Lou Harvey on Investor Learning and Modern Portfolio Theory

April 16, 2012

Some time after 2008, Lou Harvey, the founder of DALBAR, did an interview with Barron’s.  He discussed what had been learned in the 2008 bear market.  It’s worth thinking about, especially his advice on what seemed to work.  I’ve got some nice excerpts, but you can read the whole interview here.

In your study you point out that in spite of the “catastrophic” losses in 2008 “belief in modern portfolio theory has inexplicably remained strong.” MPT is grounded in the belief that asset classes are “predictably uncorrelated.” Because MPT is no longer good for all seasons you relegate it to one of several things investors need to consider.

Modern portfolio theory was pioneered by Harry Markowitz in a 1952 paper published in the Journal of Finance. It posited the construction of an “efficient frontier” of optimal portfolios offering the maximum possible expected return for a given level of risk. MPT is a principle-based investment strategy whose basic idea is that better returns can be produced if a portfolio’s holdings are diversified among different asset classes. The idea: to take advantage of the varying directions as each asset class fluctuates.

Nothing’s wrong with MPT. It’s how people use it. What is needed is a back-up plan to protect investors when the theory fails. And it will most likely happen again.

The pushback to our latest report has been strong. Who are we to criticize MPT, devised by a Nobel Prize winner? But this is our research and we stand by what we’ve found. I have lots of scars on my back to prove it. And I’m sure that after talking to you I’m going to get more. Investment results in 2008 showed clearly that correlation of asset classes varied unpredictably and with no warning. This brings into question the very basis for MPT and its ability to forecast an efficient frontier. MPT simply cannot be used in isolation. Instead it should be thought of as only one reference point for modeling the behavior of a potential portfolio. It is only one dimension of a more comprehensive investment-management process.

What’s the most important finding in your recent research?

For me the biggest recent issue stems from the 2008 market meltdown that defied many of the core beliefs in the financial community—the core belief that asset classes are not correlated. When stocks go down, bonds go up. So might real estate. By holding a little bit in each basket, the investor will make steadier returns and avoid losses. We found out that all of the methods based on modern portfolio theory worked within a certain range. Outside of that range, they all failed.

I added the bold.  I’m not sure that a theory can be said to have worked if it fails repeatedly under extreme conditions, so I differ with Mr. Harvey on that.  As another pundit said recently, it’s like having a seatbelt that only fails when you have a crash.  Of more practical interest is his observation of what did work for investors.

We surveyed investors who outperformed in the crisis and tried to glean from them points to ensure success.

One I particularly like is to take your portfolio out and parse it out into smaller, purpose-driven components, and treat each component separately. Money you can’t afford to lose should not be put into the stock market, but rather in something else that guarantees repayment. It could be an annuity. It could be high-quality bonds. The approach functions on the different ways investors look at their holdings. You look differently at money you have set aside for a gay old time on the Riviera than you do at the money you use for breakfast tomorrow. Each basket should define the risk one should take in the market.

DALBAR’s always done interesting work and their research on investor returns versus NAV returns is now legendary.  Here, Mr. Harvey suggests that investors who outperformed in the crisis were those who divided their money into buckets of differing volatilities.  This is a psychological trick gleaned from behavioral finance—just a different way of looking at the same allocation.  We’ve written about this before, but his observation suggests that it works in practice, not just in theory.

Best practices seem to suggest a belief in supply and demand rather than modern portfolio theory, and ratify the idea of using volatility buckets for clients.

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Posted by Mike Moody

A Reminder About Predictions

April 13, 2012

After the 2008 market debacle, a couple of professors devised a Financial Trust Index to gauge how Americans were feeling about things.  The idea was that a large sample would be surveyed every quarter and then the data tabulated.  (You can see their website here.)  My specific interest here is an article on the Financial Trust Index that appeared in the Wall Street Journal on July 20, 2010.  This was a little more than one year from the market bottom in 2009.  Prices had already advanced nicely, but this is what the article had to say:

About 45% of people think the stock market will drop by more than 30% in the next year, according to a survey by economists at the University of Chicago and Northwestern University. That’s even worse than the 42% a year ago who thought such a sharp decline in stocks was likely. (In December 2008, the share stood at 56%.)

And they’re not counting on much of a payback, either. The average expected return on investment in the next year was just 1.4%, versus 3.5% three months ago.

A huge percentage of investors were expecting another market drop of severe proportions.  Why?  Well, a big drop had happened in the not-too-distant past and like most forecasters, they were extrapolating more of the same into the near future.  We’ve written a lot about the folly of forecasting before, so poor forecasting technique isn’t really surprising.  Given the well-documented dismal performance of retail investors, why would the Wall Street Journal even run an article highlighting their forecasts?

Media is a business.  Like all businesses, they are trying to maximize their revenues.  Especially in this digital age, they can see which stories get the most clicks.  Some websites even have a “most popular articles” list.  The most popular stories are often stories that create fear.  Fear is a much more powerful emotion than satisfaction.  In fact, prospect theory shows that people react twice as strongly to negative outcomes as they do to positive outcomes.  Therefore, many stories in the media are going to have a negative slant.  And, of course, stories with a negative slant are most believable and appealing to us when things currently are going badly.

Ignoring forecasts in the media is a necessity for good investment performance.  You’ve got to have a thoughtful investment process—and stick to it, especially when conditions are terrible.  That was a good policy also when this article came out in 2010.  Rather than the forecasted investment return of 1.4% for the following year, the S&P 500 was up more than 22%.  That’s more than double the average annual return: it wasn’t just a decent year, it was a great year.  Reflect on that before you deviate from a reasonable investment policy.

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Posted by Mike Moody

Clients Demanding Tactical Allocation

April 12, 2012

Advisor One had an article reprising the findings of the most recent Curian Capital survey of advisors.  Their results will not surprise anyone.

• Nearly two-thirds of the advisors say that they have begun using more tactical asset allocation strategies to mitigate economic volatility, and more than half of respondents report they are using more alternative investing strategies.

• As a result of market volatility, nearly 4 out of 5 advisors report an increase in their clients’ demands for more conservative investments; in addition, 72% say their clients have an increased demand for guaranteed income features, 55% report an increase in demand for more tactical asset allocation, and 47% report an increase in demand for alternative investments.

Clients want tactical allocation strategies.  This may be for diversification, but it may also be for risk mitigation, since strategic asset allocation didn’t help them much last time around.  (I added the emphasis above.)

I find the demand for more tactical allocation interesting for a couple of reasons.  Even ten years ago, tactical allocation was derided as market timing by hard core strategic allocation advocates.  Now clients are objecting to holding asset classes during a prolonged nosedive, whether it is in service of diversification or not.  There’s much more awareness of the risk inherent in strategic asset allocation given that we have gone through two bear markets in the last decade or so.

Now that everyone is a tactical asset allocator, the question really boils down to methodology.  What process are you going to employ to make your allocation decisions?  I will suggest that gut feel will get you in trouble almost immediately.  Relying on emotion is not a good way to go.  I think either valuation or relative strength methodologies will work in the long run, but they put different analytic demands on the allocator.

To run a valuation-based process, you need to have a reliable way of generating reasonably accurate expected returns for asset classes.  (Simply using past history will not work, as many strategic allocators discovered over the past decade.)  That’s not an easy task.  It requires a ton a relevant data and a lot of testing to make sure your forecasting process has some validity.  You’re still going to have a large margin of error, so your portfolios will never be optimal.  Paradigm shifts are still going to create major problems.

Relative strength offers a reasonable alternative.  You need to have a reliable ranking method for the assets included in your universe, but we like it because you don’t have to forecast.  Instead, you are relying on the ability of the process to cast out losers and adapt to new trends.

Valuation and relative strength don’t have to be mutually exclusive.  In fact, excess returns are typically negatively correlated.  This is just a fancy way of saying that the two strategies tend to perform well at different times.  Combining two tactical allocators, one using relative strength and one using valuation, is also a very good way to go.

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Posted by Mike Moody

An Observation on Bonds

April 5, 2012

…comes from Ed Yardeni and his excellent blog:

Over the past 36 months through February, net inflows into bond mutual funds totaled $1.0 trillion, while net inflows into equity funds were close to zero. Unfortunately for bond investors, the equity funds enjoyed capital gains of $2.7 trillion over this period, while the bond funds had gains of only $437 billion. Now that bond yields are starting to move higher, those gains are likely to decline. That might convince individual investors to move back into equities.

His chart of bond flows is actually pretty amazing.  Net flows to stock funds, in contrast, have been pretty flat for the last five years.

Source: Dr. Ed’s Blog/ICI   (click on image to enlarge)

There’s no doubt that good equity returns provide some competition for risk-off assets like bonds.  However, stock returns have been pretty good for several years and it hasn’t resulted in significant behavior change on the part of bond buyers.  In my opinion, that’s because bond investors are still making money on an absolute basis.  Sure, they aren’t making what the stock market is making—but they are not losing money.  If and when bond owners start to actually lose money on a nominal basis, we might see a change in the dynamic.  (Many are already underwater in terms of real returns.)  That change could provide fuel for the stock market, but maybe only if stocks are doing well at the time.

Although seems logical that money would flow immediately when relative performance changes, there is obviously a big emotional component to investor behavior too.  Emotions and good investing don’t go well together.

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Posted by Mike Moody

Supply and Demand: Oil Edition

April 4, 2012

Admit it.  You didn’t see this coming:

Oil tumbled after the Energy Department said U.S. stockpiles surged the most since 2008 as U.S. crude output climbed to the highest level in 12 years.

“U.S. inventories are obviously more than ample,” said Bill O’Grady, chief market strategist at Confluence Investment Management in St. Louis, which oversees $1.3 billion. “U.S. production keeps increasing. This proves that when prices rise high enough producers are going to find new ways to bring supply to market.”

That snip is from a Bloomberg article on the dropping price of oil, although I still haven’t seen it at the gas pump.  It’s amazing that we are suddenly at 12-year production highs, after having carped about energy independence for several decades!

I added the emphasis.  It’s impossible to repeal the law of supply and demand.  Relative strength is just supply and demand in action.

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Posted by Mike Moody

Where Did My Return Go?

April 4, 2012

Barry Ritholtz at the Big Picture had an interesting post about real returns, that is, returns adjusted for inflation.  (He illustrated his point with some amazing graphics from The Chart Store, produced by its proprietor, Ron Griess.)  Barry apparently loves Ron’s work, and for good reason.  Very long term charts are great for perspective.  It’s kind of a “YOU ARE HERE” experience.

One of the charts, in particular, struck me.  It was a chart of the S&P 500 real return.  It shows how far in time and distance we are from the all-time index highs, as well as what has happened in past declines.

Source: The Big Picture/ The Chart Store    (click to enlarge)

The real take-away here is that nominal returns can be quite deceptive.  Just because the dollar amount on your statement keeps growing does not mean your purchasing power has been maintained.  And your wait for real returns may be measured in decades!

It also suggests that it is important to look across a broad group of assets to try to capture returns wherever they are.  Investing in stocks has the possibility of augmenting your purchasing power greatly, but there are also long, long periods where market indexes have remained stagnant.  Plenty of individual stocks may have done well, but it’s also possible that the best opportunities were in asset classes outside of equities.  A realistic investment policy will pursue returns wherever they are available.

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Posted by Mike Moody

Theory versus Practice

April 3, 2012

In finance there is often a marked difference between theory and practice.  Advisor Perspectives carried an excellent commentary from Loomis Sayles on an alternative way to think about financial markets.  It points out, very clearly, that what is often lost in theory is the human element.

In an often cynical world, standard financial and macroeconomic quantitative models give people the benefit of the doubt. Fundamental economic theory assumes the best of us, supposing that human beings are perfectly rational, know all the facts of a given situation, understand the risks, and optimize our behavior and portfolios accordingly. Reality, of course, is quite different. While a significant portion of individual and market behavior can be modeled reasonably well, the human emotions that drive cycles of fear and greed are not predictable and can often defy historical precedent.

Economic historian Charles Kindleberger can offer some insight. In his book Manias, Panics, and Crashes, Kindleberger explores the anatomy of a typical financial crisis and provides a framework that considers the impact of the powerful human dynamics of fear and greed. Economic historian Charles Kindleberger can offer some insight. In his book Manias, Panics, and Crashes, Kindleberger explores the anatomy of a typical financial crisis and provides a framework that considers the impact of the powerful human dynamics of fear and greed.

Kindleberger famously dubbed this sequence a “hardy perennial,” probably because the galvanizing human conditions of fear and greed are more often than not prone to overshoot fundamental values compared to the behavior of a rational individual, which exists only in macroeconomic theory.

Loomis Sayles contends that Kindleberger provides the qualitative framework for Hyman Minsky’s pioneering work on boom and bust cycles.  Their graphic is remarkable in its simplicity and explanatory power—and in its distance from traditional economic equilibrium models.  (You can see the image in the article.)

The cycles that Loomis Sayles discusses are driven by behavior, and often not behavior that would be considered ”rational” in the classic economic sense.  Relying on precedent—the last time that happened, this happened—may or may not work.  In fact, each time there is a paradigm shift, precedent will fail.  Overshoots can be significant, so it’s important that an investing approach be adaptive enough to reflect changes in the environment.  Most importantly, investing needs to take human behavior into account.  Asset prices are a reflection of that behavior, suggesting that paying attention to prices may be far more useful than paying attention to economic theory.

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Posted by Mike Moody

Quote of the Week

March 31, 2012

Dan Loeb at the Columbia Student Investment Conference 2012:

Think deeply about process over outcome. If you do something the right way enough times, you’ll win.

HT: Market Folly

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Posted by Andy Hyer

Price Signals

March 30, 2012

Shortly after writing my article on the dual nature of prices, I ran across this wonderful article on price signals written by Jonathan Hoenig for Smart Money.

Whether it’s gasoline or groceries, blaming traders because you happen not to care for a market’s prices is like blaming the mailman because you don’t like the mail. They are price messengers, not manipulators.

It’s a nice read and probably especially germane to current bond investors.  And Mr. Hoenig may get the prize for the most bluntly named hedge fund in the industry!

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Posted by Mike Moody

The Rise of Tactical Allocation

March 29, 2012

Portfolio construction has typically relied on strategic asset allocation to help control volatility.  The idea is that if you combine assets with low correlations, you can significantly reduce the volatility of your returns.  Lately, however, correlations have become a problem.  Jeff Benjamin, writing in Investment News, discusses the problem:

Asset classes have become so highly correlated over the past few years that many traditional diversification strategies have lost their effectiveness.

For example, take the link between growth and value stocks.

For the decade ended December 2000, the correlation between the Russell 1000 Growth Index and the Russell 1000 Value Index was just 57%. During the decade ended this past December, it jumped to 92%.

For a more extreme case, compare the correlation of the MSCI Emerging Markets Index with the Russell growth index. The former was negatively correlated to the latter by 6% — which was great for those seeking diversification — in the decade through December 2000, but the correlation spiked to 89% in the following decade.

You can see the issue—drastically changing correlations will move your efficient frontier far from where you imagined it was.

Some of the observers Mr. Benjamin quoted were blunt:

“Traditional diversification is like a seat belt that only works when you’re not in a car accident,” said Michael Abelson, senior vice president of investments at Genworth Financial Wealth Management Inc.

“Depending on risk tolerance, we might recommend allocating half a portfolio to a diversified strategic strategy and then 30% to 35% to a tactical strategy and 15% to 20% to alternatives,” Mr. Abelson said.

Besides having a knack for a fine turn of phrase, Mr. Abelson mentions something that we have noticed more and more in recent years.  It used to be the case that tactical allocation was used as a satellite strategy and might get only a 10% slice of a portfolio.  Now, we often see the tactical strategy with a 35-50% weight.  Some advisors are even using the tactical allocation as the core strategy and arranging alternatives and other asset classes as strategic overweights.

With the rise of tactical allocation come new challenges.  Chief among them is how to manage the tactical portion of the portfolio.  All-in/all-out timing decisions are notoriously difficult to get right.  Overweighting and underweighting based on valuation requires sophisticated modeling that must be constantly updated.  In addition, many assets are resistant to traditional valuation methods.

One method that does work over time is tactical asset class rotation using relative strength.  We’ve chosen that path for our Global Macro strategy because it allows a very large and diversified universe to be ranked on the same metric.  That, and because it works.

Click here and here for disclosures.  Past performance is no guarantee of future returns.

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Posted by Mike Moody

Winners Keep Winning

March 29, 2012

The Final Four has been determined for the NCAA tournament.  (I hope your bracket doesn’t look anything like mine!)  To try to reward the best teams with the easiest path to the Final Four, the tournament committee seeds all 64 (now 68) teams.  The idea is that you will get a high seed if you have been one of the top teams all season.

While there are always upsets, for the most part, the top teams continue to win.  That is, after all, why they are the top teams.

Econompic Data carried an article about the win rates for the top seeds.  Below is their graphic showing the seed level of all of the teams to get to the Final Four since 1997.

Winners Keep Winning

Source: EconompicData   (click to enlarge to full size)

As you can see from the data, more than 80% of the Final Four teams were one of the top four seeds in their division.  In effect, for the most part, the Final Four teams were a subset of the top sixteen teams.  If you start to think of high relative strength securities as top seeds you’ll see where this is going.

Every now and then a dark horse slips in, but most teams have been top teams all year.  Winners keep winning.

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Posted by Mike Moody

PDP: Leading the Strategy Indexing Revolution?

March 27, 2012

Strategy indexing is hot, according to John Prestbo of Dow Jones.  In a recent interview carried in Index Universe, he discussed what he meant by strategy index:

[Index Universe editor Olivier] Ludwig: What are we talking about here? Things like what Rob Arnott’s up to, or to those smart-beta indexes that have proliferated in the last 12 months?

Prestbo: That’s exactly what I’m talking about. I group them all together into a broad category called “strategy indexes,” where the index is not tracking a traditional segment of the market so much as it’s tracking a way of approaching the market. A lot of people want to get the best return they can, and they are willing to put in the time and effort to be flexible and manipulate their portfolio among various offerings. They combine the benefits of semi-active investing with the lower costs that come with it. The cost may be higher than the plain-vanilla indexes, but they are lower than an active manager.

I added the italics.  The Technical Leaders indexes must have been far ahead of the wave, since Powershares launched PDP more than five years ago, not in the last 12 months!  Academic factor models, like Carhart’s four-factor model suggest that there is a return premium (above inflation) available from:

  • the market itself
  • small-cap stocks
  • value stocks
  • momentum stocks (relative strength)

There are hundreds of ETFs that can give you market exposure, and many more focusing on small-cap and value stocks.  If you look hard enough, you can probably find even ETFs for small-cap value stocks in almost every market.

To my knowledge, for many years, only the Technical Leaders ETF family focused on relative strength.  PDP was launched in March 2007.  Developed (PIZ) and emerging markets (PIE) were added later, in December 2007.  Russell now has a couple of momentum indexes out, although they are less than 12 months old.

Here’s a quiz for you: Of Carhart’s four factors, which has the largest return premium?  Maybe the graphic below will help you answer the question.

Which factor has the largest return premium?

Source: Mercer Advisors

The best returns belong to the return factor that has been most neglected: relative strength.  It is a source of continuing amazement to everyone in our office that PDP has $500 million in assets, rather than billions like some of its competitors, especially given its performance.  Perhaps value investing sounds more sophisticated and small-cap investing is racier, but historically it’s been relative strength that has provided the biggest raw returns.

Good investing requires education, so maybe PDP is just ahead of the curve.  We’re hoping that, over time, there will be more discussion of relative strength as a return factor and that it will get a more prominent (and well-deserved) place within investor portfolios.

See www.powershares.com for more information about PDP.  Past performance is no guarantee of future returns.  A list of all holdings for the trailing 12 months is available upon request.

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Posted by Mike Moody

From the Archives: Essence of Relative Strength

March 27, 2012

“I can’t change the direction of the wind, but I can adjust my sails to always reach my destination.” – Jimmy Dean

—-this article originally appeared 12/11/2009.  Who knew the sausage king knew anything about relative strength?

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Posted by Mike Moody

From the Archives: Ken French Should Check His Website

March 26, 2012

A new paper from Eugene Fama and Ken French is circulating, suggesting that active mutual fund managers don’t add value.  Articles, like the one here at MarketWatch, have been appearing and the typical editorial slant is that you should just buy an index fund.

I have a bone to pick with this article and its conclusions, but certain things are not in dispute.  Fama and French, in their article Luck versus Skill in the Cross Section of Mutual Fund Returns, look at the performance of domestic equity funds from 1984 to 2006.  (You can find a summary of the paper here.)  They discover that the funds, in aggregate, are worse than the market by 80 basis points per year–basically the amount of the fees and expenses.  (After backing out fees and expenses, the funds are 10 basis points per year above the market.)  After that, Fama and French run 10,000 simulations with alpha set to zero to see if the distribution of returns from actual fund managers is any different from the distribution of returns from the random simulations.  They conclude it is not very different and suggest that any fund manager that outperforms is simply lucky.

Let me start my critique by pointing out that, based on their sample and their goofy experimental design, their conclusions are probably correct.  Existing mutual funds in aggregate pretty much own the market portfolio and underperform by the amount of fees and expenses.  There clearly are some above-average mutual fund managers, but as Fama and French point out, it’s difficult to tell statistically from just performance data if they are good or simply lucky.  Within a big sample of funds like they had, after all, a few are bound to have good performance just because the sample is so large.

This is quite a quandary for the individual investor, so let’s think about the realistic scenarios and their outcomes–in other words, let’s take actual investor behavior into account.

Scenario 1.  Buy a mutual fund after its good performance is advertised somewhere and bail out when it has a bad year.  Continue this behavior throughout your investment lifetime.  According to Dalbar’s QAIB and other data, this is what actually happens most of the time.  Not a good outcome–underperformance by a large margin, often 500 basis points or more annually.

Scenario 2.  Buy a decent mutual fund and make the radical decision to leave it alone, come hell or high water.  Do not be tempted by the blandishments of currently hot funds or panicked by underperformance in your fund when it inevitably happens.  Close eyes and hold on for dear life.  Continue your ostrich-with-its-head-in-the-sand routine throughout your investment lifetime.  Your outcome, as Fama and French point out, will probably be market returns less the 80 basis point per year in fees.  Your returns will probably be 400 basis points annually or more better than Scenario 1.

Scenario 3. Throw active management overboard entirely.  Buy an S&P 500 index fund or a total market index fund and proceed as in Scenario 2.  Your outcome might be 60-70 basis points per year better from reduced costs than the investor in Scenario 2.  (Your cost is that you don’t get to brag at cocktail parties on the occasions when your actively managed fund has a good year.)  On the other hand, you are no less likely to succumb to Scenario 1 than an actively managed mutual fund investor.  Unfortunately, index mutual funds tend to show the same pattern of lagging returns due to investor behavior as actively managed funds.

Scenario 4. Visit Ken French’s own website.  Look for factors that are tested and that have outperformed consistently over time.  Hint: relative strength.  (Academics tend to call it ”momentum,” I suspect because it would be very deflating to have to admit that anything related to technical analysis actually works.)  Find a manager that exposes a portfolio to the relative strength factor in a disciplined fashion over time.  Buy it and pretend you are Rip Van Winkle.  Continue this dolt-like behavior for your entire investment lifetime.  Your outcome, according to Ken French’s own website, is likely to be market outperformance on the magnitude of 500 basis points per year or more.  (You can link to an article showing a performance chart back to 1927 here, and the article also includes the link to Ken French’s database at Dartmouth University.)

I prefer Scenario 4, but maybe that’s just me.  Since it is well-known even to Eugene Fama and Ken French that momentum has outperformed over time, what is their study really saying?  It’s saying that essentially no one in the mutual fund industry is employing this approach.  That’s more a problem with the mutual fund industry than it is with anything else.  (Mutual fund firms are businesses and they have their reasons for running the business the way they do.)  One option, I guess, is to throw up your hands and buy an index fund, but maybe it would make more sense to seek out the rare firms that are employing a disciplined relative strength approach and shoot for Scenario 4.

Their flawed experimental design makes no sense to me.  Although I am still 6’5″, I can no longer dunk a basketball like I could in college.  I imagine that if I ran a sample of 10,000 random Americans and measured how close they could get to the rim, very few of them could dunk a basketball either.  If I created a distribution of jumping ability, would I conclude that, because I had a large sample size, the 300 people would could dunk were just lucky?  Since I know that dunking a basketball consistently is possible–just as Fama and French know that consistent outperformance is possible–does that really make any sense?  If I want to increase my odds of finding a portfolio of people who could dunk, wouldn’t it make more sense to expose my portfolio to dunking-related factors–like, say, only recruiting people who were 18 to 25 years old and 6’8″ or taller?  In the same fashion, if I am looking for portfolio outperformance, doesn’t it make a lot more sense to expose my portfolio to factors related to outperformance, like relative strength or deep value, rather than to conclude that managers who add value are just lucky?  No investigation of possible sub-groups that were consistently following relative strength or deep value strategies was done, so it is impossible to tell.  Fama and French are right, I think, in their assertion that plenty of luck is involved in year-to-year performance, but their overall conclusion is questionable.

In short, I think a questionable experimental design and possible sub-groups buried in the aggregate data (see this post for more information on tricks with aggregate data) make their conclusions rather suspect.

—-this article originally appeared 12/3/2009.  It turned out to be one of the blog readers’ favorite rants, so I am reprising it here.  I still think active management can add value over time through disciplined exposure to a reliable return factor.

Leave a Comment » | From the Archives, From the MM, Investor Behavior, Markets, Relative Strength Research, Thought Process | Permalink
Posted by Mike Moody

Why You Are A Trend Follower, Part…

March 26, 2012

Morgan Housel sheds some light on valuations:

This all raises the question of where valuations are today. When looking at a broad index like the S&P 500, the unfortunate (but honest) answer is no one really knows. Using a straight P/E ratio, the market looks a little cheap historically. Using a metric like the cyclically adjusted P/E ratio that averages 10 years’ of earnings together, it looks a little pricey. Profit margins are near all-time highs and could contract. But interest rates are low, so stocks look attractive when compared with bonds. Equally smart people disagree on what these all actually mean.

Clear as mud?  This is just your daily reminder of why you are a trend follower!

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Posted by Andy Hyer

Balanced Funds Make a Comeback

March 22, 2012

According to an article in Smart Money, balanced funds have been attracting client money this year.

So-called balanced funds, which invest in a mixture of stocks and bonds — and occasionally cash, commodities and other asset classes — suddenly are back in style. So far this year, investors added $7.1 billion to these portfolios, according to Lipper, a research firm. That is a huge reversal from last year, when investors yanked $20 billion from these funds.

The turnaround also stands in contrast to pure stock funds, which had inflows of just $56 million this year through March 14. And some investing experts say demand for balanced strategies is likely to rise. “There’s a little ‘Goldilocks’ appeal for investors,” says Russel Kinnel, director of fund research for Morningstar, meaning the funds are “just right” in finding a spot between timid and risky.

Indeed, advisers say they are using the funds to bring clients who are still spooked by last year’s extreme market volatility — but tired of record-low yields in the bond market — back into stocks. The pitch is that these funds offer most of the upside if the market surges but less of the downside if it tanks.

…advisers say balanced funds are often a good fit with younger investors, or those looking for a set-it-and-forget investment. Some also use the funds as core holdings for clients, and supplement them with alternative assets and funds to get even broader diversification.

Advisors are finding that clients are a bit more receptive to the equity story, but far from willing to go “all in.”  We’re seeing some glimmers of that in our own survey of investors’ risk appetite.  Investors are finally peeping out of the foxhole they have been in since 2008 and surveying the environment.  They are beginning to realize that today’s low bond yields will not get them to their goals, but they also seem to want some fixed income as a buffer from market volatility.  A balanced fund is a pretty good compromise.  (You can find more out about balanced funds generally here.)

The Arrow DWA Balanced Fund (DWAFX) that we sub-advise crossed its 5-year anniversary last summer, while outperforming 90% of its peers.  There are dedicated sleeves for fixed income, domestic equities, international equities, and alternative investments.  The alternative sleeve, which is something many balanced funds do not include, can come in pretty handy for inflation protection and always adds an additional layer of diversification.

I’ve included a snip with the asset allocation as of 12/31/2011 and the performance of each strategy sleeve.  Every sleeve has a positive return since inception in 2006, even with the 2008-2009 bear market.  I think it is primarily the hybrid nature of these funds that is making them attractive to clients right now—and DWAFX might be something to consider for clients just easing back to a more normal asset allocation.

Source: Arrow Funds

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

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Posted by Mike Moody

From the Archives: Why Systematic Models Are Great

March 22, 2012

James Montier wrote this piece in 2006, but it is so great that I have to bring it up again!  This article is a gem, worth reading over and over again.

What could baseball, wine pricing, medical diagnosis, university admissions, criminal recidivism and I have in common? They are examples of simple quant models consistently outperforming so-called experts. Why should financial markets be any different? So why aren’t there more quant funds? Hubristic self belief, self-serving bias and inertia combine to maintain the status quo.

Montier gives numerous examples of situations in which the models outperform both experts and experts using the models as additional input.  Using your “expert knowledge” just makes it worse most of the time.  In fact, in a study of over 130 papers comparing systematic models with human decision-making, the models won out in 122 events.

So why don’t we see more quant funds in the market? The first reason is overconfidence. We all think we can add something to a quant model. However, the quant model has the advantage of a known error rate, whilst our own error rate remains unknown. Secondly, self-serving bias kicks in, after all what a mess our industry would look if 18 out of every 20 of us were replaced by computers. Thirdly, inertia plays a part. It is hard to imagine a large fund management firm turning around and scrapping most of the process they have used for the last 20 years. Finally, quant is often a much harder sell, terms like ‘black box’ get bandied around, and consultants may question why they are employing you at all, if ‘all’ you do is turn up and crank the handle of the model. It is for reasons like these that quant investing will remain a fringe activity, no matter how successful it may be.

Lack of competition may be the best reason of all to use a systematic approach.  How many investors are willing to go through a thorough and rigorous testing process to build a robust model—and are then willing to stick with the model through thick and thin?  As Montier points out, it may remain a “fringe activity” no matter how successful it is.

—-this article originally appeared 12/22/2009.  This is a powerful, powerful argument in favor of using a systematic model.  Montier’s discussion of why investors resist using models is still very true.

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Posted by Mike Moody

From the Archives: Sorry, No Correlation

March 21, 2012

How should today’s news, that the nation’s gross domestic product rose at a lower annual rate in the third quarter than previously estimated, factor into your investment decisions?  Bad news for stocks?

Recently, Brandes issued a report, Gross Domestic Product: A Poor Predictor of Stock Market Returns, that points out that stock market performance has not been correlated with GDP performance.  Note this research covers an 80 year period of time.

Exhibit 1 shows the predictive power of changes in GDP (in explaining concurrent equity returns) was not statistically significant.  The coefficient of determination, or the portion of the stock market performance, explained by GDP changes, is only 0.1619, and the regression line is a poor fit.

(Click to Enlarge)

In addition, Exhibit 2 reveals that predictive power for changes in GDP in explaining subsequent equity returns is not statistically significant. The coefficient of determination for this relationship is 0.0225, and again, the fit of the regression line is poor.

(Click to Enlarge)

It may seem logical to you to try to link GDP growth with stock market performance, but the results just don’t back that thesis up.  I believe that these results confirm that investors are best served  by focusing on the price movement of a security/market itself when evaluating the merits of an investment.

—-this article originally appeared 12/22/2009.  It’s a very good reminder to stay focused on the relative strength of the individual security and not on all of the surrounding economic noise.  The fact is that there is no correlation, and where there is some relationship, it is usually the stock market that leads.

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

The Economy Does Not Equal The Stock Market

March 20, 2012

Aussie Trader, Jessica Peletier, succinctly points out the disconnect often seen between an economy and its stock market:

I admit it – I’m jealous.

Right now, I want to be American.  I want to buy cheap houses and eat mega-huge fast food.

But most of all, I want a stock market that goes up.

Ours appears to have forgotten how.   In fact it’s almost as though it’s pulled the doona over its head and decided never to get up again.

If you ask me, that’s kind of bizarre because you’d think the Australian Market has everything to live for.

You see, economically we rock.  We have stable banks, interest rates that actually pay money and a resource sector that has the rest of the world drooling.  And we have jobs for anyone who actually wants to work.

Now compare that to our American friends.  Their banks have a less than sterling reputation, interest rates can barely go any lower, and there’s very few jobs in many areas – in fact whole towns are dying through the extinction of industry.

And yet their market is merrily making higher highs without a care in the world, while ours is languishing like a drunk on Sunday morning.

It simple really – the economy does not equal the stock market.

What does equal the stock market is people’s perception of what might happen in the future, and this goes some way toward explaining what’s going on with the US market.

Even though right now their economy is junk, people are overjoyed that there are green shoots appearing.  People are more optimistic about the future.  It doesn’t matter that right now, things are still rubbish – the fact is there is hope.

If the markets were a reflection of the economy, the US market may have risen marginally to reflect the odd green shoot.  But what’s happened is not marginal, it’s a beautiful big fat money-making up-trend.

This is exactly why it makes sense to go directly to trading price trends!

HT: Abnormal Returns

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Posted by Andy Hyer

Relative Strength and Value

March 20, 2012

Numerous academic studies, some archived on our website, suggest that outsized returns can be achieved over time by purchasing cheap stocks with high relative strength.  In fact, James O’Shaughnessy highlighted this in What Works on Wall Street as one of the best strategies over the past 50 years.  Lost in all of the hullabaloo over Apple’s dividend, oil prices, Iran, and so on is the fact that the market is undervalued—and has been for most of the past year, according to Morningstar’s fair value estimates.

Source: Morningstar  (click on image to enlarge)

What I know about valuation methodologies could probably fit on the head of a pin, but that’s what Morningstar’s analysts do all day.  When they look at where stocks are selling relative to their estimates of fair value, the market as a whole—and even most sectors—is still undervalued.

Retail investors have been incredibly reluctant to re-engage with the stock market since being burned in 2008-2009.  For a couple of years now, much more investor money has been flowing to bond funds than stock funds.  I’m just not sure if that is a rational move when stocks are undervalued.

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Posted by Mike Moody

In Praise of Concentration

March 19, 2012

Our separate account portfolios are quite concentrated, typically only 20-25 stocks at one time.  Having a concentrated portfolio creates a little bit of additional volatility, but it also increases the odds that a strong performer will have an outsized positive impact on the account.  A recent article in Advisor Perspectives discussed this and other benefits of portfolio concentration.

Investors who avoid concentrated equity miss out on the triple benefits of excess returns, lower risk, and lower correlations. A portfolio concentrated in best-idea stocks has an excellent chance of generating excess returns. In turn, the cumulative excess return to investors lowers the risk of underperformance over time. Finally, a portfolio comprised of a small number of stocks is characterized by a low stock-market correlation. Thus the concentrated equity triple play: higher returns, lower risk, and lower correlations.

Concentrating a  portfolio on a few choice assets dramatically increases an investor’s chance of  superior performance.  Nonetheless, most  advisors and investors shun portfolio concentration as unacceptably risky. To a  great extent, this is driven by the myth that adequate diversification is  impossible unless one holds many stocks…

Many believe that  concentrated portfolios are much more volatile than are broadly diversified  index portfolios. It turns out the diversification benefit of adding additional  stocks to a one-stock portfolio is largely captured within the first few  additions, as shown [in Figure 1] below.

The author, C. Thomas Howard, includes a graphic that shows clearly how rapidly additional diversification is achieved by adding stocks to a portfolio.

Source: Advisor Perspectives  (click on image to enlarge)

With 20 stocks, you’ve already eliminated more than 90% of the standard deviation from the market!  In our particular portfolios, given that we also enforce a certain amount of macrosector diversification, the reduction in tracking error may occur even more rapidly.

The author discusses a number of papers (which are in the appendix of his article) that point out that “best ideas” have a strong likelihood of outperforming and that more stocks just tend to water down returns.

Instead of limiting themselves to their 10 or so best ideas, the typical active equity mutual fund manager holds 100 stocks. As shown in Figure 2, the “last”-ranked stock earns a negative excess return of between -2% and -3%. In  fact, excess returns go negative somewhere around 30th-best stock.  Thus, the typical portfolio is comprised of 30 positive excess-return stocks and 70 negative excess-return stocks. Not exactly a recipe for success!

So why don’t funds limit themselves to their best ideas? There are powerful institutional incentives to overdiversify and destroy performance.

The primary incentive is  that mutual funds earn fees based on assets under management (AUM) — the bigger, the better. But getting big makes it increasingly difficult to focus strictly on best ideas; thus the resulting purchase of many more stocks in order to “round out” the portfolio. The need to fit a particular style box and closely track a “style index” can also force advisors to water down their  portfolios, as can the need to soothe investor fears by keeping volatility low.

Collectively, these  incentives encourage a fund manager to move away from a concentrated portfolio; all too often, he or she may essentially become a closeted indexer.

In short, there are institutional incentives to move away from concentrated portfolios, often to the detriment of long-term investor returns.  I added bold type to the tidbit that excess returns go negative somewhere around the 30th best stock.  If that is the case, there is no point in adding more names beyond those that have a prospect of adding excess returns.

What’s the downside of a concentrated portfolio?  Well, there’s certainly more short-term volatility, even if the long-term returns are higher.  And a concentrated portfolio isn’t exactly designed to “soothe investor fears.”  As always, the road to better returns is usually psychologically uncomfortable!

To receive the brochure for our Separately Managed Accounts, click here.  

Click here and here for disclosures.  Past performance is no guarantee of future returns.

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

From the Archives: Capturing Trends

March 19, 2012

Intuitively, investors feel like the more nimble they are, the better they will do.  They put tremendous pressure of themselves to capture every wiggle in the market.  Yet, much of the time, going faster is counterproductive.

In this blog post, “Understanding How Markets Move,” noted psychologist and trader Brett Steenbarger uses the simple example of a moving average system applied to the S&P 500.  The more you speed up the moving average, the worse it does.  That seems counter-intuitive, but you have to keep in mind that trends are what make money and trends  are often slow.  The faster you go, the more noise you capture, and thus, the worse you do.

We find exactly the same process at work when using relative strength.  Reacting to short-term relative strength does not perform well over time.  The best-performing models follow intermediate to long-term relative strength—and just tough out the periods that are rocky.  Many clients have trouble sitting still when going through a rocky period, but as Steenbarger points out in his post, you have to deal with the asset you’re trading.  Stocks have their own time frames for trends and an impatient investor isn’t going to speed it up.  If you want to trade financial assets, you have to work with them on their own terms.

—-this article originally appeared 12/16/2009.  Repeat after me: going faster is counterproductive.  The last nine months or so have been lousy for trends, so it’s prime time for thinking that trends could be captured if only one were more nimble.  Tough periods don’t last.  The market will trend again when it feels like it!

Leave a Comment » | From the Archives, From the MM, Investor Behavior, Markets, Thought Process | Permalink
Posted by Mike Moody

From the Archives: Beating Buy-and-Hold, Again

March 16, 2012

Although it always seems counterintuitive for incredibly simple momentum strategies to be able to beat the market, yet more evidence is provided in a brief article from CXO Advisory.  (Relative strength is often called “momentum” in academic literature.)

Their method was simple.  They used the nine domestic sector SPDRs, held the top one based on a simple momentum ranking, and revisited the ranks monthly, switching if necessary.  Three simple models were used: 1) top 6-month return, 2) top 6-month return ending 1 month ago, and 3) top 6-month return or cash if the top sector SPDR was below its 10-month moving average (a la Mebane Faber’s paper).

You can see the equity curve below, although there is better detail in the original article.  (The model that can go to cash was obviously helped by two big bear markets in the last ten years; in an up market decade it might be different.)

Now, I’m not sure any compliance department would sign off on a strategy that only held one sector at a time, but it is certainly eye-opening that all three strategies outperformed the market.  This finding is rampant throughout many, many academic and practitioner studies, including ones archived on our website.  Systematic use of relative strength works.

—-this article was originally published 12/22/2012.  Evidence for the effectiveness of relative strength continues to pile up, most recently in the five-year performance of PDP.

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Posted by Mike Moody

Heart Monitors and Gender Screening

March 16, 2012

John Coates, formerly a senior trader at Deutsche Bank and Goldman Sachs, has an interesting proposal for dealing with the negative consequences of emotional investing:

First, he wants banks and regulators to monitor traders’ biology; after all, he says, it would not be hard to install heart monitors, or blood tests in banks, to spot hormonal swings. Second, he wants banks to employ more women and older men on trading floors, not for reasons of political correctness, but because female traders and older men tend to have lower testosterone and better functioning vagal nerves. A better biological mix, he insists, will mean fewer swings in testosterone and cortisol, and thus fewer market dramas.

This quote led me to ask our team whether our investment model is a boy model or a girl model.  I sure hope it’s a girl!

Minimizing the negative effects of emotional trading is one of the primary reasons that our investment decisions are model-based.  We do extensive research to understand how best to apply relative strength to portfolio management, we build systematic investment models, and then we execute!  Sometimes we have a good feeling about a particular trade, sometimes we have a terrible feeling, but we execute nonetheless (and there have been plenty of times when those terrible feelings have preceded winning trades and vice versa).  When you’ve got an investment factor with results as compelling as relative strength, inserting emotions doesn’t make a whole lot of sense.  If hand-wringing over particular trades can be avoided altogether by reliance on a systematic model, then why not?  In the absence of systematic models, then sure, give the heart monitors and gender screening a try!

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Posted by Andy Hyer

Jim Rogers on Inflation

March 15, 2012

From an interview on Clusterstock:

Everybody is paying higher prices for oil and that obviously impacts consumption everywhere.  It’s not just oil, it’s food and everything else that’s going up.  There’s inflation everywhere, the U.S. lies about it.  I mean, the U.S. government lies about inflation but there’s inflation everywhere. I mean, I don’t know if  you go shopping, but if you do, you know prices are up. The government says they’re not. I don’t know where they shop. Everybody else’s prices are up.

There’s obviously inflation in Mr. Roger’s neighborhood.  Based on the Everyday Price Index, inflation is a lot higher than the reported CPI.  They’re different measures, but depending on what you buy, your personal inflation rate could be a lot different than the government’s.

The market doesn’t seem to be reacting strongly to inflation pressures right now, but there is no telling if that will change in the future.  Some asset classes respond poorly to inflation, but others perform well and can act as inflation hedges.

I don’t get the sense—judging from the public’s heavy bond buying—that inflation is on the radar for most investors.  It’s probably wise to have an investment policy that is flexible enough to include inflation hedges if they are needed.  Or you could just let a manager handle the global tactical allocation strategy for you.  I’m just saying.

Source: CNBC            (click to enlarge)

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Posted by Mike Moody

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