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Tag Archives: asset allocation

Is Hope The Only Active Strategy Left?

There are so many stories going on in the press about the demise of the active management industry that one gets the impression that every portfolio manager must be feeling like a gambler pawning his last possession.

I recently attended a wealth management forum put together by Marketwatch were the commonly held view among attendees and panelists was that active management is dead and that the whole investment industry has been commoditized.

Certainly when evaluating security selection strategies relative to passively constructed benchmarks the recent record of active management leaves a lot to be desired. Times have been tough for active management shops and investors have been flocking to a myriad of index strategies. Exchange-traded funds (ETF) and multi-asset class strategies such as Target Date Funds have been the primary beneficiaries.

Barron’s magazine recently reported that only 33 percent of active equity managers managed to beat their benchmark last year. Outflows from actively managed strategies surpassed $288 billion (through November) – worse even than for 2008.

The popular S&P SPIVA report shows that the situation is not any better if one looks at a longer time period.  For example, as of June of 2016, only 8 percent of US large cap strategies managed to beat the S&P 500 index over the trailing five years.

Midcap and small cap managers did not fare any differently.  How about REIT managers? Not really – only about 11 percent of active strategies beat their index over the last five years.

International equity managers did fare a bit better than their US counterparts with close to 40 percent beating their index over the last five years.  32 percent of emerging market equity managers likewise beat their benchmark. A bit more hopeful but still nothing to write home about!

What about fixed income active strategies? A bit better in smaller pockets of the markets such as municipals, short and intermediate term investment grade where the majority of funds had higher returns than their corresponding index.

But among longer maturity strategies the situation was as abysmal as for equity managers. For example, only 3.5% of Long Government strategies outperformed over the trailing five years.  Even in the emerging market debt category only 8 percent of active strategies outperformed.

Is hope the only strategy left for the active investor? Just like the gambler down to his last pennies it sure feels lonely out there. All active management friends seemed to have slithered out the back door.

If the data cannot be tortured to confess, what about using theory to defend active management? Unfortunately, little help seems to be coming from the halls of academia.  Many years ago Bill Sharpe published his famous paper on “The Arithmetic of Active Management”.  The basic idea that active managers bear higher costs than passive investors thus creating a wedge in performance between the two has stuck as a reasonable theoretical explanation for the under-performance of  active management.

Recently, there has been some debate about some of the logic used by Sharpe (see the recent Lasse Pedersen paper) but in general while it is clear that index funds are not totally passive (due to new issues, repurchases, and index membership changes) the consensus still seems to be that the basic disadvantage of active management is due to its higher costs.

Another argument working against active management was espoused by another Nobel Prize winner Paul Samuelson even longer ago.  Samuelson held that the stock market is micro-efficient, but macro-inefficient. 

What this means is that at the level of individual stocks (where active managers ply their trade) it is much harder to beat the overall market but that the market itself may occasionally exhibit economically significant deviations from fundamental value.  Research by Jung and Shiller at Yale corroborates the Samuelson story of micro-efficiency and macro-inefficiency.

Every active manager knows that outperforming benchmarks is tough especially in a consistent manner.  A quote by Charlie Ellis of Greenwich Associates has stuck with me over the years. While I can’t remember the exact wording it goes something like this – “outperforming is difficult not because investors are stupid but because they are smart and compete with each other”.

I might have butchered Charlie’s quote but the basic idea is that with so many smart people participating in the markets today active management has become at least conceptually a zero sum game with the additional handicap of higher costs.

What this means is that on a capital weighted basis for every winner there must be a loser (assuming a fairly static market portfolio) but both must bear the burden of higher costs.  These costs are especially detrimental in an environment of lower capital market returns such as the one currently anticipated by Global Focus Capital.

Given all the evidence against active management what is the investor to do? Load up on ETF’s and run away from actively managed strategies?  The flow of funds data certainly seems to be confirming this behavior.  Active equity and bond managers have seen massive outflows to their strategies while flows to ETF’s have grown consistently for over ten years.

Continue reading

Sincerely,

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

 

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERROR

 

 

That Free Rebalancing Dessert Can be Costly!

dessert-1326898-638x428Rebalancing is a topic held near and dear to the heart of many investment advisors and often forms a key building block of what the advisor perceives as his or held value add.  If diversification is viewed as a free lunch then rebalancing is often viewed as free dessert.

Unfortunately while the benefits of true diversification stand the test of time the same cannot be said about rebalancing especially when done in a highly automated way such as frequently seen in many robo-advisor offerings.

What do we mean by rebalancing? There are many reasons why investment advisors intentionally shift the weights of their portfolio components over time.  The manager may have a changed view on future expected returns or they may deem a certain investment to now possess an unacceptable level of risk and thus wish to cut back on the exposure.  Others may wish to more closely track a commercial index and do a wholesale portfolio rebalance to minimize deviations from benchmark weights.

In general there are two basic underlying motivations for rebalancing.  The first is informational – the weighting structure of the portfolio is consciously changed to reflect an updated perspective on forward-looking estimates of return and/or risk.

The second basic motivation for rebalancing is purely driven by an automated rule that is agnostic to changing views on capital market risk and return conditions.  The rebalancing rule is followed religiously regardless of the capital market environment.

This second form of rebalancing and the focus of this note we refer to as a constant mix strategy.  Constant mix strategies take their cue solely from relative asset price changes over a chosen period of time and seek to bring portfolio weights back to a set of pre-defined time-invariant weights.

Why are many automatic constant mix rebalancing strategies viewed as a free dessert? Constant mix strategies trim relative winners and top up relative losers.  Assuming fairly priced asset classes at the beginning of the period a constant mix rebalancing approach can be construed as a value-oriented strategy buying up cheap assets and selling expensive assets.

The working assumption is that capital market forces will correct relative asset class mis-pricings.  Under this scenario markets are constantly displaying mean-reverting behavior.  Asset classes that go up must come down and vice versa.  Kind of a rollercoaster of relative performance.

Rebalancing programs will pick up nickels and dimes by selling relatively expensive assets and investing the proceeds into relatively cheap securities.  Transaction costs and short-term capital gain taxes will be incurred but according to proponents of such rebalancing programs, such costs will be offset by gains in portfolio values and as a side benefit – the icing on the cake – a reduction in portfolio risk. Risk in this context is frequently equated with downside volatility as valuation changes are viewed as the primary cause of mean reversion in asset prices.

The idea of buying low and selling high is alluring and under a mean reverting type of market a constant mix strategy would deliver on the promise. But the romantic notion of mean reverting markets often fades away as real capital market behavior with all of its flaws sets in.

Do real capital markets behave in the idealized mean reverting manner necessary for constant mix strategies to shine? Capital markets are ever changing as asset class fundamentals, risk characteristics and investor demand fluctuate for perfectly sensible as well as irrational reasons.  Capital markets are constantly calibrating supply and demand conditions and over short-term intervals changes in investor sentiment tend to overpower fundamentals.

There is also a lot of both academic as well as practitioner research on time series momentum.  In general the conclusion is that over intermediate time frames such as 12 to 24 months there are trends in asset class performance.  Mean reversion as a concept has been thought of more as a 3 to 5 year concept but over the typical time periods used in rebalancing programs (monthly or quarterly) the evidence is more consistent with trends in asset class prices.

Apart from taking advantage of mean reversion patterns in asset class performance how does rebalancing really work?  In a recent paper titled Rebalancing Risk, Granger, Greenig, Harvey, Rattray and Zou derive analytical formulas as well as provide empirical evidence on the behavior of constant mix strategies versus an approach that allows asset class weights to drift depending on relative performance.

In the paper they neatly decompose the performance drivers of the constant mix strategy.  What they show is that the constant mix strategy can be decomposed as follows:

Constant Mix Portfolio

=

Buy & Hold Portfolio

+

Selling Put and Call Options on Relative Asset Performance

The constant mix strategy carries negative convexity meaning that it outperforms when asset class return divergences are small by collecting the premium received for selling the puts and calls on the underlying portfolio.

However, when asset return divergences are large the selling of puts and calls results in losses and the buy and hold portfolio out-performs.  In extreme cases when one asset class significantly lags the rest of the portfolio such as in a stock market crash the negative convexity of the strategy can magnify the drawdown.

Another way to think of the constant mix strategy is to  put yourself in the shoes of the investor selling puts and calls.  When volatility rises holders of the options will benefit and commensurately sellers of options will see an economic loss. That is why the constant mix rebalancing approach is often described as a short volatility strategy.

The authors of Rebalancing Risk  conduct a set of empirical and simulation exercises using US stock and bond data. What do they find?

  • Constant mix portfolios exhibit small positive returns when relative asset class performance (stocks versus bonds in this example) do not perform too differently from each other.
  • When there are large differences in asset returns the tendency is to exhibit losses relative to buy and hold portfolios. The losses are magnified during periods of extreme relative performance.

The basic prerequisite for constant mix strategies to out-perform buy and hold strategies are reversals in asset class performance.  From a risk perspective, constant mix strategies add an element of risk as the approach involves additional option related features.  Justifying the use of a constant mix approach by implying risk reduction benefits is theoretically and empirically unfounded.

Access the full report here That Free Rebalancing Dessert Can be Costly!

 

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at http://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

Feeling Unsettled – An Update on Investor Risk Aversion

New England Spring DayInvestors have been feeling a bit unsettled this year. Right off the bat risky assets fell off the cliff only to recover strongly in March. Since then financial markets have felt like a typical spring day in New England –at times warm and sunny followed by cold winds and clouds.

Investors have become highly sensitized to changing capital market conditions – one moment feeling upbeat and confident and the next being rife with doubt and stress.

Back in 2009 Mohamed El-Erian then at Pimco described the changing mood swings of investors using the risk on/risk off label.

While the risk on/off concept makes a lot of sense to truly grasp the investment implications of such mood swings one needs an objective yardstick to properly identify these periods of euphoria and sheer despair.

At Global Focus Capital we measure investor sentiment using our Risk Aversion Index (RAI).  The higher the RAI the more fearful investor are, or in other words the more risk averse.  As a reminder to readers we classify investor risk aversion into three zones – Extreme Risk/Risk Allergic, Neutral, and Risk Loving/Seeking.

RAI MAY 2016Thus far in 2016 we have spent most of our time in the Extreme Fear/Allergic and the higher end of the Normal Zones.  Investors are clearly nervous.

The chart shows the ten day moving average of our daily risk aversion index.  During the early part of the year risk aversion was in the very high end as global stock and commodity markets were tumbling.

As risky assets found their footing in mid to late February so did investor risk aversion.  After almost reverting back to the Extreme Fear/Allergic Zone in mid-April, investor risk aversion has been trending down while still remaining in the high end of the Neutral Zone. Investor sentiment remains fragile.

What does it mean to be in each one of these risk zones?  Without going into all the portfolio construction issues let us just focus on returns.  A separate note will explore the risk management aspects of each risk regime.

We illustrate average monthly returns since 1995 for the major asset classes typically part of our asset allocation strategies at Global Focus Capital. Among equities and fixed income we split the asset classes into domestic and international and also include alternatives such as real estate and commodities.

RETURNS ACCORDING TO RAI.png

Periods of capital market stress such as those when the RAI is in the Extreme Risk/Allergic Zone (red bars) are difficult for investors holding risky asset classes such as equities.  In line with conventional wisdom the higher the perceived risk the more negative the average returns. When the RAI is in this zone all equities suffer but emerging markets takes the biggest hit (down 2.3% on average). Our two alternatives (Real Estate and Commodities) also take a hit but the overall negative effect is dampened due to their exposure to non-equity risk factors.

Fixed income on the other hand tends to exhibit positive average returns during this high risk aversion phase. In fact, the highest average returns of all asset classes correspond to government bonds (US and Non-US developed market).  US Government bonds for example show an average monthly return of 1% in the Risk Allergic Zone.

Let’s see what happens when the RAI falls in the Risk Loving/Seeking Zone (green bars). Here the situation is reversed. Asset classes with higher perceived risk tend to do better. Emerging market equities do best on average and small caps outperform large cap stocks. Real estate also does well. Within fixed income emerging market bonds do best, but in general the performance of safer assets lags significantly behind that of riskier investments. 

When in the Risk Loving/Seeking Zone it pays to be aggressive, but one must also be mindful of taking on too much risk in exchange for less and less potential reward.  Both the Long Term Capital Management implosion in 1998 and the 2008 Financial Crisis debacles occurred on the heels of investors being highly dismissive of the risks involved.  In both cases investors were taking on a disproportionate amount of risk for smaller amounts of potential return.

Finally when evaluating returns in the Neutral Zone (orange bars) it is interesting to note that, on average, equities tend to exhibit the best monthly returns when in this risk phase. All four equity classes show this tendency. Likewise real estate also shows the highest average returns in the Neutral Zone. Interestingly, the highest perceived risk asset within fixed income – Emerging Market Debt – also shows this characteristic.

Where is the RAI now and what should we be doing? Our barometer is currently entrenched in the Neutral Zone with a reading in the 59th percentile.  The RAI has been trending down (becoming a bit less risk averse) but remains in the higher end of the Normal Zone.  Pick your poison – low global growth, negative policy rates, disappointing corporate earnings, Brexit, a Greek default – investors are finding lots of reasons for remaining nervous.

ACTION PLAN ACCORDING TO RAI

In looking at the pattern of how investor risk aversion typically evolves our research has found that investor risk aversion tends to be sticky over the short-term

There is about a 65% probability of remaining next month in the current risk zone, a 25% chance of moving to the contiguous zone (say from Neutral to Extreme Risk) and only a 10% chance of moving from one extreme to the other (say Risk Seeking to Risk Allergic).

Our current reading of 59th percentile is on the high side for the Neutral Zone.  Coming off the Extreme Risk/Allergic Zone at the beginning of the year the portfolio implication is a lowering of tracking error and an increase in investment volatility.  We are thus advocating becoming less dissimilar from the benchmark if a relative return orientation is applicable.

When investor risk aversion is in the Normal Zone, low volatility strategies lose their effectiveness and we, therefore, do not recommend a low volatility tilt anymore.

Should investors get spooled again and our RAI return to the Extreme Fear Zone our recommendation would be to tilt toward lower volatility investments and sectors.  Such a set of moves would increase deviations relative to the benchmark and we would expect to observe higher levels of strategy tracking error.

What could sour the mood of global investors leading to a jump up in risk aversion? Potentially a whole host of issues frequently best understood in hindsight.  But on a more practical note we would highlight three areas of concern. First, should the UK vote to withdraw from the European Union we would expect a large spike up in investor risk aversion.  Risky assets such as stocks and commodities would likely take a big hit should this event occur.  We think that investors will react extremely negatively to Brexit especially in terms of their European stock and bond holdings.

The second concern involves contagion effects should a Greek default occur.  At the very least the interest spread between safe and riskier debt should jump up.  This would lead to a higher RAI and riskier investments will likely bear the brunt. Haven’t we seen this movie before? Yes, too many times but unless debt relief is in the cards we will we seeing another re-run this summer.

Finally, a Chinese growth scare could also trigger investor fears and bring about very negative consequences for emerging market equities and commodities.  The official target growth rate is between 6.5 and 7% with a focus on internal consumption and services growth.

The wildcards remains the health of the real estate market and the credit worthiness of off-balance sheet financing.  According to the IMF China currently accounts for over 16% of Global GDP when adjusted for purchasing power parity. The US accounts for a similar fraction of global growth. A significant negative revision to growth in either country would no doubt roil equity and commodity markets while leading monetary authorities to expand their loose monetary policy further into the future.

At Global Focus Capital we continue to believe that investment risk has been underpriced for a while and that there is no better time than now to evaluate one’s willingness to trade off risk in relation to potential reward.

Monetary authorities have provided investors with a nice safety cushion and allowed aggressive investors to benefit disproportionally.  Lackluster global growth and seemingly high absolute valuation levels for stocks and bonds are likely to lead to a decade of lower than average capital market returns where many investors will struggle to meet their stated target portfolio returns.

A proper understanding of realistic sources of potential returns and associated risks together with a willingness to remain tactically flexible with a portion of the overall portfolio will reward investors with a higher likelihood of achieving their goals without going too far out on the risk curve.

 

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at http://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS.

Beyond the Fog of Daily Capital Markets

foggy-mountains-1503271-1279x1926As an active manager one of the toughest psychological tasks is to invest for the long-term but have to deal with the daily noise and chatter of the markets.  The unrealistic expectation of having superior performance over all measurable holding periods leads to behavior often inconsistent with the goal of prudent long-term capital accumulation.

Given the volatility of capital markets a lot can happen over the short-term that over time gets washed away and becomes a mere blip on the radar. Conversely, other things that in the hustle and bustle of the markets seem minor turn out to be much more impactful over the long-term.  Empirical research shows that returns typically are more volatile in the short-term than warranted by changing fundamentals.  The net result is a lot of noise that dissipates once investors take a longer term view.

Taking a Step Back.  In recent years we have started thinking that stepping back a bit and watching the whole landscape unfold perhaps gives us a better sense of what really matters.

As archaic as this may sound to a high frequency trader in our research we have started focusing more on looking at company and capital market fundamentals over longer time periods.  Looking for example at year by year annual company financials gives us a better sense where business fundamentals are going.  Same with broad capital market relationships at the asset class level.  Aggregating annual periods to look at secular trends gives us another way to process information in a manner that may seem old-fashioned but that hopefully removes some of the noise.

Shifting our Focus toward Long-Term Performance.  We recently put together heat maps of annual performance for a variety of capital market breakdowns.  We looked across the major asset classes as well as within each asset class.  The results were revealing in each case.  We found a lot of surprises especially when looking at cumulative returns over the last ten years!

In this note I will share the heat map for the ten major asset classes used in our asset allocation strategies.  The returns for 2016 are as of January 22.  All returns are in US dollars and correspond to commonly used indices.

2015 ASSET MIX HEAT MAP

What We Expected:

  • Lots of variability from year to year – this we expected. After all this is the point of creating a heat map.
  • We did not see a lot of relative mean reversion over one or two calendar years. Again this was expected given the strong empirical evidence that momentum persists for up to three years. We did not see a lot of “going from worst to best” or vice versa.
  • Not all higher risk categories outperformed lower risk assets – this we expected given the hits suffered by equity-oriented assets during the Financial Crisis. For example, US bonds have out-performed international equity investments over the last ten years.  Needless to say this was achieved with much lower volatility.
  • US stocks had below average ten-year returns. The annualized return on US Large Caps (S&P 500) was 7.7%, more than 2% below historical averages. US Bonds (Barclay Aggregate) also had below average returns compared to history.

What Surprised Us?

  • A big surprise was the extremely poor performance of commodities (COM) – down 48% over the last ten years. For most investors the promise of uncorrelated returns to the stock market has come at a very high price.  Bye-bye commodity super-cycle!
  • I was also surprised by the 2X out-performance of US stocks compared to international equity indices. Some was due to currency but not all. There were major geographic performance differences over the last ten years.
  • US REITS (RE) edged out US large cap stocks by a slight margin over the last ten years. We expected a larger margin of out-performance but we had forgotten that in 2007 REITS were a precursor to what would happen during the Financial Crisis.
  • Emerging Market Debt proved to be a revealing surprise with a 97% total return. Pretty close to US equity market returns and vastly superior to international equities. Much lower volatility too.
  • The 91.7% return to the 60% S&P 500/40% Barclay Aggregate portfolio. The balanced portfolio lagged the S&P 500 by only 0.59% on an annualized basis but with much lower short-term volatility. Not bad for such a simple portfolio.

Insights to Share:

  • The short-term noise in the capital markets can obfuscate long-term secular changes as well as disproportionally focus the mind on events that over the long-term have little to no significance.
  • Expect lots of variability from year to year in terms of performance but over longer-term periods asset values will converge toward the fundamental drivers of return – income generation, growth and valuation.
  • To reinforce the previous point, a lot of capital market volatility is just noise and should be ignored unless there is a change to fundamentals.
  • Simple strategies such as the annually rebalanced 60/40 portfolio can prove sometimes incredibly effective at managing through the daily fog of markets
  • Effectively distinguishing noise from fundamental signal is the key goal of capital market research. Capital markets are always evolving but the fundamental drivers of return and associated risk should be the backbone guiding your perspectives.

Sincerely,

Eric J. Weigel

Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

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