The Year In Review: 2015 Investor Commentary
The past year was challenging for investors and particularly difficult for investors in strategies like ours. At Blue Sky our goal is to provide consistent results in any environment, however in 2015 we failed to achieve that goal. Our Dynamic Asset Allocation Strategies strive to do well in bull and bear markets, but we are aware from our research that sideways markets, like we experienced in 2015, are challenging for us. After delivering 9.43% in 2013 (July to Dec) and 9.16% in 2014 net of fees in our Moderate Strategy -7.05% was all that we could manage in the sideways market of 2015.
While this is the first year of underperformance for our strategies relative to our benchmarks, at times it has felt like an eternity. Our research tells us that the performance we experienced is within the expected range, but it is still painful nonetheless. We also know from our research that to be confident (95% confidence) that our strategy will outperform its respective benchmark we need at least three years and possibly five. Unfortunately, research on investor behavior shows that investors probably won’t give you that much time (source: Dalbar).
We believe strongly that we will protect investor capital in a protracted bear market, but our fear is that investors will make the costly mistake of switching to more passive and conventional strategies at the worst possible time. We are now in the seventh year of one of the longest bull markets since World War II. Markets are overvalued and the global economy is fragile. The market can certainly go up another year, but the odds are getting better that we will see a bear market as every month passes. In a bear market, to use an analogy, a passive investor is riding in a car with no brakes down a steep hill in a thunderstorm. We believe in having a car with brakes and a steering wheel so that we can avoid a terrible accident. If the market was a car race, the passive investor will embarrass us the most when a cautious approach was warranted but nothing bad ever happened. In that case they will beat us to finish line for that particular year. Such was the case with 2015.
Being a portfolio manager is a much more humbling experience than most professions. Due to the large random component in markets, it is impossible for even the most skilled investor to shine consistently every year and more importantly across every market environment. This year many market legends such as Warren Buffett, Bill Ackman and David Einhorn had some of their worst years in history. While we accept that our performance is within the realm of possibility, it does not make it any easier to live through even for the portfolio manager that has the most knowledge and conviction in the strategy. Cliff Asness of AQR describes the difference between knowing the odds and the research and actually having to live through a period of underperformance as a portfolio manager:
Well the single biggest difference between the real world and academia is — this sounds overly scientific — time dilation. I’ll explain what I mean. This is not relativistic time dilation as the only time I move at speeds near light is when there’s pizza involved. But to borrow the term, your sense of time does change when you are running real money. Suppose you look at a cumulative return of a strategy with a Sharpe ratio of 0.7 and see a three year period with poor performance. It does not phase you one drop. You go: “Oh, look, that happened in 1973, but it came back by 1976, and that’s what a 0.7 Sharpe ratio does.” But living through those periods takes — subjectively, and in wear and tear on your internal organs — many times the actual time it really lasts. If you have a three year period where something doesn’t work, it ages you a decade. You face an immense pressure to change your models, you have bosses and clients who lose faith, and I cannot explain the amount of discipline you need
Cliff Asness interview in Efficiently Inefficient, Lasse Pedersen
In this commentary we want to highlight what happened in the market in 2015 and more importantly how it relates to our strategy to diagnose what went wrong and why. The good news is many of the factors that caused us to struggle in 2015 are easily explained and we believe that they are short-term factors. The other good news is that we made a series of enhancements in October based on nearly a year of research to improve our ability to manage a variety different market environments/regimes. By adjusting our strategy and trading operations to have the potential to trade daily versus being limited to monthly reallocations we improved our responsiveness. This also ensures that we do not get stuck with a lot of risk exposure intramonth if the market falls significantly. We believe that this will pay off in 2016 and beyond. We will continue to improve and enhance our proprietary indicators and algorithms over time.
The Market in 2015
In 2015, we saw the market teeter on the verge of falling into a bear market several times only to recover just as fast. We also witnessed the first interest rate hike since 2006. Big headlines during the year included the problems in Greece and China, the vicious bear market in oil, peppered with dozens of statements from different Fed members that showed a glaring lack of consensus about policy. The action of the market indices in 2015 can be compared to riding the portion of the roller coaster where you are climbing and falling repeatedly and violently turning and twisting without a major rise or fall. The only difference is that when you are investing money, you are often riding blindfolded. Suffice to say this makes the ride a lot more dramatic.
In 2015, the market finished with a small gain despite substantial volatility along the way. What was most unusual was that there were no major asset classes that had standout performance. As a result, last year was generally a humbling experience for active managers regardless of style. Societe Generale did a historical analysis of asset class returns and concluded that 2015 was one of the hardest years to make money since 1937. In short, unless you were betting on a fall in commodities or emerging markets, a long-biased tactical manager had no opportunities to make significant returns. The table below summarizes broad asset class returns across different categories:
The average performance across categories was a loss of 8.3%, and no category offered positive average returns. Even hedge funds that had maximum flexibility failed to deliver positive returns. Within categories the best performer was domestic real estate followed by a passive position in the S&P500. In a nutshell, 2015 offered few opportunities to make any money.
What Drives the Performance of Our Strategies?
We are tactical managers that use momentum to determine which asset class categories to invest in, and also whether to be on offense or defense. Therefore there are two basic decisions that drive our performance: 1) Where to Invest and 2) How Much to Invest.
Where to Invest
We can invest in three major asset class categories: 1) Equities 2) Fixed Income and 3) Real Assets. Within those categories we can also over/underweight the best/worst performers. The benefit of this approach is that we are flexible enough to adjust to market conditions and invest in the better performing markets to enhance returns. As long as there are asset class categories and/or asset classes that are performing well we can produce returns even in bear markets.
How Much to Invest
To manage risk, we adjust our exposure to each of the asset classes that we are holding. We use a “Macro Risk Indicator” or MRI to determine whether to hold a full, partial or cash position in each asset class holding. By doing this we strive to provide a form of dynamic insurance against bear markets where there are long and protracted declines. This insurance is not free, it costs money in the form of potential whipsaw trades when the market does not trend significantly in either direction while generating substantial volatility. In other words, it works well in bull and bear markets, but not as well in sideways markets.
Case #1: Investing with Perfect Hindsight
To address the first driver – where to invest – we need to know how much opportunity was available in the market for a given year. It is instructive to see how this compares to the past 20 years of history. Imagine that you knew what the return of each asset class was going to be at the beginning of every year? Such a situation reminds us of a scene in “Back to the Future” where one of the characters has a sports almanac and travels back in time to bet on the outcomes that he knows in advance. Looking at broad asset classes – Domestic Stocks (VTI), International Stocks (EFA), Emerging Markets (EEM), Bonds (IEF), Commodities (DBC) and Real Estate (IYR) – we will assume that you could pick the best performer in advance. How would you have done every year?
Investing With Perfect Hindsight Using Broad Asset Classes (1995-2015)
What we see is that 2015 offered the lowest opportunity to make money over the past 20 years. The ETF tracking Treasurys was the “big” winner with a return of 1.3%. Even in 2008 and during the bear market from 2000-2002 there were areas to make significant returns. This confirms the analysis from SocGen, only they were able to track data back to 1937! Without significant opportunity available in 2015 the best we could do was to focus on real estate and equities—both substantial holdings throughout the year—and hope to add value through managing offense/defense.
Conclusion: There was nowhere to invest in 2015
Case Study #2: Sideways Markets- Market Noise Dominated Returns
To address the second driver – how much to invest – we need to look at how predictable the trends were in order to see if there was the ability to add value through the offense/defense decision. While the stock market managed to eke out a small positive return in 2015, it did so with tremendous volatility. In many ways 2015 was like a Seinfeld episode called “The Opposite” where George Costanza discovers that doing the opposite of what he normally does is the most successful choice. We can look at the S&P500 index and see how often the price crossed its moving average to determine how often the trend changed each year and compare that to other years across history. We then converted to a percentile ranking to show how this year ranked compared on average throughout time. The higher the percentile ranking, the more rare was the occurrence of a given number of trend changes across history.
Number of Trend Changes in 2015 Versus Last 20-years
On a rolling basis, the number of trend changes across any trend lookback from 10 through 120 days was among the highest across the last 20 years of history. On a calendar year basis, the intermediate trend lookbacks hit the highest number of trend changes in the last 20 years.
Conclusion: Trends failed to follow through in 2015 and instead the market moved sideways
Quant Nerd Corner: A more academic way of looking at sideways markets is to look at the absolute market return relative to volatility. Large absolute (positive or negative) returns relative to volatility indicate trending behavior. In contrast, small absolute relative to volatility indicate non-trending or sideways behavior. We can compare the absolute value of the 1-year S&P500 return relative to its implied volatility (VIX) to measure this ratio across history. We take the inverse of this ratio so that high values indicate substantial noise relative to the trend. Using a moving average of this value smooths the ratio over time.
In 2015, the noise relative to the trend (absolute return/volatility) reached the highest values in history. At least the good news is that this metric is highly mean-reverting— sideways periods occur over short time frames and are followed by long trending periods.
Conclusion: In 2015 it was difficult to figure out how much to invest.
Case #3: Benchmark Performance of Simple Momentum Strategies
If we learned that there was “nowhere to invest” in 2015, and that it was difficult to figure out “how much to invest” then a final question relates to how we performed versus the simplest and most basic models. This helps to serve as a benchmark for our own strategy and we may choose to track this performance in future monthly commentaries to gain a better understanding of relative performance.
The simplest momentum strategy is to pick the best performer between stocks and bonds using historical returns with different daily lookback periods. Essentially, momentum is a strategy that bets on the winning asset class. For example if stocks are up 10% and bonds are up 5% over the past 120 days, we will choose to hold stocks in our portfolio. If stocks are down -15% and bonds are up 7% we will choose to hold bonds in our portfolio. We will assume monthly rebalancing and next-day execution which we also used for most of 2015. Most momentum or tactical investors tend to use a 60-252 day lookback since this is more practical and has the most support in the research. However we show parameters between 20- 252 days in line with monthly, quarterly, semi-annual and annual lookback periods.
As you can see the performance of simple momentum strategies gross of fees and trading costs was absolutely terrible in 2015. This helps to also confirm our assertions regarding market noise and lack of opportunity. In comparison, we did substantially better than most of these simple strategies which demonstrates that there is nothing specific to the model construction that was responsible for our poor performance.
Conclusion: Momentum strategies performed poorly in 2015
Last year was a difficult year for our strategies but this can be traced back to simple explanatory factors that drive our performance rather than features specific to our model. Data indicates that these factors are mean-reverting: that means that we can probably expect better conditions for our strategy in the future. However, we don’t know when conditions will revert, although recent indications show that we may be entering a trending period with greater asset class dispersion. Simple benchmark momentum strategies had much worse performance, further confirming that this was a difficult year but our strategy did well by comparison. Momentum is validated by hundreds of years of research and is used successfully by many of the best investors. As a result, we plan to stick to our knitting and hope that the best years for Blue Sky are yet to come.
This article is copyrighted by Blue Sky Asset Management, LLC (“BSAM”) with all rights reserved. Any reprinted material is done with permission of the owner. This material has been prepared for informational purposes only and is not an offer to buy or sell any security, product or other financial instrument. Past performance is not necessarily a guide to future performance. All investments and strategies have risk, including loss of principal. The above referenced investment performance represents actual performance of a dollar weighted representative sample of client accounts which are solely invested in the DAA Composite Portfolio net of BSAM fees and expenses using the GIPS® performance methodology. GIPS performance verification is pending and subject to change. the actual performance of a dollar weighted representative sample of client accounts which are solely invested in the Blue Sky Dynamic Asset Allocation Moderate Strategy net of typical BSAM fees. Investment advisory fees charged by an investment adviser are not accounted for.
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The author(s) principally responsible for the preparation of this material are expressing their own opinions and viewpoints, which are subject to change without notice and may differ from the view or opinions of others at BSAM or its affiliates. Any conclusions presented are speculative and are not intended to predict the future of any specific investment strategy. This material is based on publicly available data as of the publication date and largely dependent on third party research and information which we do not independently verify. We make no representation or warranty with respect to the accuracy or completeness of this material. One cannot use any graphs or charts, by themselves, to make an informed investment decision. Estimates of future performance are based on assumptions that may not be realized and actual events may differ from events assumed. BSAM is not acting as a fiduciary in presenting this material. Benchmark indices are presented or discussed for illustrative purposes only and do not account for deduction of fees and expenses incurred by investors.
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