Wednesday, August 19, 2015

How Counter Trend Models Can Adapt to Changing Market Environments

Trend following methodologies attempt to buy into market strength and sell into market weakness.  Counter trend methodologies do the opposite, buying into market weakness and selling into market strength.  Trend following works under the premise that investments tend to trend over time and works best over intermediate term time frames (1-6 months).  Counter trend models work under the premise that over shorter time periods (daily to weekly) markets are dominated by noise, fear, and greed, causing them to overshoot to the upside and downside before snapping back to equilibrium.

Counter trend models can add needed diversification to tactical portfolios dominated by trend following models.  Trend following works extremely well in straight up or down markets, but doesn't work is well in choppy markets or equity peaks.  Trend following models also can't participate in bear market rallies.  Counter trend models don't work as well in straight up or down markets but do very well in choppy markets and equity peaks.  They can also participate in bear market rallies.  

The basic idea behind counter trend models is to use some measure to determine whether a market is oversold, overbought, or at equilibrium.  These could be static models that perhaps buy on n day lows and sell on n day highs or they could use some sort of dynamic logic.  Because markets are dynamic I have not seen static counter trend models work well over long periods of time.  Dynamic models are usually a much better option.  

There are two market factors that will determine how a counter trend model will react and perform, noise and volatility.  Noise is a measure of whether the market has a direction or not, while volatility measures the extent of up and down moves.  Market noise will determine how well a counter trend model will perform while volatility will determine what types of market moves a counter trend model will need for it to determine whether a market is overbought or oversold.  Counter trend models tend to work best in markets that are noisy and volatile.  They tend to work worst in markets that have low noise and high volatility (trend following models work best in this environment).   

So far in 2015 we have had an extremely noisy market with no direction, but volatility has been low.   In this environment---high noise, low volatility---an adaptive counter trend model wouldn't need large moves to determine whether the market is overbought or oversold and it could move in and out of noisy markets very frequently.  This is what we have seen in our counter trend models this year.  In a high volatility market, adaptive models would need larger changes to move in and out of markets.  

The Smart Beta Dilemma

The debate about whether smart beta strategies add value vs. market cap weighted indices will probably never end.  Smart beta strategies continue to launch with impressive backtested results that show outperformance over market cap weight.  The main questions revolve around whether those backtests are curve fitting and/or anomalies and whether that outperformance can persist.

If you are a long term buy and hold asset allocator then this presents a problem.  You are benchmarked against market cap weighted indices so any allocation to smart beta involves risk of underperformance.  You have to be sold on the backtest and the idea that any outperformance will be persistent.  If you are right you might add alpha, if you are wrong then you have a problem.

Tactical asset allocators don't have that problem.  Whether any smart beta idea is an anomaly or not isn't as relevant if you are not going to buy and hold something for ever.  The only relevant issue is whether or not a smart beta idea has periods where it outperforms a relevant market cap weighted index and how volatile that performance is.  Using relative strength or absolute momentum models of smart beta along with market cap weighted products allows the tactical investor to switch back and forth between smart beta and market cap weight (or cash in the case of absolute momentum).  Whether the outperformance will persist over the long term isn't relevant as long as it persists long enough for the tactical investor to make money and isn't so volatile that it moves down faster than a tactical model can exit.  

For the tactical investor, smart beta is another tool in the toolbox.  Maybe smart beta strategies are better than  market cap weighted indices, maybe they are not, but they do give tactical investors another set of assets to use in their models.