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. 

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