The figures, from the National Association of College and University Business Officers and the Commonfund, show total returns for university endowments averaged about 19% during fiscal year 2011, which ended June 30…

I don’t know if the returns are calculated on a dollar-weighted or equal-weighted basis, but any way you cut it, that’s not a bad year for a broadly diversified account.

You may or may not be aware that Dorsey Wright Money Management acts as a sub-advisor for the Arrow DWA Balanced Fund, a fund that was designed with the endowment model in mind.  It has dedicated sleeves for domestic equities, international equities, fixed income, and alternative assets.  According to Morningstar, our returns were similar over the fiscal year, coming in at 20.9%.

The balanced fund is not designed to be a high-octane vehicle.  It aims for steady performance in a wide variety of market environments and might be just the thing for clients who are looking for a little less volatility, while still having a chance for capital growth.

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

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!

First, let me set the scene for you.  Mr. Veres indicated that he had spent a month doing data analysis of a survey of over 1000 financial planners.  One of the most interesting takeaways:

Perhaps the most striking thing I learned is that, post-2008, activities once labeled “market timing” are now solidly in the mainstream.  No, planners are not moving into or out of the market based on reading the entrails of animal sacrifices. But they seem to be taking a much more active approach to protecting clients from downside risk. The survey asked whether advisors planned to raise or lower their allocations to each of 35 different investment classes or vehicles in the next three months. A remarkable 83% are anticipating at least one tactical adjustment – and the great majority expects to make several.

Mr. Veres raises a legitimate question about how accurate planner’s forecasts are, and what the possible consequences of poor forecasts could be.  As an example, he cites inflation forecasts:

One of the most provocative set of responses came when advisors were asked to forecast the inflation rate and the real (after-inflation) return of both equities and 10-year Treasuries over the next 10 years. On inflation, the majority of responses clustered between 3% and 5%, and the remaining responses had a center of gravity on the 6% to 7% part of the chart. If there is wisdom in the crowd, the crowd of advisors seems to believe we will experience above-average inflation for at least the remainder of this decade.

But we also had responses as low as -4% a year (projecting severe Japanese-style deflation), several as high as 10% and one advisor who anticipates annual inflation of 13% over the coming decade. One or the other group on the fringes is going to be spectacularly wrong (or both will), and I suspect that damaging consequences will show up in the portfolios they recommend.

He is absolutely correct in his belief that a strategic allocation based on a wildly incorrect forecast will be damaging to a client.  And, he indicated that expectations for real returns were even more widely dispersed.  It’s where he goes next that made me think.  He writes:

Say what you will about the buy-and-hold ethos that lasted until September 2008. It may not have been an ideal strategy during the worst of the bear markets, but it did keep the members of the herd from straying too far from the center – and, more important, it kept the profession from getting the kinds of black eyes I think advisors are going to encounter in the future.

I think there is a critical error in this line of thinking.  Buy-and-hold strategic allocations are typically based on historic returns.  Those historic returns, of course, are the same for everybody and they do have the effect of keeping everyone in the middle of the herd.

This is the critical error: basing your allocation on historic returns is also a forecast–it’s simply an implicit forecast that historic returns will continue along the same path!  If that doesn’t happen, you will end up just as horribly wrong as the advisors on the forecasting fringes!  Yes, you will fail conventionally along with everyone else in the middle of the herd, but you will fail nonetheless.  (How do you think most clients feel right now, with their equity allocations based for the last decade on an 8-10% historic return, a return that has not materialized?  And there’s always Japan.)

Frankly, if you’re going to do strategic asset allocation at all, research shows that naive equal-weighting performs as well as anything else.  The reason advisors are gravitating toward tactical management in the first place is because traditional strategic asset allocation has so much trouble with tail events, and 2008-2009 was a big tail event.  Clients have memories, and advisors are simply responding to client demand for a more active form of risk management.  Now, like Mr. Veres, I’m not very confident in the forecasting abilities of financial planners.  I’m not very confident in the forecasting abilities of anyone, for that matter, including me.

All forecasting is flawed, whether it is explicit or implicit.  To me, there are only two realistic choices for asset allocation.  Either 1) equal-weight a large number of asset classes and rebalance periodically or 2) commit to a systematic method of tactical asset allocation.  There are funds that use valuation triggers and funds that use relative strength to rotate among asset classes–and I suspect either will perform acceptably over time if it is systematic and disciplined.

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.

1. Austerity and deflation
2. Explicit default
3. Mild inflation
4. Runaway inflation
5. Miraculous growth

He points out further that this state of affairs is pretty chaotic–and that every opinion can be supported with precedents and sound reasoning.  There’s no easy way to figure out what is more or less likely.  Not to mention that the range of outcomes pretty much covers the waterfront.

In a “normal” economic environment investors debate a narrow range of outcomes: will the U.S. grow by 2.8% or 3.2%? Will inflation remain at 2.0% or climb to 2.3%? Debating a future of inflation vs. deflation is radically new territory for investors. The chaotic nature of the choice facing societies is whipsawing equity markets and dominating bottom-up factors.

There is a wide range of opinions, each supported by relevant precedents and sound economic reasoning. Yet despite our intense focus, we don’t know the answer with certainty.

This is brutal for investors, at least if you are trying to construct a strategic asset allocation.  Your ideal allocations would be almost diametrically opposed if they were optimized for austerity/deflation or runaway inflation!

The situation is further complicated by the fact that different players may make different choices.  For example, what if Greece decides on explicit default, but the UK opts for austerity and deflation?  Trying to figure out the net result of that interaction for a multitude of financial assets is a daunting prospect.

No investment method is going to get everything right ever, and especially not in this environment.  Yet, it seems to me that an adaptive process powered by relative strength has a good chance of rolling with the punches enough to capture returns from some of the themes.  Different assets will respond to evidence of different outcomes, and while there will doubtless be any number of cross-currents, the strongest assets will probably point us toward the weight of the evidence.  A disciplined tactical asset allocation process might be the best we can do when the range of possible outcomes is so wide.

—-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.

It’s not you, it’s me….  I think everyone has used that line at some point, but nobody does it better than George Costanza!

I have been putting data together to update our white papers.  It’s no secret that running a Global Tactical Asset Allocation (TAA) strategy was difficult last year.  But when I looked at the data it was very clear that the problem wasn’t the strategies.  The real problem was how the market behaved during 2011.  It’s not you, it’s me.  It’s not your trend following strategy, it’s what you’re trying to follow.  The market was essentially a psycho, stage 5 clinger last year!

The data I will reference in this post is an extension of the data we published last year in two white papers.  If you haven’t read them you can find them here.  Our research process for this dataset takes a diverse universe of ETF’s and creates 100 different equity curves for a number of different momentum factors.  The universe has a number of different asset classes represented including Equities (Domestic & Foreign), Bonds, Commodities, Currencies, and Real Estate.  The results provide a good idea about how a momentum-based, global TAA strategy would have performed.  By creating 100 different equity curves we are taking luck out of the equation and showing a realistic range of outcomes from buying high relative strength securities out of our universe.

Most of the momentum factors we follow underperformed last year.  The factors we are showing refer to the lookback period to do our rankings.  The 1MORET factor (1-month return) means we used 1 month of data to calculate our momentum ranks (all securities are held until they fall out of the top of the ranks, which might be as short as one week or as long as a couple of years).  The 12MORET factor uses the prior 12 months of price data to rank the securities.  The 3-month factor actually performed the best in 2011, but only 40 out of the 100 trials outperformed the S&P 500, so you needed some luck to outperform.  The 6-month factor was the next best, but only 1 trial outperformed so you needed to be really lucky.  All the other trials were very poor.  There was so much short-term volatility back and forth last year that the very short 1-month formulation period was deadly.  It paid not to be too quick on the trigger last year!

Full Year 2011

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But looking at 2011 in aggregate doesn’t really tell the whole story.  The beginning of the year was good for these strategies.  That person you were dating held it together pretty well for the first couple of dates!  Through the end of April, most of the strategies were outperforming the S&P 500 on average.  The 6-month factor was doing great as all 100 trials were outperforming.  Ironically, the factor doing the worst was the 3-month factor.

2011 Through April

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The problems for trend following strategies began in May.  There were a series of sharp trend reversals in a number of different assets: Bonds, Stocks, Precious Metals, Currencies (Yen & Swiss Franc).  No matter what factor you were using from May to the end of the year it was difficult.  It was tough to get traction anywhere.  The only factor that did even so-so was the 3-month factor, and that was the worst factor through April.  That’s just one of many examples of how crazy the 2011 market was!

2nd Half 2011

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So where do we go from here?  Well, the, “It’s not you, it’s me…” line always leads to a breakup.  That’s probably not a bad idea when dealing with something that doesn’t change.  Does that psycho, stage 5 clinger ever get any better?  Nope.  It only gets worse.

But markets change, and TAA based on momentum is very adaptive.  We will not be in a choppy, range bound environment forever.  Trends will emerge. (If they don’t, it will be the first time in history.)

Investors were euphoric about momentum-based TAA strategies in the first part of the year.  Looking at the data you can see why – they were working exceptionally well.  After the last few months, people are certainly not as excited.  In reality, now is the time to be really excited about relative strength strategies, not back in April.  Now is the time you want to be adding money.

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.

In Jefferson National’s 2010 survey, 66% of advisors said clients were more confident with a tactical asset management strategy, while only 34% said clients were more confident with a traditional buy-and-hold strategy.

That’s a big change.  The majority of clients are now more comfortable with a tactical strategy—the problem is that very few management firms embrace tactical allocation.  (In fact, many of them have gone out of their way to ridicule it in the past.)  There’s not a lot of proven product in the tactical allocation space because buy-and-hold was the mantra for the last 20 years.

It’s important to do your due diligence and find experienced managers with a robust strategy, whether it is relative strength or valuation-based.  Both styles should work over time, but are likely to perform well at different points in the market cycle.  (Of course, we are partial to the Arrow DWA Balanced Fund, a top-quartile fund with a five-year track record!)

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

The moment you read the word Japan, I’ll bet your eyes glazed over. I’ll bet you thought about flipping the page to see if there was something more interesting elsewhere in this month’s issue — on Greek bonds, maybe, or Apple. (Or gold?) You’re not alone. No one wants to hear about Japan. Fund managers have lost money on Japanese shares every year they can remember, except 2005. Tokyo has been in a bear market for 20 years — about as long as commodities were.

How are the mighty fallen! Twenty-two years ago, Japanese stocks accounted for nearly half the value of the world’s stock markets. The land occupied by the Imperial Palace in Tokyo was valued more highly than all of California. The Japanese were conquering the world. No one could stand in their path.

Today, according to FactSet, Tokyo’s share of global stock values is down to 7.5 percent, the smallest it’s been in decades.

His article then makes the case for Japan being a good value:

Most important of all, the stock market is cheap. Possibly very cheap — at a time when nearly everything else looks pricey. The Nikkei 225, Japan’s major stock market index, trades at just 10 times forecast earnings. The dividend yield is up to 2.3 percent — a hefty amount in a country with zero inflation.

Japanese equities today trade for half of annual revenues, according to FactSet. (The figure for the U.S.: 1.2 times revenues.) And they trade for less than book value, while U.S. stocks trade for twice book.

We all know that good values can become even better values, so that alone shouldn’t justify buying Japan.  However, I think it is an interesting exercise to take an absolutely hated investment (Japan in this case) and ask yourself if your investment process is flexible enough to capitalize on a change in a long-term trend.

One way to see if Japan’s apparently attractive valuations translate into strong relative strength is to watch the amount of exposure given to Japan in the PowerShares DWA Developed Markets Technical Leaders Portfolio (PIZ):

Source: PowerShares, PIZ

While the current exposure to Japanese equities in PIZ is less than the weight given to Japan in the MSCI EAFE Index (21.58%), Japanese exposure has increased from the 4% weight in PIZ at the beginning of 2011 to its current weight of 11.51%.

Please see www.powershares.com for more information about PIZ.