Sunday, December 20, 2015

The Current Market Environment and Implications for Tactical Asset Allocation Part II

In the fist article in this series we talked about some of the implications of this new market environment with choppy markets and V shaped corrections.  Time will tell whether this type of market environment is the "new normal", something that is likely to happen more frequently, or an anomaly that is unlikely to happen very often.  It is possible that this type of market is an anomaly but if it isn't then we need to be prepared.  Most tactical strategies are built around momentum.  Traditional momentum methodologies will work great in straight up or down markets but they struggle in choppy markets.  Designing robust strategies that can generate attractive returns in choppy markets without sacrificing anything in straight up and down markets is challenging but not impossible.  Here are a few steps that practioners can take:

1. Deal with rebalance date risk----Instead of rebalancing a strategy all on one day, it can be broken up over perhaps 5 days where 20% of the portfolio is rebalanced each day.  This can minimize the risk of shifting an entire portfolio on one random day.

2. Use multiple, uncorrelated methodologies with some sort of optimization approach to decide allocations to each---Instead of diversifying by asset class you should diversify by tactical methodology.  An optimization approach like maximum Sharpe, maximum return, minimum volatility, or regime switching could be used to determine methodology allocation.  Using a rebalance date risk strategy you would cycle in and out of methodologies.

3. Overemphasize counter trend methodologies over momentum methodologies---counter trend methodologies are much more suitable for choppy markets and a well designed counter trend methodology shouldn't give up much, if anything, in an up market.  Counter trend methodologies using different logic and different markets should be used.

4.  Use models that can have a short side---Counter trend methodologies buy weakness and sell strength.  In a bear market or major correction short term weakness can continue for a time without any short term strength, locking the counter trend methodology in.  While we do not believe in going net short, we can combine long only counter trend methodologies with other models that can go short to reduce total equity exposure in bear markets and corrections.

5. Use very short term momentum methodologies to capture major upside in V shaped corrections---V shaped corrections are characterized by quick and sharp downturns followed by equally quick and sharp upturns.  Momentum methodologies with traditional lookbacks will not be able to perform well during these corrections.  Short term momentum methodologies can get out near the top and in near the bottom.  However, these types of methodologies are significantly flawed in other types of environments.  The optimization approach should ensure that you can cycle into these methodologies during market environments that are more conducive and out of them in other market environments.

Using these five steps in strategy design can create robust tactical strategies that can perform well in any type of market environment. 

Saturday, December 19, 2015

Some More Nails in the Mutual Fund Coffin

Two things happened this month that hammered a couple of more nails into mutual fund coffin.  First we saw the Third Avenue announced that they are suspending investor redemptions from their junk bond fund.  They way mutual funds work if an investor wants to redeem shares then the mutual fund manager either uses cash on hand or sells securities to send the investor cash.  Under normal circumstances this is no problem, funds keep cash and typically own liquid securities that can easily be cashed in.  However, under extraordinary circumstances, like when a fund owns junk bonds that are tanking and not easy to sell and when more investors than normal want cash, that can create a problem.  That is what happened with Third Avenue, they either couldn't, or didn't want to sell bonds at a steep discount so they locked shareholders in.  ETFs work differently.  Normally, when an investor goes to sell they don't sell to the ETF issuer, they sell to a buyer on the market.  If an investor, or investors, want to liquidate large amounts then a trading firm called an authorized participant (AP) sends a request to redeem to the fund custodian.  Instead of getting cash they get a basket of securities that the fund owns and it is their responsibility to sell it on the open market.  If a junk bond ETF ran into trouble like Third Avenue investors could still sell, however the APs would probably extract some cost for ending up with a basket of illiquid securities.  At least as an ETF investors would have the choice of selling at a discount or holding on.  Now they have no choice.

The second thing that happened is that Eaton Vance announced the launch of Next Shares.  These are non-transparent ETFs that will allow actively managed mutual funds to offer ETF versions of their funds without everyone knowing what they own.  Eaton Vance's launch will be followed by a number of other companies.  Wall Street still has to work out the technology to trade these but they will be cheaper and better than the mutual fund versions.  Any shareholder in an actively managed fund that has a Next Share version who doesn't have built up capital gains should switch from the fund to the ETF.