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.

Monday, May 9, 2016

What World War Z Can Teach Us About Investing

In the movie World War Z a virus starts turning people into Zombies and they threaten to take over the world.  The main character, played by Brad Pitt, is tasked with finding out what happened and how to cure it.  On this mission he hears that Israel was the only country not overrun by the zombies because they built a massive wall before the outbreak.  When he travels to Israel to find out how they predicted what was going to happen they tell him about the 10th man doctrine.  This is a committee of 9 people and a 10th man.  If all 9 people agree on something, it is the 10th man's responsibility to disagree, not matter how far fetched his findings might be, and prepare for that eventuality.   When the Israelis first heard word of zombies all 9 people agreed that it was nothing, the 10th man then had to disagree and build a wall just in case there was a zombie apocalypse. 

What does this have to do with investing?  Everything.  In investing the path of least resistance is to conform to what everyone else is thinking, that way if you are wrong everybody else is wrong at the same time.  It is also easier to believe the most recent past will equal the future.  So if we are in a bull market the consensus is that the bull market will continue, if we are in a bear market then the consensus is that the bear market will continue.  The 10th man doctrine would force you to look beyond the consensus at other possible scenarios and prepare for them. 

Since we have been in a bull market for 7 years one likely scenario is that it will keep going.  If you listen to CNBC that is probably the consensus, so you must be prepared for it.  However, what if it doesn't keep going?  Other likely scenarios are a bear market or the market we have seen since August, with large corrections followed by large rallies without really going anywhere, continuing.  Since you can't predict markets your portfolio has to be prepared for either of these eventualities as well.