From the Archives: Chaotic Evolution

February 6, 2012

John Kay of the Financial Times has recently written a nice article explaining why the chaos of free markets leads to significantly better results than centrally-planned economies, as has been tried and failed in the Soviet Union, East Germany, Nigeria,  and Haiti (and periodically makes inroads in economies found in Great Britain, the United States, and others.)

Kay explains that free markets generate superior results because:

Prices act as signals – the price mechanism is a guide to resource allocation rather than central planning. Markets are a process of discovery – an economy adapts to change through a chaotic process of experimentation. The third element is the capacity of the market to bring about diffusion of political and economic power. This is the most effective way to protect society from rent-seeking – a culture in which the principal route to wealth is not creating wealth, but attaching oneself to wealth created by others…

… Centralized systems experiment too little. They find reasons why new proposals will fail – and mostly they are right. But market economies thrive on a continued supply of unreasonable optimism. And when, occasionally, experiments succeed, they are quickly imitated.

If market economies are better at originating and diffusing new ideas, they are also better at disposing of failed ones. Honest feedback is not welcome in large bureaucracies, as the UK government’s drug advisers can testify. In authoritarian regimes, such reporting can be fatal to the person who delivers it.

Disruptive innovations most often come to market through new entrants. The health of the market economy depends on constant replenishment of ideas, often from unpredicted sources. If you had been planning the future of the computer industry in the 1970s, would you have asked Bill Gates and Paul Allen? If you had been planning the future of European aviation in the 1980s, would you have asked Michael O’Leary or Stelios Haji-Ioannou? If you had been planning the future of retailing in the 1990s would you have asked Jeff Bezos? Of course not: members of the politburo, cabinet or large company board would have consulted grey men in suits like themselves.

I wholeheartedly agree with Kay’s macro-economic analysis.

Furthermore, this line of logic also underpins the process that we employ to manage money.  Price (specifically relative price performance) acts as a signal to guide portfolio allocation.  We rely on rules-based relative strength models to sort out the winners from the losers from a given investment universe.  We buy any security that meets our criteria and sell every security out of the portfolio that fails to maintain strong relative strength.  There are no committee meetings where the portfolio managers debate the merits of the stocks before making a decision.  There is no emotional attachment to current holdings.  Rather, the models, which we have designed,  execute a plan that is based on a method with a track record of generating superior investment results over time.  A large percentage of our trades turn out to be either losers or just market performers.  To the uninitiated, the process can indeed appear to be chaotic.  It certainly leads to inferior investment results over certain periods of time (just like free-market economies periodically experience difficulty.)  It is only a minority of our trades that turn out to be the big long-term winners.  Frequently, the trades that end up generating the biggest gains are trades that made us scratch our heads when they were added to the portfolio.

It turns out that perceived chaos, on both the macro-economic level and on the portfolio management level, leads to very desirable outcomes over time.

—-this article was originally published 11/4/2009.  Price acts as a signal in portfolios too.

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Posted by Mike Moody

From the Archives: Thinking of Relying on an Expert?

February 3, 2012

From The Frontal Cortex:

In the early 1980s, Philip Tetlock at UC Berkeley picked two hundred and eighty-four people who made their living “commenting or offering advice on political and economic trends” and began asking them to make predictions about future events. He had a long list of pertinent questions. Would George Bush be re-elected? Would there be a peaceful end to apartheid in South Africa? Would Quebec secede from Canada? Would the dot-com bubble burst? In each case, the pundits were asked to rate the probability of several possible outcomes. Tetlock then interrogated the pundits about their thought process, so that he could better understand how they made up their minds. By the end of the study, Tetlock had quantified 82,361 different predictions.

After Tetlock tallied up the data, the predictive failures of the pundits became obvious. Although they were paid for their keen insights into world affairs, they tended to perform worse than random chance. Most of Tetlock’s questions had three possible answers; the pundits, on average, selected the right answer less than 33 percent of the time. In other words, a dart-throwing chimp would have beaten the vast majority of professionals. Tetlock also found that the most famous pundits in Tetlock’s study tended to be the least accurate, consistently churning out overblown and overconfident forecasts. Eminence was a handicap.

This is the very reason that we rely on systematic trend following. Experts may sound convincing, but don’t count on their predictions.

—-this article was originally published 11/17/2009.  Expert opinion is still worse than random chance.  Improve your odds with a systematic investment process.

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Posted by Mike Moody

From the Archives: Supply & Demand is Everywhere

February 1, 2012

NPR has a great story about monkey economics and how special skills in short supply translate into higher monkey income.  I first saw this on Greg Mankiw’s blog.  Even monkeys bow down to supply and demand!

—-this article was originally published 11/12/2009.  Human economics and monkey economics are exactly the same–scarcity creates value.  The story is quite funny too.

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Posted by Mike Moody

From the Archives: Another Way To Look at Modern Portfolio Theory

January 27, 2012

This week the noted management consultant, Russell Ackoff, passed away.  He was famous for gathering data and trying to use it to make the correct decision.  His fundamental theory was this:

All of our social problems arise out of doing the wrong thing righter. The more efficient you are at doing the wrong thing, the wronger you become. It is much better to do the right thing wronger than the wrong thing righter! If you do the right thing wrong and correct it, you get better!

Since the origination of Modern Portfolio Theory in the 1950s, academics and practitioners have been polishing it up and implementing in better and better ways.  It may just have been a case of getting more efficient at doing the wrong thing—and the wronger it got.  After 2008, even many of its supporters began to acknowledge that there were problems with its implementation.

This recognition has fueled a rush to the new magic potion, tactical asset allocation.  If tactical asset allocation is indeed the “right” thing, it should work out better than doing something wrong.  Yet there are significant challenges in the design and execution of a systematic tactical asset allocation process as well.  I think going forward, it’s going to be important to distinguish between marketers who are trying to exploit the latest fad and practitioners who have a well-thought-out and well-executed process for tactical asset allocation.

—-this article was originally published 11/13/2009.  It’s hard to do the right thing right, but don’t settle for doing the wrong thing righter!

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Posted by Mike Moody

From the Archives: Will I run out of money?

January 25, 2012

The number one concern among many investors approaching retirement is, “Will I run out of money?” This question is causing sleepless nights for many approaching retirement.  In fact, at the end of October, the U.S. Center for Retirement Research released a report that 51% of Americans are at risk of reduced living standards in retirement – including 42% of those in high income households. And if the cost of health care and long-term care were included, these numbers would be even higher.  It is just a fact that many people, including high-income earners, will enjoy a reduced standard of living in retirement due to inadequate savings.

However, simply pointing this reality out to a client with inadequate savings who is approaching retirement doesn’t do them a lot of good.  That information may be motivational to younger people who still have the time to increase their savings, but those approaching retirement need two things.  First, they need financial planning help to determine a prudent withdrawal rate on their portfolio to minimize the risk that they actually do run out of money.  Second, they need help determining a prudent approach to asset allocation to take them through the next 30 plus years.

One of the most influential studies on withdrawal rates and asset allocations in retirement was a 1998 paper by three professors of finance at Trinity University.

Its conclusions are often encapsulated in a “4% safe withdrawal rate rule-of-thumb.” It refers to one of the scenarios examined by the authors. The context is one of annual withdrawals from a retirement portfolio containing a mix of stocks and bonds. The 4% refers to the portion of the portfolio withdrawn during the first year; it’s assumed that the portion withdrawn in subsequent years will increase with the CPI index to keep pace with the cost of living. The withdrawals may exceed the income earned by the portfolio, and the total value of the portfolio may well shrink during periods when the stock market performs poorly. It’s assumed that the portfolio needs to last thirty years. The withdrawal regime is deemed to have failed if the portfolio is exhausted in less than thirty years and to have succeeded if there are unspent assets at the end of the period.

The authors backtested a number of stock/bond mixes and withdrawal rates against market data compiled by Ibbotson Associates covering the period from 1925 to 1995. They examined payout periods from 15 to 30 years, and withdrawals that stayed level or increased with inflation.   The table below shows the percentage of trials in which the portfolios survived for the entire testing period.

Table: Portfolio Success Rate: Percentage of all Past Payout Periods From 1926 to 1995 that are Supported by the Portfolio After Adjusting Withdrawals for Inflation and Deflation

Note: Numbers in the table are rounded to the nearest whole percentage. The number of overlapping 15-year payout periods from 1926 to 1995, inclusively, is 56; 20-year periods, 51; 25-year periods, 46; 30-year periods, 41. Stocks are represented by Standard and Poor’s 500 Index, bonds are represented by long-term, high-grade corporates, and inflation (deflation) rates are based on the Consumer Price Index (CPI). Data source: Calculations based on data from Ibbotson Associates.

Source: Retirement-Income.net

It becomes clear from reviewing this table that being “conservative” and allocating heavily to bonds may be safe in the short run, but it may very well lead to eating dog food over the long term.  Furthermore, any withdrawal rate over 3-4% is likely to be disastrous over a 30 year period of time.

The biggest opportunity for a financial advisor to be able to add value to their client’s dilemma is to be able to help them commit to an appropriate withdrawal rate and then to focus on the asset allocation.  The financial advisor who is able to clearly explain how a global tactical asset allocation strategy may be able to address the weakness of static asset allocation or strategic asset allocation and potentially decrease the probability of running out of money is the financial advisor who can make a real difference for their clients.

—-this article was originally published 11/24/2009.  The payout tables are based on 1926-1995 returns and suggest real conservatism in withdrawal rate assumptions.  Returns since 1995, and especially since 2000, have been lower than the long-term averages.  If you had opted for a high withdrawal rate, things would be tough right now.  Investors need to save more and invest intelligently and patiently to have retirement success.  Consider incorporating portfolio fecundity into your withdrawal assumptions because it will better reflect the current investing environment.

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Posted by Mike Moody

From the Archives: Why Americans Are in Debt

January 24, 2012

James Surowiecki has a fantastic article in the New Yorker about why Americans take on so much debt.  Incentives work and we have incentives to use debt embedded in our financial structure.  I’m a big fan of his writing anyway, but this short piece explains a lot.

John Kenneth Galbraith wrote that all financial crises are the result of “debt that, in one fashion or another, has become dangerously out of scale.”

That’s his thesis and in a couple of paragraphs he explains how we got there so efficiently.

—-this article was originally published 11/16/2009.  This article has a fantastic explanation of how effectively incentives work.  And a couple of years down the road we can see even more clearly how debt has saddled Western economies.

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Posted by Mike Moody

From the Archives: A Shocking U-Turn

January 13, 2012

After decades of some consultants and institutions ridiculing proponents of tactical asset allocation or deriding it as “market timing,” some have now apparently become convinced of its benefits as a risk diversifier and return enhancer.  OMG!  According to this article in Pensions & Investments, a number of firms are now poised to roll out their own tactical asset allocation solutions.  Bar the door and hide the children.

—-this article originally appeared 10/7/2009.  In the last couple of years, tactical asset allocation has actually become fashionable—because buy-and-hold isn’t working.  Of course, I don’t think buy-and-hold proponents are dead.  Like Monty Python’s parrot, they’re just resting.

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Posted by Mike Moody

From the Archives: The Brave New World of Asset Allocation

January 11, 2012

“We think asset allocation, certainly over the next five to 10 years, begs for a tactical component that is very hard for many investors to deal with because they aren’t structured to think about macro things like equity exposure…”  Ah, yes. Now everyone is singing the praises of tactical asset allocation.  The quotation above is from a major article in Barron’s over the weekend, which is an interview with Mark Taborsky, the head of asset allocation at PIMCO. (subscription required)  If you don’t get Barron’s, at the very least you might want to borrow a friend’s copy and take a look at the interview.

Tactical asset allocation is gaining notice because it is a very useful way to navigate what markets are actually doing, instead of what they should be doing in theory.  Taborsky says, “The majority of people who use the modern-portfolio-theory approach — and it has been with us for more than 50 years — recognize that it has many shortcomings. Anyone who has done it more than a year recognizes how far off their estimates of expected returns are by asset class and how far off their expectations of volatilities and correlations are. It is a very elegant approach, but it doesn’t really work that well.”  It’s refreshing to hear someone else make these points for a change!

Mr. Taborsky sums up the shortcomings of traditional strategic asset allocation very concisely:  ”The traditional approach to asset allocation relies on looking back in history to what asset classes returned. There is a huge reliance on mean reversion. There is a huge reliance on historic volatilities and correlations.”  The problem with reliance on historical norms is that when there is a regime change, and the norms change, you are completely at sea.  PIMCO believes that we have had a regime change, which they call the “new normal.”  If they are correct, strategic asset allocation could have a rough go of it for a while.

Tactical asset allocation seems to be the only logical way to respond systematically to the constantly changing relationships between asset classes.  Our Systematic RS Global Macro strategy (in separate account form or in mutual fund form in the Arrow DWA Tactical Fund) is designed to handle the rotation among asset classes for investors.  Given the fear that retail investors still harbor, it might be just the thing to consider when moving cash from the sidelines back into the markets.

Click here to visit ArrowFunds.com for a prospectus & disclosures.  Click here for disclosures from Dorsey Wright Money Management.

—-this article originally appeared 10/5/2009.  It’s amazing that retail investors are still as nervous now as they were then!  Strategic asset allocation is still subject to breakage every time there is a regime change.  Tactical asset allocation won’t always have smooth sailing either, but it has the prospect of being able to adapt to new conditions.

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Posted by Mike Moody

From the Archives: Prices are “Objective Reality”

January 9, 2012

Barry Ritholtz succinctly makes the case for relative strength (without actually using the term relative strength.)

—-this article originally appeared 10/7/2009.  My favorite quote from Barry’s piece:  “Indeed, prices matter a great deal more to traders than theories or annoying things like ‘Objective Reality.’ To a trader, prices ARE the objective reality; to them economic theorists are peripheral players trying to rationalize reality.”  Price is what matters, and relative strength uses only price.

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Posted by Mike Moody

From the Archives: Investor Overreaction

January 4, 2012

Investors overreact to good and bad short-term results.  So says Morningstar in their article “Why Your Results Stink.”  A quote from the article:

Why do investors make such a mess of things? In short, because of volatility, emotion, and a focus on short-term results. Volatile funds push all the wrong emotional buttons. When they go way up, we get greedy and buy. When they go way down, we despair and bail out. And we read too much into recent performance.

Destructive investor behavior has been well-documented and yet it persists.  Why?  My guess is that it is because most investors are operating without any kind of systematic framework for decision-making.  Creating a systematic process demands much more work.  You have to start with a theory and then do extensive, rigorous testing to see if your hypothesis holds up.  Even when it does, you will see quite clearly that your strategy is not always optimal–there will be certain quarters and/or certain market conditions in which it will perform poorly.

For some reason, investors have a hard time with this.  They don’t just want to win over time; they want to win all the time.  In their quest to avoid the psychic pain of occasional losses, they react emotionally with predictable long-term results.

With a systematic process in place, on the other hand, you’re not a loser just because you will lose periodically; you tend to be a loser if you quit before giving the process adequate time to work.  There are no guarantees in investing, but reacting emotionally is usually a route to poor results.

—-this article was originally published 10/13/2009.  With year-end performance results coming out shortly from many managers and mutual funds, this is the prime season for overreaction.  Bad year, dump the manager.  Good year, double up.  That’s how investors pile into the hot asset classes right before they blow up—or bail out of the styles that are poised for good performance going forward.

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Posted by Mike Moody

From the Archives: What It Takes to Manage Money

December 8, 2011

William Bernstein has an eclectic background and is well-known in the world of finance.  He’s done a lot of thinking about asset allocation and runs the Efficient Frontier website as well.  An excerpt from the foreword of his new book has a discussion of the qualities it takes to manage money well.  The emphasis is mine.

Successful investors need four abilities. First, they must possess an interest in the process. It is no different from carpentry, gardening, or parenting. If money management is not enjoyable, then a lousy job inevitably results, and, unfortunately, most people enjoy finance about as much as they do root canal work.

Second, investors need more than a bit of math horsepower, far beyond simple arithmetic and algebra, or even the ability to manipulate a spreadsheet. Mastering the basics of investment theory requires an understanding of the laws of probability and a working knowledge of statistics. Sadly, as one financial columnist explained to me more than a decade ago, fractions are a stretch for 90 percent of the population.

Third, investors need a firm grasp of financial history, from the South Sea Bubble to the Great Depression. Alas, as we shall soon see, this is something that even professionals have real trouble with.

Even if investors possess all three of these abilities, it will all be for naught if they do not have a fourth one: the emotional discipline to execute their planned strategy faithfully, come hell, high water, or the apparent end of capitalism as we know it. “ Stay the course ” : It sounds so easy when uttered at high tide. Unfortunately, when the water recedes, it is not. I expect no more than 10 percent of the population passes muster on each of the above counts. This suggests that as few as one person in ten thousand (10 percent to the fourth power) has the full skill set. Perhaps I am being overly pessimistic. After all, these four abilities may not be entirely independent: if someone is smart enough, it is also more likely he or she will be interested in finance and be driven to delve into financial history.

But even the most optimistic assumptions — increase the odds at any of the four steps to 30 percent and link them — suggests that no more than a few percent of the population is qualified to manage their own money. And even with the requisite skill set, more than a little moxie is involved. This last requirement — the ability to deploy what legendary investor Charley Ellis calls “ the emotional game ” — is completely independent of the other three; Wall Street is littered with the bones of those who knew just what to do, but could not bring themselves to do it.

I am most interested in the emotional game.  We use a systematic investment process that is objective and unemotional for just that reason, but our firm is rare in the industry.  Most everyone else flies by the seat of their pants for security selection and asset allocation.  It’s very possible to have some remarkable successes that way when you hit something just right, but it’s very difficult to sustain the success, especially when, as Bernstein phrases it, the tide goes out.

I was working late last night on proxies (fun, fun) and happened to answer a call from an investor interested in using our services.  He talked a good game, told me all about his views on the dollar and the market, and told me that he was a “sophisticated investor.”  But what had he done?  He was invested with a value manager and hung in until November 2008, when he finally lost his nerve and sold out.  He mocked the value manager for continuing to buy on the way down because securities were perceived bargains, although that is pretty much the job description for a value manager.  He felt good that he had missed a few months of the bear market, from November to March 2009.  But he never had the nerve to get back in, and railed against the rise in the market as a “false rally.”  I’m sure that characterizing market action that way helped ease the sting of completely missing the boat.  Since the S&P 500 is now higher than it was in November, his emotions have cost him a fair amount of money.  This is a very typical investor and a very typical sequence–the first story or impression you get is rarely the whole story.  The client was pretty sophisticated about markets, but totally lacking in emotional resilience.

Following the path of least emotional discomfort is a road to failure.  In my view, using a tested, systematic process is the only way to succeed in the very long run.

—-this article was originally published 10/23/2009.  Recent volatility and news sensitivity have caused investors to damage themselves again, just like 2008-2009.  Emotional resilience is still the key to long-term investment success.

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Posted by Mike Moody

From the Archives: Commodities Can Burn Your Fingers

December 2, 2011

The Financial Times of London had an interesting article about commodities that pointed out that buy-and-hold is not a useful strategy to employ.  Commodities, because of the frequent lack of correlation with other asset classes, can be an outstanding tool for risk diversification in a portfolio, but they cry out for use in a tactical fashion.  For retail clients, being able to get commodity exposure through ETFs and ETNs has been extremely helpful, but it may be important to have some kind of systematic tactical process in place as well.  Holding positions for long periods of time just to have exposure may not be the optimal strategy.

—-this article was originally published 10/13/2009.  Buy-and-hold in the commodity futures world is just as dangerous as ever, what with contango waiting to jump up and bite you.  A rotational strategy makes sense for exposure to this asset class.

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Posted by Mike Moody

From the Archives: Look Who’s In Counseling

November 30, 2011

—-this was originally published 10/26/2009.  Although the US dollar has recently held up relatively well versus the Euro (until today!), there is still significant concern about its long-term status.

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Posted by Mike Moody

From the Archives: Stops Degrade Performance

November 23, 2011

Ok, I wrote that just to tweak you.  But it is true–most of the time.  Perry Kaufman, in his book Smarter Trading discusses (and provides evidence) stops and the effect they have on trading systems.  Most of the time, they make your performance worse–but that doesn’t mean you can do without risk management entirely.  At the very least, you need some kind of catastrophe insurance, whether it is a very wide stop loss or some kind of exposure regulation for an entire portfolio.

This graphic from our friend at Blackstar Funds, Eric Crittenden, by way of Michael Covel’s Trend Following website, shows that a lot more stocks go boom than academics would predict, making that catastrophe insurance quite handy.  And they don’t always come back, by the way, a fact that makes bottom-fishing akin to running through a dynamite factory with a match.  You might live, but you’re still an idiot.

—-this article was originally published 10/23/2011.  Bottom-fishing is no less dangerous today.  Using relative strength works counter to that strategy.

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Posted by Mike Moody

From the Archives: Performance Chasing

November 21, 2011

Jason Zweig, in an interview with Morningstar, points out that performance chasing is seen in all parts of the investment world:

There was a beautiful study that was published in the The Journal of Finance a couple of years ago about the selection of institutional money managers. It basically found that the professionals who pick money managers, in this case it was pension funds, tend to buy high and fire low. They invest in whichever managers have the best trailing three-year performance and then sell whichever have the worst trailing three-year performance. The study showed that if they had flipped their decisions–if they had bought the ones with the worst three-year performance and sold the ones with the best–they actually would have gotten better returns. And of course if they had done nothing–if they had just put the portfolio on ice–they also would have done better. Performance-chasing, despite all the propaganda you hear in the financial industry, is not purely the province of retail investors. It’s not the so-called “dumb money” on Main Street that buys high and sells low. Everyone does it.

You have three choices: you can go with a manager when they are hot, you can go with a manager when they are cold, or you can do nothing.  Investors, in aggregate, make the worst choice of the three!  If you don’t have the emotional resilience to go against the grain, at least have the patience to sit on your hands.

—-this article originally appeared 10/23/2009.  We’re a couple of DALBAR reports down the line and investors, in aggregate, continue to make the worst possible choice.  Your best bet is to pick a sound strategy and add to it during periods of underperformance.

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Posted by Mike Moody

From the Archives: Entitlement Society

November 4, 2011

Click to enlarge

—-this article was originally published 9/3/2009.  Calvin and Hobbes demonstrate a keen understanding of economics as currently practiced by some companies.

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Posted by Mike Moody

From the Archives: Is the Endowment Model Dead?

November 3, 2011

Mike Hennessy, co-founder and managing director of investments at $9 billion Morgan Creek Capital Management, doesn’t think so.

The “endowment model” practiced by most of the big university endowments and many big foundations (but also by some astute smaller endowments and foundations) has overwhelmingly outperformed virtually all other models over any reasonable time period, and has done so for a very long time now…The model employs the broadest asset allocation possible, literally encompassing all asset classes globally and virtually all strategies globally.

Hennessy’s comments also touch on the role that ETFs play in making this type of  model available to all investors, not just the endowments.

One relatively new twist on the model is a result of the industry having evolved to make available a staggering array of efficient, inexpensive and highly liquid investment vehicles such as ETFs (Exchange Traded Funds) and other liquid investments which make it easier, more effective and less punitive than ever to infuse liquidity within the model.

The expansion of the ETF universe has made possible our Arrow DWA Balanced Fund (DWAFX) and Arrow DWA Tactical Fund (DWTFX).  As a reminder, last month the Arrow DWA Tactical Fund (DWTFX) completed its conversion to a global macro style so that the strategy is now aligned with our Systematic RS Global Macro strategy which is available as a separately managed account.

Click here to visit ArrowFunds.com for a prospectus & disclosures.  Click here for disclosures from Dorsey Wright Money Management.

—-this article was originally published 9/15/2009.  Judging from the asset flow to our ETF funds, investors still find the endowment model fairly compelling!

 

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Posted by Mike Moody

From the Archives: The Global Flow of Business

November 2, 2011

The Times Online reports that Brevan Howard, the UK’s largest hedge fund ($27 billion), is planning to relocate  to Switzerland due to  a new performance tax of 50% facing the firm.  More firms are likely to follow.

Some politicians seem totally unfamiliar with the concept of elasticity, which is taught in every basics economics course.  They seem to think that the imposition of higher taxes will simply result in more revenue without realizing that onerous taxes could have just the opposite impact on revenue.  In economics, elasticity is the ratio of the percent change  in one variable to the percent change in another variable. It is a tool for measuring the responsiveness of a function to changes in parameters in a relative way.  A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the quantity demanded or supplied.   On the other hand, an inelastic good or service is one in which changes in price witness only modest changes in the quantity demanded or supplied, if any at all.   In the case of Brevan Howard, and many, many others, apparently the elasticity  associated with this tax hike is greater than imagined by the politicians.

In our global economy, talent is willing to relocate to locations where business is treated more favorably.  Therefore, an investment strategy should be able to do the same.   We take great comfort in knowing that our global tactical asset allocation strategies are able to adapt to these changes in the flows of business from one part of the world to the other with great ease.

—-this article first appeared 9/28/2009.  If anything, globalization has increased since this article was first published.  Politics in Europe—or anywhere else—have the potential to impact economic growth in the US and other regions.  The one thing that hasn’t changed is that money still goes wherever it is treated best.  Your investment strategy should be elastic as well.

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Posted by Mike Moody

From the Archives: The Dilemma

October 25, 2011

O’Shaughnessy has another insightful article discussing the flood of money out of equity funds and into bond funds this year.  Click here to read.  He shows the results from shifting allocations dramatically to fixed income after the last 14 recessions…not pretty.

This is quite the dilemma for investors.  Their heart tells them to shun stocks.  Their mind tells them that they should overweight stocks.  I can’t think of a better reason to give serious consideration to a global tactical asset allocation fund, like our Global Macro strategy, that systematically allocates to different asset classes based on their relative strength.

Click here for disclosures from Dorsey Wright Money Management.

—-this article originally appeared 9/10/2009.  The sluggish economy of the last several years has done nothing to resolve this dilemma for investors.  Global Macro still makes a lot of sense.

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Posted by Mike Moody

From the Archives: The Truth About Rebalancing

October 20, 2011

Among devotees of strategic asset allocation, rebalancing is considered to be a crucial tool for risk management.  Jason Zweig of the Wall Street Journal does the math and points out that rebalancing sometimes just makes things worse.

The truth is that no investment method is magic.  Every single method ever devised has advantages and disadvantages; thus there will always be alternating periods of outperformance and underperformance.  Retail clients, by their performance-chasing behavior, obviously believe otherwise.  Sorry to have to break this to them–you’re better off doing careful due diligence to find a strategy likely to outperform over the long run and then just sticking with it.

—-this was originally published 9/24/2009.  There is still no magic investment method, but the pursuit of it continues unabated.  Be especially wary of magic methods during difficult economic times.  It’s much more appealing than thorough due diligence, but it may not serve you well in the end.

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Posted by Mike Moody

From the Archives: Bubble-nomics

October 18, 2011

Alan Greenspan used to believe that bubbles did not exist.  One group of economists thinks bubbles can’t be stopped, while others think they can be identified and should be deflated.

In reality, bubbles occur all the time and for all sorts of reasons, some rational and some not.  Often bubbles have a fundamental basis originally, followed on by mob psychology at the end.  Every bubble is a little different and a lot the same, as this insightful article from the International Herald Tribune points out.

The history of markets is one bubble after another, some large and some small.  This is the main reason that we are not concerned about trends disappearing from the markets.  Relative strength gives us a way to measure the strength of the trends, in order to pick out the trends we want to participate in—the strongest trends.

—-this article originally appeared 9/15/2009.  Despite the very challenging environment lately, unless human nature somehow changes, I suspect trends will be with us forever.

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Posted by Mike Moody

From the Archives: Why Predictions Are Often Wrong

October 14, 2011

We all know how difficult it is to get predictions right.  And even when the forecaster is extremely knowledgeable about the topic—maybe even the world’s leading expert—the prediction is often wrong.  Why does that happen?

In a great post about predictions, Phil Birnbaum notes, “The problem is that no matter how much you know about the price of oil, it’s random enough that the spread of outcomes is really, really wide: much wider than the effects of any knowledge you bring to the problem.” (The emphasis is mine.)  In other words, the standard deviation around the mean is so huge that getting it right is simply a matter of luck.

Rather than rely on prediction (luck), we rely on our systematic process to guide our investment decisions.  A systematic process is not always correct either, of course, but the decisions are made on the basis of data rather than relying on luck.

(Thanks to John Lewis for the article reference.)

—-this article originally appeared 9/23/2009.  The spread of outcomes in any situation is really, really wide, and it seems especially so when politics are heavily involved in markets.  The range of outcomes for the peripheral European debt problem, for example, is mind-boggling.  You’re better off sticking to the data than going with an unreliable forecast.

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Posted by Mike Moody

From the Archives: Warren Buffett on the Dollar

August 12, 2011

Buffet on the status of the fiscal predicament of the United States:

…Last fall, our financial system stood on the brink of a collapse that threatened a depression. The crisis required our government to display wisdom, courage and decisiveness. Fortunately, the Federal Reserve and key economic officials in both the Bush and Obama administrations responded more than ably to the need.

They made mistakes, of course. How could it have been otherwise when supposedly indestructible pillars of our economic structure were tumbling all around them? A meltdown, though, was avoided, with a gusher of federal money playing an essential role in the rescue.

The United States economy is now out of the emergency room and appears to be on a slow path to recovery. But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself…

Buffet on the solution to the fiscal predicament of the United States:

…Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes. In fact, John Maynard Keynes long ago laid out a road map for political survival amid an economic disaster of just this sort: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens…. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose….”

Unchecked greenback emissions will certainly cause the purchasing power of currency to melt. The dollar’s destiny lies with Congress.

In case you don’t have faith in Congress to do the politically difficult things, like cutting expenditures, investors can find some solace in the fact that a weakening dollar will benefit your foreign investments immediately because it helps drive those international returns higher as international assets appreciate in value relative to the dollar.

For example, a U.S. investor in the MSCI EAFE Index over the past five years (8/18/04 – 8/18/09) is up 12.74%, while the European investor in the same index and over the same time period is down 1.74% – all thanks to a declining U.S. dollar.

Click here to read Buffet’s complete Op-Ed in today’s NYT.

—-this article originally appeared on 8/19/2009.  Congress is making Warren Buffett look like a prophet.

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Posted by Mike Moody

From the Archives: Master of Disaster

July 29, 2011

Ken Rogoff is just a brilliant guy. First of all, he is an International Grandmaster in chess and in the 1970s won the U.S. Under 21 Championship when he was only 16. After getting his Ph.D. in Economics from M.I.T., he served as the chief economist at the International Monetary Fund, where he had to deal with systemic banking failures in a number of nations. He and Carmen Reinhart have written insightfully on the banking crisis in the past. Mr. Rogoff might know more about how to solve banking crises than anyone, and certainly more than Congress or their lobbyists.

His latest piece is important reading. He concludes “within a few years, western governments will have to sharply raise taxes, inflate, partially default, or some combination of all three.” Possibly like the rest of us, he sees little prospect that Congress will ever actually cut spending.

Most western nations, and certainly the U.S., have not been in that position in the recent past. If Mr. Rogoff’s scenario comes to pass, having a Global Macro-type portfolio could be a lifesaver. The only way to protect hard-earned capital might be to have investment access to a wide range of asset classes around the globe.

Click here for disclosures from Dorsey Wright Money Management.

—-this article originally appeared 8/27/2009.  We’re two years down the road now and it looks like all of these things are going to happen, or have already.  As the saying goes, “There’s nothing new under the sun, just history you haven’t read yet.”

Leave a Comment » | From the Archives, Markets, Tactical Asset Alloc | Permalink
Posted by Mike Moody

From the Archives: How to Level the Playing Field

June 2, 2011

David Swensen is a legendary endowment manager at Yale University. In a recent interview with Consuelo Mack on Wealthtrack, the following exchange occurred. (You can read the full interview here.) Mr. Swensen is talking about the difficulty that individuals have succeeding in the market. It turns out that Yale outsources all of the management to firms who have found an edge they can exploit. It’s the only way to level the playing field because, as he points out, most people “have something they do with their lives other than studying financial markets.” We believe that relative strength has been proven to be just such an exploitable edge. He makes the point elsewhere in the interview that most firms do not have any kind of quantifiable edge. I was also struck by the fact that, although he is surrounded by talent at Yale, his group outsources all of the management. They focus on the overall asset allocation and spend their time trying to identify the managers that have an edge. Recommended reading.

CONSUELO MACK: It seems so unfair. So you think that individuals are always going to be, essentially, at a disadvantage, so the best that we can hope for is to have market returns and to have a portfolio that has some noncorrelated assets? Is that –

DAVID SWENSEN: Yeah, it seems unfair in a sense, but most everybody has something that they do with their lives other than studying financial markets.

CONSUELO MACK: Right.

DAVID SWENSEN: And I know how hard it is to beat the markets. They’re actually quite efficient. And so I’ve got an incredibly highly qualified, wonderfully motivated group of colleagues at Yale, and we work really, really hard to put together these market-beating portfolios.

CONSUELO MACK: And the market-beating portfolios, our viewers should know — you’re not investing the money yourself.

DAVID SWENSEN: No.

CONSUELO MACK: You outsource.

DAVID SWENSEN: With outside stock managers.

CONSUELO MACK: Right. So is there one or two things that you insist upon in choosing a manager? I mean, what are the things that you look for in choosing a good investment manager? Criteria.

DAVID SWENSEN: If we talked about this 20 years ago, I probably would have come up with a list of objective criteria.

CONSUELO MACK: And now?

DAVID SWENSEN: And now, I just say it’s all about the people. You want to have really high quality people, great integrity, very intelligent, hard-working, people that have found an edge that they can exploit.

CONSUELO MACK: In their particular niche.

DAVID SWENSEN: In their particular niche. And I would say it’s people first, people second, people third. You just want to be partners with great people.

—-this article was originally published July 30, 2009.  The advice is timeless—outsource to great people.  Everyone is great at something, but it usually isn’t portfolio management.

1 Comment | From the Archives, Markets, Thought Process | Permalink
Posted by Mike Moody

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