Thursday, November 5, 2015

Tactical Duration

Investors are aware of the term duration as applied to bonds.  Duration is the measure of how sensitive a bond will be to moves in interest rates.  Typically, the longer term the bond is, the more sensitive to changes in rates.  Shorter term bonds are less sensitive to changes in rates.  Tactical methodologies also have duration in relation to how sensitive they will be to market movements.  Unlike bonds however, short term strategies have a high tactical duration, while long term strategies have a lower tactical duration.

When implementing a tactical methodology you are often looking back over a period of time to judge the trend of an asset class.  You also have to decide how often you do this lookback and rebalance your methodology.  Short term lookbacks and/or short term rebalancing make tactical strategies very sensitive to short term market shifts, creating a high tactical duration.  Longer term lookbacks and/or longer term rebalancing make tactical strategies much less sensitive to day to day market movements, creating a low tactical duration. For example, assume we wanted to create a moving average crossing system to trade the S&P 500.  It would generate a buy signal when the S&P crossed a moving average to the upside and a sell signal when it crossed a moving average to the downside.  You have two variables to your model---which moving average to choose, and how often to do the analysis.  If you pick a longer term moving average and a longer term analysis the model will be less sensitive to market moves.  A short term moving average with a shorter term analysis will be more sensitive.

A 200 day moving average with a daily rebalance applied to the market moves we saw during August, September and October would have gotten you out sometime near the end of August and would have gotten you back in near the end of October.  Assuming you were good with your trading you would have missed much of the decline and also much of the rally, but you would have ended up right about where you started, either a small loss or a small gain.  If instead of a daily rebalance you rebalanced at month end you would have gotten out at the end of August and back in at the end of October.  That would create a much different outcome as you would have experienced most of the loss and none of the rebound.

If you had decided to use a 50 day moving average and a daily rebalance you would have gotten out sooner and missed more of the loss.  You also would have gotten back in much sooner and experienced a good chunk of the gain.  However, if you had decided to rebalance this model monthly then it would have generated the same results as the monthly 200 day moving average.

During the most recent market decline the 50 day moving average with a daily rebalance would have generated the best results by far. Does that mean it is the best methodology?  No, it worked the best in that situation, but in other scenarios different combinations would have worked best.  During the market decline we had in January and subsequent rally in February a 50 day moving average with a daily rebalance wouldn't have done as well.  It would have exited the market three times during January, only to get back in each time at higher prices.  A 200 day moving average would have been much less sensitive, it would have stayed in during the decline in January and then experienced the entire rebound in February.

Some tactical practioners use methodologies based on some sort of fundamentals.  For example, we have a tactical model that looks at S&P 500 earnings.  Because fundamental factors are much less noisy and move much slower than market prices these types of methodologies tend to have the least sensitivity to market moves, and therefore have the lowest tactical duration.

So methodologies that have lower tactical duration (longer term lookbacks and/or longer term rebalancing or based on fundamentals) work best in certain markets while methodologies with higher tactical duration (shorter term lookbacks and/or shorter term rebalancing) work best in others.  Which ones should practioners and investors use?  Since no tactical duration is optimal the answer is to use all of them.  There are two ways to implement this.  Just like investors use laddered or barbell bond portfolios to lessen the impact of any one duration, investors can ladder or barbell tactical methodologies, combining different tactical durations.  More sophisticated investors could use an optimization approach that determines which duration is working best in a certain market and skew allocations to that methodology.

Whatever investors choose they need to be aware that different tactical methodologies have different sensitivities to market moves and need to allocate their portfolios accordingly.

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