of asset management but we don't need another market cap weighted index.  So if you are going to issue a new ETF it has to be something different.  Add in the fact that the research shows that just about any other way to weight an index beats market cap weighting over time.

The million dollar question is why does Smart Beta outperform market cap weighting and will it persist?  One idea why is simple, curve fitting.  With computer technology you can find a bunch of anomalies that beat the market.  To guard against this you need to start with a valid premise that should work, and then test it to see if it does.  For example, weighting companies by fundamental factors, meaning the companies in the best shape get a larger weight in the index and the companies in the worst shape get a lower weight, should beat simple market cap weighting.  You can then test it and see what the results are.

The link below it a video from Rob Arnott talking about Smart Beta, it is a couple of years old but makes an interesting point about why Smart Beta strategies likely outperform.

He took a look at a bunch of different Smart Beta approaches and found that they beat market cap weighting.   He then took the opposite of those approaches and found that they also beat market cap weighting.  On the surface this makes no sense.  For example, if overweighting low beta stocks beats market cap weighting because their is something uniquely powerful about low beta stocks, the the inverse, overweighting high beta stocks, shouldn't beat market cap weighting, but it does.

The answer most likely is that Smart Beta strategies, regardless of how they are constructed, encompass two tilts---value and size---that do better than market cap weighting.  In a market cap weighted index you are always going to overweight the most expensive and therefore the largest stocks.  In most Smart Beta approaches you are going to tilt more towards value and smaller stocks, this is most likely where the outperformance comes from.

For example, we use the Guggenheim Equally Weighted S&P 500 (RSP) ETF a lot in our strategies. Like the name suggests it equally weights all the companies in the S&P 500.   According to Morningstar over the past 10 years (as of 3/13/15) RSP has an average annual return of 9.13% vs. a return of 7.76% for the S&P 500.  Also according to Morningstar, the average market cap of the portfolio is $21.9 billion vs. $73.4 billion for the market cap weighted S&P 500.  So where did the outperformance come from?  It could be a random anomaly that was curve fit, but most likely it is the size tilt towards smaller cap stocks.

Will Smart Beta outperformance persist?  Who knows.  However, it makes sense that value---buying something for a low price, and small stock outperformance should continue over time so any strategy that tilts towards those factors should be fine.

Thursday, March 12, 2015

Time To Think Globally?

As a tactical manager there is no reason why you need to invest globally.  The whole point of being tactical is making as much money as possible and avoiding the large loss.  If you can do that in US Stocks then why bother complicating things?  However, if in the future there will be more opportunity in the making as much money as possible part internationally then I can't ignore that.  Below is a chart of the current CAPE ratios of markets around the world.  The US currently has the highest valuation.  The CAPE is an awful timing tool as markets can stay over and undervalued for a long time.  Markets that are undervalued are also undervalued for a reason---Russia doesn't have a CAPE of 4.62 because investors haven't discovered it yet.  However, the price you buy things at matters, if you are buying a market at high prices then your future returns will probably be lower than markets you are buying at lower prices.   We are working on a global strategy that we might ultimately want to launch as a global alternative to TUTT.

As of Date Market Current CAPE Median CAPE
Dec-14 Russia 4.62 7.4
Dec-14 Brazil 9.13 16.4
Dec-14 Italy 9.22 22
Dec-14 Poland 10.38 14.6
Dec-14 Spain 11.59 15.6
Dec-14 Turkey 11.72 13.4
Dec-14 UK 12.04 14.7
Dec-14 South Korea 12.19 16.6
Dec-14 France 13.81 19.3
Dec-14 China 14.04 18.2
Dec-14 Australia 15.68 16.4
Dec-14 Germany 16.6 17.8
Dec-14 Hong Kong 17.84 18.1
Dec-14 Thailand 17.98 20.5
Dec-14 Malaysia 18.14 21.6
Dec-14 Canada 18.79 19.1
Dec-14 Taiwan 19.29 19
Dec-14 Sweden 19.62 20.5
Dec-14 India 19.75 23
Dec-14 Indonesia 20.33 24.2
Dec-14 South Africa 20.39 18.8
Dec-14 Mexico 21.11 23.7
Dec-14 Switzerland 22.87 19.5
Dec-14 Japan 24.89 38
Dec-14 US (Large) 27.1 15.9

Source:  Research Affiliates LLC

Tuesday, March 10, 2015

Dynamically Weighting Uncorrelated Investment Methodologies

In our Trend Aggregation approach we believe in using a number of different, uncorrelated methodologies together.  Some methodologies, like counter trend, perform better in a choppy market. Others, like momentum, perform best in a trending market.  The million dollar question that comes up when you use different methodologies that work best in different markets is how to weight them.  We have experimented with all sorts of risk parity approaches but nothing seems to add any value over and above equal weighting.  We have always been fascinated by the idea that perhaps a timing mechanism could be developed that would dynamically weight different methodologies based on the probability that they would outperform.

Value and momentum are two facts that have been proven in a number of studies to beat the market over time.  They also tend to be uncorrelated with each other so a portfolio that is split 50/50 between value and momentum strategies has crushed the S&P 500 over time.  Could you improve on a 50/50 split by timing when it is best to be in value and when it is best to be in momentum?  I think you can, but the guys over at Alpha Architect just published a study showing one approach----using valuation spreads----doesn't add any value.

That doesn't mean that it can't be done, just that perhaps this is not the way to do it.  This is an area we will continue to do work on as I believe that finding a way to dynamically weight uncorrelated methodologies has the potential to add a ton of value.

Monday, March 9, 2015

Value Investing Works---So Why Don't Individual Investors Do It?

I once heard a quote that the stock market is the only store where when things go on sale people leave.  We are all value investors at heart, just look at stores on Black Friday.  There has also been tons of academic research that value investing beats the market handily over time and that investors who put money into a market when it is undervalued do well, while investors who put money into an overalued market do poorly.

So if it is that easy why doesn't everyone do this?  Two reasons---the media effect, and the watch your neighbor get rich effect.

Media Effect----Value investors often have to be patient, it can take time for investors to recognize value so it is typically a longer term approach.  Value will also often underperform during times of speculative excess.   Therefore, it is very hard to be a value investor when you constantly turn on the TV or open the paper and hear about new highs.

Watch Your Neighbor Get Rich Effect---Many people think losing money is the most difficult thing to stand in the market, its not.  The most difficult thing to do is watch somebody else make money while you are not.  There is always some hot stock or hot sector somewhere and we all know somebody who is making money investing in it.  The longer that goes on the more tempted you become to buy it, once you finally capitulate it is frequently right at the top.

These two effects turn investing into a short term proposal, where the most important thing is how much you are making every day, week, or month.  The problem with that thinking is that those gains are just on paper and you typically give them all back, and then some, when the market goes down.  It is extremely hard to do but you need to look at investing as a longer term proposal.

You can make value investing more palatable and profitable by combining it with momentum and tactical asset allocation.  People who buy when there is "blood in the streets" will almost always make more money over time.  However, psychologically this is the hardest thing to do and often times you will be catching a falling knife.  Using momentum with value can avoid value traps where you buy something after it has gone down a lot and it keeps falling.  Value strategies are also not immune to drawdowns during bear markets.  Adding a tactical overlay can help cut maximum drawdowns down to a reasonable level.

What is Going On With Dividend Paying Stocks

In an era of low interest rates the dividend stock trade is real interesting.  If you can get a higher yield on a good quality stock than you can on a 10 year Treasury Bond it almost seems like a no brainer.   We all know that the Fed will eventually start raising interest rates, we just don't know when and by how much.  We also all know that when they do that it will hurt the prices of bonds, but what about dividend stocks?  The past couple of jobs reports have stoked fears of an earlier than expected Fed tightening.  Around both of those reports we have seen dividend stocks sell off quite a bit.  Year to date they are not doing that well.  Below is the year to date return (as of 3/6/15) of a couple of popular dividend stock ETFs compared to the S&P 500:

iShares Select Dividend (DVY)  -2.72%
Schwab US Dividend Equity (SCHD) -.28%
Vanguard Dividend Appreciation (VIG) .14%
S&P 500 1.00%

So what does history tell us about dividend stocks during rising rate environments?  Not that much.  I found a research paper from O'Shaughnessy that looked at the performance of dividend paying stocks over every period of rising rates

Overall they found that dividend stocks underperformed the market but the results were not that conclusive.  Even more interesting is that they found using a shareholder yield approach outperformed the market.  Shareholder yield is something we have been interested in for a while.  It looks at all the ways that companies return cash to shareholders---dividends, stock buybacks, and debt retirement.  We have just come out with a new tactical dividend stock strategy that uses shareholder yield as one of our metrics.

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.