We are commonly asked about the method we use to tilt our Dynamic Asset Allocation (DAA) portfolios between an offensive or defensive stance. Based upon years of extensive research we have developed what we refer to as The Macro Risk Indicator (MRI). The MRI is employed in the DAA models to determine whether to emphasize holding defensive assets such as treasury bonds or offensive assets such as equities. The MRI doesn’t forecast the future using obscure economic indicators as the name might suggest, but rather it uses momentum and trend-following to make decisions. Both momentum and trend-following of which have been demonstrated within academia and in practice by some of the world’s top portfolio managers to be the single most robust approach to making systematic decisions in financial markets (To learn more please read our whitepaper on Momentum). We apply the proven concepts of momentum and trend-following on the broad equity market indices such as Vanguard Total Stock Market – VTI or iShares S&P 500 Index – SPY. Why VTI/SPY you may ask? These indices are very good proxies for economic growth expectations that have a measurable and consistent effect on virtually all other assets classes.
In March, equity markets began with a sharp correction then had a brief rally after the FOMC meeting which did not manage to follow through. The S&P500 finished down 1.57% in an otherwise choppy and volatile month. In contrast, bonds managed to gain some ground finishing with positive performance on the month. Commodities resumed their long term downward trend with the exception of Copper. The industrial metal has begun to show signs of breaking out of a four year long bear market. Copper is a key metal used in building residential and commercial property, and higher prices may reflect an uptick in global economic activity. Economists often refer to metal as “Dr. Copper” since it has had a better than average ability to forecast economic trends. But two months of positive performance does not make a new trend, and at this point it is a development worth watching out for. In the currency markets, the US Dollar picked up additional momentum in spite of a drag from Federal Reserve communication suggesting they may not raise rates as fast as the market was expecting. As we have highlighted previously, the trend in the Dollar is well established and has been persistently strong across time periods.
A New Season for the Economy?
On March 20th the western world welcomed a change in seasons as spring replaced the long and cold winter. Why do seasons change? The four seasons are the result of differences in the level of sunlight—which in turn is determined by how our planet orbits the Sun and the tilt of its axis (source: Farmer’s Almanac). For world financial markets, the seasons are largely determined by the Fed which sets the level of interest rates. [Read more…]
The conventional method for portfolio management in the industry is to create portfolios with static weightings across asset classes. Different portfolios are created for investors with different suitability profiles. Rebalancing to policy weights is done perhaps once or twice per year. This is called a strategic asset allocation approach, and is the most widely used method in the industry. The greatest debate in the industry seems to be whether to hold passive index funds or ETFs versus actively managed mutual funds within this strategic asset allocation framework. We think that both camps are missing the ‘big picture.’ It is the asset allocation that matters, not the choice of components. Closer inspection reveals that the research does not support a strategic approach as being optimal for investors. Furthermore, investors have a hard time sticking with a strategic allocation. Evidence for this premise is demonstrated by their poor realized investment performance versus nearly any industry benchmark. Instead, research shows that a Dynamic Asset Allocation approach is optimal from an investment management perspective and may be easier for investors and advisors to stick with in the long run.
Dynamic Asset Allocation from an investment perspective implies that we change portfolio weights in response to movements across global financial markets. A large rise in interest rates for example should change our expectations for the future. Modern Portfolio Theory (MPT) tells us that a change in expectations should yield a mathematical change in portfolio allocations. These expected inputs can be generated using different factors in the quantitative field. The challenge is to figure out what factors to focus on and how to use them effectively. Momentum is the tendency of past trends to continue in the same direction. An asset that has been trending upwards generally tends to continue going up. Similarly, an asset that is outperforming other assets on a relative basis generally tends to continue to outperform. Therefore, a simple and effective model for asset allocation can use various forms of momentum analysis to determine: 1) which assets are likely to perform the best (or worst) and 2) whether they are likely to have positive (or negative) performance. Momentum is well-accepted in academia, and is considered the most pervasive anomaly in finance. More importantly momentum has been used exclusively by some of the best investment managers in the world. Using momentum within a dynamic asset allocation framework can potentially enhance returns and reduce risk.
February 2015: Reversing Course
This month we saw a reversal of fortunes for different asset classes: January’s winners became February’s losers and vice versa (see Figure 1). What is perhaps more significant about these reversals is that they happened in the context of longer term trends as well. Commodities showed rare strength against the backdrop of a brutal bear market. In the table below, you can see that the last 3, 6, 9, and 12 month returns for Commodities have all been significantly negative. The S&P 500 in contrast managed to recover from a dip in January. February performance was strong, and recent momentum has re-established the continuation of the bull market in U.S. Equities that began in 2009. Silver and Gold were among the worst performers, and may have extinguished hopes for a new bull market after having a good month in January. Perhaps February’s moves are signs of the start of new trends, but research shows to bet that the long term trend will remain intact.
The U.S. Dollar continues to remain in the most consistent uptrend of all asset classes, although there have been some signs of slowing momentum. Part of this strong bull market in the Dollar can be explained by the shift in monetary policy stance. The Federal Reserve continues to communicate the intention of beginning to raise rates sooner rather than later. [Read more…]
Much like the “Left Shark”- the costumed sidekick to Katy Perry at the 2015 Super Bowl- the stock market in January danced around aimlessly with a complete disregard for rhythm. Unlike the Left Shark, the sideways dance of the S&P500 was far less entertaining to investors.
January was an eventful month in world markets. Actions taken by the Swiss demonstrated that central banks around the world are becoming increasingly intertwined. The Swiss National Bank removed the Swiss Franc’s peg to the Euro in anticipation of the European Central Bank’s announcement of the planned creation of 1.1 trillion Euros ($1.3 trillion) to buy government bonds. The Federal Reserve announced that they will be adding “international developments” to the list of things they will be using to asses as they begin to “normalize the stance of monetary policy,” or allowing short-term rates to move off of the zero bound.
Expectations of this shift in Federal Reserve policy to allow rates to rise are diverging as can be seen in the flattening of the yield curve, driven by increasing yields at longer maturities (Figure 1), as well as the declining spread between the 10 Year Treasury and the 3 Month Treasury (Figure 2).
The confluence of factors developing in international central bank policy maneuvering have manifested in [Read more…]
As the prognostications come pouring in for 2015 it is informative to reflect back to what the “consensus” of experts were saying at the start of 2014. Many experts were calling for a bear market in bonds. They speculated that the Federal Reserve would raise interest rates as inflation would finally rear its ugly head and the U.S. Dollar would depreciate. Fast forward to the present, and the U.S. Dollar is breaking out to multi-year highs, interest rates are still near zero, and oil, an inflationary bellwether, is now trading in the 50 dollar range. In 2014 we also saw Long Term Treasuries rise over 25%! So much for the experts…. Looking at the yearly returns of 13 major asset classes since 2008 (Figure 1) it is apparent that the long-term prediction game can be difficult. The shifts in leadership from year to year are quite dramatic. Forecasting just one asset’s location in the table for next year is difficult enough, trying to forecast the location of 13 assets (as in Figure 1) is practically impossible as there are over 6.2 billion possible ways the assets could be arranged! So what will be the stories and trends of 2015? Better to bet that you will be surprised.
While no one can predict what will happen one year from now, perhaps the most successful and well-documented approach is to constantly shift your portfolio into the best performing assets over the previous 12-months and constantly monitor for changes in leadership. Research1 shows that the best-performing assets over the past 12-months (and at almost any interval between 1-12 months) outperform while the worst-performing assets under-perform. One of the reasons why this works is because sophisticated investors who have superior information begin to invest in certain assets in advance. Another reason is that investors are slow to react and adjust to new information – or they may interpret new information incorrectly. The DAA Portfolio also employs momentum using a proprietary model. The DAA Portfolio reacts to what is actually happening in the market rather than predict what will happen using some arbitrary rationale. If you are on a surfboard in the ocean, you are better off watching the waves that are actually coming in rather than sit in a room analyzing data to forecast when a wave will come days in advance. Given a choice between those two alternatives, reacting is more accurate and less risky than predicting. By predicting well in advance you have no means to correct yourself if you are wrong– much like the experts who called for rising rates missed a big move in bonds because they weren’t paying attention to what was actually happening.
Speaking of which, the month of December was much less dull than many predicted. The equity markets spent the first half of December declining before quickly reversing course and making new highs as the Federal Reserve adjusted its message to “patience” in thinking about when to decide to begin raising interest rates. This unusual volatility pulse in the context of a long-term Equity Bull Market caused the Macro Risk Indicator to become more cautious and shift allocations for the DAA Portfolio in January to a more Defensive stance (Figure 2).