Thursday, January 28, 2016

Forward Looking Due Diligence

One important skill we try to teach financial advisors is how to do forward looking due diligence on money managers and investment strategies.  Backward looking due diligence looks at what a manager or strategy did in the past and assumes, usually wrongly, that past performance will persist.  It is the path of least resistance as it is easy to just look at a stream of returns.  Forward looking due diligence tries to figure out whether past performance will actually persist into the future. 

Forward looking due diligence involves answering a couple of key questions:

1. How was the past performance achieved?
2. Why will it persist into the future?
3. And, in the case of a money manager, how will you change your strategy when market dynamics change?

As an example, lets say we are going to do due diligence on a large cap growth money manager and it is March 1, 2000.  If we do backwards looking due diligence all we would do is look at past returns and call it a day.  The manager would have had stellar returns from 1995-2000 and we would make the assumption that they would persist.  Of course we would have been horribly wrong as the manager would have tanked from 2000-2002.  Forward looking due diligence would have sniffed this out by answering the key questions:

1. How was the performance achieved?  You don't need to know the intricacies of the manager's strategy or how they pick stocks.  The answer to this question is simple, large cap growth stocks went up like a rocket ship in the late 1990's.  Since this manager owned large cap growth stocks they rode the market up. 

2. Why will this persist into the future?  Here is the problem.  Growth stocks earned about 30%/year for five years.  That's great but long term returns on stocks are closer to 10%.  Since we know markets mean revert it is safe to assume that not only can't the manager return 30% a year, they also need some losses to get back to more normal average returns.

3. If market dynamics change how will this manager's strategy change?  Here is another problem.  If market mean revert it is safe to assume that at some point we would need to see a bear market.  Since this is a buy and hold money manager they ride the market up, and they ride the market down.

Forward looking due diligence would have failed this money manager on two out of the three questions and it wouldn't take any advanced financial knowledge to figure this out.

Now lets say we are looking at a tactical manager who uses a simple strategy of buying the S&P 500 when it is above its 200 day moving average and selling below.  This strategy would have a very strong backtest most likely showing returns equal to buy and hold with less volatility.  The answers to the three questions would be as follows:

1. How was the performance achieved?  It was achieved because over the intermediate term markets trend.  This is based on psychology and the fact that once the smart money has started to buy or sell something it takes the dumb money a long time to join in.

2. Why will this persist?  Again since this is based on psychology the performance will persist, but we have a small problem here.  Since the manager uses only one methodology there will be times when it cycles in and out of favor, and when it cycles out of favor it can cycle way out of favor.  The performance will persist but it might not be ideal.

3. If market dynamics change how will this manager's strategy change?  This is the make or break question here.  Since we know the strategy will cycle in and out of favor and market dynamics could change to the point were it cycles out of favor more than it cycles in, it is very important to know if the manager is willing to improve their strategy if need be.  If the answer is no then it is time to move on.

Most of the biggest investment mistakes are made because investors only use backward looking due diligence to evaluate opportunities.  Forward looking due diligence can avoid many of these mistakes.

Tactical Diversification

In traditional asset allocation the goal is not to find the "best" asset class, it is to find the best combination of asset classes that gives the client the best chance of achieving the desired result.  Each asset class, be it large cap growth, value, small cap, etc, goes through periods where it appears to be the best.  Imagine you were doing due diligence on a large cap growth manager in March 2000 and looking at how they had done over the past five years.  It would be easy to fool yourself into believing you found the Holy Grail.  The same would go for any asset class, that is why you are better off combining asset classes than you are trying to be in just one. 

The same logic works in Tactical Asset Allocation .  There are a number of tactical methodologies (sets of tactical rules) that work over time.  Things like buying the S&P 500 when it is above the 200 day moving average and selling below or using a 2 period RSI to determine overbought and oversold points will have periods where they will do extremely well.  It is also not a rare occurrence to do a backtest on a set of rules and find that it does extremely well over the entire backtest period.  Tactical methodologies be even more misleading than asset classes as they can go through much longer periods where they are doing well than an asset class can.  However, just like there is no one best asset class, there is no one best tactical methodology.  Every methodology will fall on its face at some point.  Instead of expending effort to find the one methodology that does well in every market, the goal should be to have a mix of different methodologies and expend effort finding the combination that produces the desired results.

Wednesday, January 20, 2016

A Shorter Bear Market?

Nobody can predict the markets but it is useful to look at a number of different possible scenarios to make sure you are prepared when/if it happens.  This recent decline in the market has brought about a possible scenario involving an abbreviated bear market.  We have had three bear markets in history that haven't really lasted that long:

1. 1957 3 Months -20.7%
2. 1962 6 Months -28%
3. 1966 8 Months -22.2%

The sharp decline the market has had since December 2 increases the possibility that we are in another short term bear market.  If this is the case then the lower price target on the S&P 500 would be around 1630-1730 (1737 is the February 2014 low which would be the next major support area if we break the October 2014 lows).  If this scenario actually plays out the market could actually reach new highs by year end.  The Fed will have a lot to say about this, they are probably one and done for now until things stabilize, but things get really interesting if they reverse the December rate hike. 

Another possibility if this is a short term bear market is that we don't reach new highs but we bop around between the new lows and old highs.  For anyone who likes turbulence on a plane this scenario would be lots of fun.

There is still the disaster scenario if the oil continues to decline and China implodes.

Tuttle Tactical Management US Core ETF (TUTT) announced as a 2015 ETF.com awards finalist

We are pleased that TUTT has been announced as a finalist for best new asset allocation ETF in 2015 by ETF.com.  You can read the announcement Here

Friday, January 8, 2016

A Contrarian Investment Strategy for Any Market

The Holy Grail of investment management is to try to create an investment strategy that can generate returns in any market environment.  Markets either move up, down, or sideways.  It is not hard to devise a method to profit in one of those environments, being able to profit in all three is quite difficult.  This post will present a contrarian investment strategy that can do just that because it doesn't depend on the overall direction of the market, instead it focuses on the predictable emotional responses of human beings who trade in the markets.

Traditional Approaches

The traditional investment approaches all have significant flaws:

1. Buy and hold an S&P 500 Index Fund---In this approach you would just buy a fund that tracks the market (S&P 500) and hold onto it forever.  You would ride the market up and you would ride the market down.  The obvious flaw here is the ride the market down part.  You would have some great gains in a bull market and give them all back, and possibly then some, in a bear market.  All along the way this approach would also be very volatile so you would have to endure a wild ride as you move up and down with the market swings.

2. Asset Allocation/Modern Portfolio Theory--In this approach you would hold a diversified portfolio of assets.  You would have large stocks, small stocks, value, growth, international, and some bonds.  This would probably offer an improvement in volatility over holding an index fund and it could do a little better in a bear market. However, investors would still be subject to large losses as assets that may not be perfectly correlated when markets are rising become correlated when they are falling and there is panic selling. 

3. 60/40 Portfolio---In this approach you would have a static allocation to 60% stocks and 40% bonds.  The idea is that the bonds would provide protection against a market decline.  The problem is that the stocks will have much larger moves than the bonds, so in a bear market the bonds may increase in value but not enough to protect against large losses.  Furthermore, in strong bull markets the bonds will reduce returns.

4. Market Timing--A market timer tries to predict what direction the market is going to go in and position accordingly.  While this sounds good in theory, in practice nobody can accurately predict the market.   You might get lucky sometimes but over the long term this is not a winning investment strategy.

5. Traditional Tactical Asset Allocation--This approach seeks to be in harmony with market trends.  When markets go up you are in stocks and when they start to go down you get out of stocks. Unlike the market timer, the tactical investors isn't trying to predict the market they are reacting to it.  This approach is the closest to being able to work in all markets, it can work well when  markets go up and when markets go down, but it will tend to struggle in sideways markets as there is no real trend to hitch onto. 

None of these approaches work because markets are not random or efficient.  They are not random or efficient because human beings are making the trading decisions that move markets.  Human beings have emotions and there is no way to avoid having their emotions influence their trading decisions.  The two strongest emotions that dictate where stocks will go on a day to day basis are fear and greed. 

When the market is rising greed kicks in.   Maybe some good news came out and the market starts to go up.  Investors see this and get optimistic and start to buy and buy some more.  Then greed kicks in and investors move markets up to a level where people start to worry that prices have moved too far too fast.  Investors who bought also want to take their profits as they start to worry that their profits on paper might disappear.  Fear is starting to kick in.  This causes markets to move back down to some sort of equilibrium that balances out buyers and sellers.  The same process works on the downside.  Maybe some bad news comes out and now the market is declining.  Fear is a more powerful emotion than greed and investors start to sell indiscriminately as they are afraid that the markets will crumble and they will lose a lot of money.  Markets decline to a point where bargain hunters come in, greed is now starting to kick back in.  The bargain buying moves the market back up to some sort of equilibrium.

Greed and fear in the market cause the market to reach levels knows as overbought (moved up too far too fast and due for a retracement) and oversold (moved down to far too fast and due for a retracement).  Regardless of the overall longer term direction of the market these cycles play out on a daily basis with the market moving from equilibrium to overbought, back to equilibrium, to oversold, etc. 

Buy Low, Sell High

We have all heard the adage "Buy Low and Sell High".  It makes perfect sense, if you want to make money consistently then buy a security for a low price and sell it for a higher price, but investors don't do it.  Most investors believe that the most recent past equals the future.  When the market is going up they believe it will continue up and when it is going down they believe it will continue down.  This causes them to buy into rallies and sell into downturns, buying high and selling low.  Because of investors emotions causing the market to move between overbought and oversold, this is the exact opposite of what they should be doing.  A contrarian strategy would be to buy when markets are oversold, buying low, and sell when markets are overbought, selling high.

This is easier said then done.  To make this strategy work you need to be buying when most people are selling and when the talking heads in the media are spreading doom and gloom.  Then you need to sell when most people are buying and the media is telling everyone how wonderful things are.  Going against the herd is not easy, but it is profitable.  Study after study shows that the average investor doesn't make money in the market.  If you want to do well then  you can't do what the average investor does, you have to do the opposite of what they do.

There are a couple of steps necessary to make this approach work:

1. It needs to be quantitative---If you try to be a contrarian without a quantitative approach then your emotions will betray you.  You need to create a system and stick to the system.  A well thought out contrarian approach will be profitable most of the time if you stick to it.

2. You need to have multiple ways to measure if a market is overbought or oversold----There is no one measure that can tell you when a market is overbought or oversold.  There are a number of methods that work very well---RSI, cyclical analysis, intermarket analysis, etc---but they don't work all of the time.  Instead of trying to find the one approach that works best, you should blend multiple approaches.

3. While the overall direction of the market doesn't matter for this strategy you still need to treat uptrending markets differently than downtrending markets.  In a bull market greed is the dominant emotion.   From time to time it gets replaced by fear but it will quickly come back.  So in a bull market, buying the dips is almost a license to print money.  In a bear market fear is the dominant emotion.  It sill makes sense to buy the dips but every once in a while you will buy a dip that keeps on dipping longer than usual.  So, while in a bull market you might want to use leverage to boost returns, in a bear market you may want to keep large amounts of cash and/or Treasuries as a hedge and only buy the dips with part of the portfolio.

This contrarian strategy can work well in any  market environment---up, down, or sideways---because it doesn't rely on the long term direction to make money.  Instead, it relies on investors having predictable emotional responses to the daily moves of the market.

Thursday, January 7, 2016

How Tactial Asset Allocation Can Handle Market Corrections

I have been writing a lot lately about the new market environment and its implications for Tactical Asset Allocation.  Now that it looks like we are back in a market correction this article will go into more detail about how to handle these types of moves.

In the past any type of tactical methodology could successfully  navigate a market correction.  Corrections gave plenty of warning before the majority of the decline and before the majority of the recovery.  In this new market environment, corrections give little, if any warning, making navigating them much harder than ever before.  If practioners implement the following steps then market corrections can be an opportunity rather than something to be dreaded:

1. Use multiple tactical methodologies.  No one methodology works well in every  market environment.  Instead of trying to find the one "best" methodology, multiple, un correlated, methodologies should be combined.

2. Use some sort of optimization and/or regime switching approach to be able to move to the methodologies that are particularly suited to the present market environment.

3. The approach should take volatility into account so that you can increase risk when market volatility is decreasing and reduce risk when it is rising.

4. Emphasize counter trend models over trend following and fundamental.  Counter trend models which seek to buy into short term weakness and sell into short term strength can offer better risk adjusted returns than other types of models.  They also typically do this with much less time in the market than other methodologies.

5. Ladder your counter trend methodologies.  During a correction markets can get very oversold and very overbought.  Counter trend methodologies should be laddered just like a bond portfolio might be laddered so that they scale into and out of markets.

6. Use conditional filters.  Looked at over a large period of time it may seem as if the performance of different methodologies is fairly uniform.  However, when time frames are reduced you may find that a model has much better success with long trades when the underlying security is above a certain moving average, or corporate earnings are increasing, etc.  These types of things can be used to filter trades and reduce risk.

7. Use a short side.  You may not be comfortable being net short the market but using models that have the ability to short can offset the risk of models that may be long during a correction.

8. Incorporate extremely short term momentum models.  Over long periods of time, extremely short term momentum models will not work well.  However, they can navigate a correction very well, getting out near the top and back in near the bottom.  If you apply an optimization or regime switching approach you can be allocated to these models when the environment is conducive and out of them when it is not.

9. Eliminate as much of the rebalance date risk you can.  Because corrections are so sharp and come so quickly rebalancing a portfolio on one fixed date could bring a lot of extra risk.  Instead of rebalancing portfolios on one fixed date they can be tranched.  For example, a strategy that rebalances weekly on Mondays could be changed where 20%  of the portfolio is rebalanced on a daily basis. 

Incorporating these steps will help tactical strategies successfully navigate corrections in this new market environment.

Wednesday, January 6, 2016

Laddering Counter Trend Models

Tactical methodologies generally fall into one of three categories---trend following, counter trend following, or fundamentally based.  In a Trend Aggregation approach no one methodology is better than the other, each has markets it works well in and markets it doesn't, and a diversified tactical portfolio should have dynamic exposure to all three.  However, counter trend strategies will generally provide the best risk vs. return and work well in more market environments than the other two.  A counter trend model will use some sort of metric to determine whether a market is oversold (everyone who has sold is done selling and it is at a level that is likely to draw in bargain hunting buyers) or overbought (everyone who has bought is done buying and it is at a level that will entice people to take profits).  The model would buy what is oversold and sell, or sell short, what is overbought.  Basically acting counter to the trend. 

The one "Achilles Heal" that counter trend models can have is around V shaped corrections.  These are sharp selloffs that come with very little, if any warning, following by sharp reversals.  Because counter trend models buy into weakness they can be hurt when that weakness continues for a while.  In a "normal" market, a counter trend model would buy into a short term low and then sell on a bounce.  In a V shaped correction, the short term low can keep going lower, and lower.  Also, in a "normal" market a counter trend model would sell into a short term high and look to buy back in at a lower price.  In the reversal from a V shaped correction a market can move up quite a bit, leaving the counter trend model behind. 

Just like bond investors ladder bonds to protect from interest rate risk, tactical investors can ladder counter trend models to protect from V shaped correction risk. This is done by using models that have different metrics and time frames.  That way, all  models won't go  from bearish to bullish at the same time, they will tend to leg into markets on the downside.  The same concept works on the upside where models will tend to leg out.  A simple example of this could be combining different period RSI counter trend models.  The RSI is a measure of the magnitude of prices changes in a security.  Typically, high RSI readings can indicate a security is overbought and low readings could indicate that it is oversold.  A 2 day RSI model could be combined with a 3 day model and a 4 day model.  The 2 day model would need weakness over 2 days to get into a market and strength over 2 days to get out.  The 3 day model would need weakness over three days, and the 4 day model would need 4 days.  You could also change the levels that the model needed to hit, some models could need to be very oversold to trigger a buy, while others might just need to be moderately oversold.  Finally, some models could use a moving average filter, while others do not.  For example, an RSI model for the S&P 500 could shut off entirely when the S&P is below its 200 day moving average. 

Instead of using one counter trend model that will be either all in or all out, investors will be better served using multiple models that don't use the same time frames and metrics so they can scale in and out of volatile markets.