August 1st 2011: Intuitions Behind MyPlanIQ Tactical Asset Allocation

08/01/2011 Share 0 comments

As promised in our previous newsletters, we will try to outline several intuitions behind our Tactical Asset Allocation (TAA). However, let's first address a reader's comment that 'accused' us of trying to prove TAA is better than SAA in our previous newsletter.

Let's be clear: we are not trying to convince anybody to use a particular strategy, in regards to either SAA or TAA. In fact, since we are not registered investment advisors, we are not even qualified to provide such advice. However, we do try to provide research data and evidences as objectively as possible to support or dispute certain notions so that our users are informed when they make their own investment decisions. This is what our service is about.

There are three key intuitions behind TAA.

The first is a well known factor: momentum (also called trend). In investment, momentum means that if a security's price goes up, the security has a tendency to keep rising. Numerous research results have supported that momentum is indeed an important factor that affects investment returns. In fact, it is one of Fama-French-Carhart's four factors that explain a stock fund's return. The other three factors are market return, size return (large/small), and value return (value/growth). Momentum factor was first proposed by Carhart in his On Persistence in Mutual Fund Performance article and was later incorporated by Fama and French in their model. Notice this is only about stock investments.

Another classic study on stock momentum is Narasimhan Jegadeesh & Sheridan Titman's Momentum that showed "There is substantial evidence that indicates that stocks that perform the best (worst) over a three- to 12-month period tend to continue to perform well (poorly) over the subsequent three to 12 months."

Intuitively, momentum exists everywhere in nature. Furthermore, even in fundamental based stock investing, momentum is used: in fact, growth style stocks are from companies that exhibit strong earnings momentum. Fundamental momentum drives price momentum until the price gets out of hand (thus the bubble) or until the fundamental loses its momentum. Fundamental momentum is reflected by price momentum.

The second key intuition behind TAA is that momentum is much easier to observe and thus exploited for major asset classes. A major asset class represents a large economic or financial segment such as U.S. stocks, international developed country stocks, emerging market stocks, commercial real estates, commodities, or debts (bonds). The fundamentals of these asset classes drive their prices. Since these asset classes represent a large economic or financial segment, their fundamental change will not happen overnight and is much easier to be spotted and followed.

In physics, Newton's first law of motion states that an object in a state of motion tends to remain in that state of motion until an external force is exerted. This law of inertia bodes well to the concept of momentum.

Furthermore, momentum = mass x speed. So when 'mass' is large (such as the underlying fundamental of an asset class), the momentum becomes large. For an object (asset class) that has large mass, its acceleration is smaller (Newton's second law of motion: Force = mass x acceleration). As a result, it is much easier to observe (large momentum) and follow (smaller acceleration) a major asset class.

What this means is that following the trend of a major asset class such as S&P 500 index is much easier (and less risky) than following that of an individual company stock.

The third key intuition lies in a saying: there is always a bull market somewhere. By working among an array of diversified asset classes, often uncorrelated or negatively correlated, one can spot out earlier trend changes and capture the trend. A favorite (but not always certain (correct), as always in a statistical world) example is the relationship between long term U.S. treasury bonds and U.S. stocks. Usually more conservative and calculated, bond investors tend to react to underlying economic trouble earlier and drive up safe haven investments, such as treasury bonds, higher. Such a reaction is not necessarily always right. But when treasury bonds have a momentum that is higher than stocks, this is a good indication (i.e. high probability, again not with 100% certaintainty) that something worse will happen in the coming months. This was what happened before 2008 financial crisis: in late 2007, treasury holders started to drive up long term treasury bonds' prices to such an extent that U.S. stocks lost relative momentum against treasury bonds.

The second and third observations lead to the so called 'cross-asset' momentum notion. Representative research results in this area include the following two papers:

• Blitz, David and Van Vliet, Pim, "Global Tactical Cross-Asset Allocation: Applying Value and Momentum Across Asset Classes". Journal of Portfolio Management, May 2008.
• Asness, Clifford S., Moskowitz, Tobias J. and Pedersen, Lasse Heje, Value and Momentum Everywhere (March 6, 2009). AFA 2010 Atlanta Meetings Paper.  

As always, readers are reminded that there will never be a firm/binary proof that can show one strategy is better than the other, however how strong intuitions are. The key to success in such an uncertain world lies is getting yourself educated and comfortable with strategies you are using within your risk tolerance range.

Due to space consideration, we will continue to discuss momentum/trend following based asset allocation and MyPlanIQ's actual implementation in our future installments. In the meantime, interested readers are referred to research papers on our TAA page or cited above.

Market Overview

Markets were affected by the stalled debt ceiling deal negotiation between the Democratic party and the GOP. The impasse drove U.S. stocks and the rest of risk assets lower.

The most noticeable developments last week were:

• Gold and international, emerging market bonds were strong due to U.S. dollar weakness.
• Treasury bonds rose substantially
• Commodities and REITs remain in the top spots but international and U.S. stocks are now ranked lower than total bond index.
• The riskiest Frontier stocks is now ranked lower than cash (treasury bills).

For more information on how these assets are ranked, please see here. 

Benchmark Portfolios

It has been a very tough period for the so called 'macro' hedge funds as reported  by the Wall Street Journal in July. The report stated that "In the first half of 2011, the HFRX Macro Index, which tracks the performance of 500 hedge funds that follow a macro strategy, fell 2.2%."

Our TAA delivered a mixed result: for plans with diverse asset classes, it has done well but for those plans that have limited asset classes choices, it has suffered.

On the other hand, our SAA portfolios have done reasonably well, delivering no surprises. This clearly shows SAA's advantage: simple and predictable.

The following compares the performance of the model portfolios of six core asset and three core asset.

For more detailed comparison, see here.

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