Wednesday, May 11, 2016

Changing the Structure of Tactical Return Generation

Tactical equity strategies that seek to outperform the market will typically try to accomplish this goal by limiting downside capture during bear markets.   By their nature, tactical strategies don't expect to get 100% upside capture during a bull market (unless they are using a decent amount of leverage) so the only way to outperform the market is through limiting downside capture.  If this can be done consistently then the tactical strategy won't outperform the market on a year by year basis, but it should outperform handily over a full market cycle. 

Since by their nature tactical strategies will have significant periods when they are out of the market, they will miss some upside.  The tradeoff is that they should also miss a lot of downside and a lot of volatility.   If the investor can take a long term view , instead of comparing the tactical strategy to the market every month, quarter, or year then they will experience very attractive returns vs. conventional investment strategies.  However, this is often easier said than done as bull markets are much more prevalent than bear markets and it is hard for investors to ignore the noise without making comparisons to the market.  Traditional tactical strategies are much better than modern portfolio theory and buy and hold but not quite optimal from an investors standpoint.

To be truly tactical a strategy must have times when it is out of the market or underinvested in the market.  These will usually be times of great risk, however during some of these times the market will still rally.  Since most tactical strategies take an intermediate to longer term view of markets, the times they are out or underinvested can be over a month, a quarter, or even a year.  The longer they are out of the market or underinvested the greater chance of missing out on upside capture.  A solution to this issue is to shrink time frames from rebalancing monthly or weekly, to rebalancing daily or even intraday.  So instead of being out of the market or underinvested for a month or longer, a strategy using daily and intraday time frames might be out for a day.  So instead of losing upside capture for a month, quarter, or year, such a strategy would lose upside capture for a day.  This can completely change the definition of a market cycle, instead of having to wait years to outperform the market the market cycle can be compressed into a month.  Instead of corrections lasting weeks, a correction in this case is a down day.  Instead of bear markets lasting a year or more, a bear market in this case could last a week.  Compressing the time frames in this manner allows the tactical strategy to outperform the market on a monthly basis and creates return streams that are much more palatable to ordinary investors.

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