Dorsey Wright Managed Accounts

January 27, 2014

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Our Systematic Relative Strength portfolios are available as managed accounts at a large and growing number of firms.

  • Wells Fargo Advisors (Global Macro available on the Masters/DMA Platforms)
  • Morgan Stanley (IMS Platform)
  • TD Ameritrade Institutional
  • UBS Financial Services (Aggressive and Core are available on the MAC Platform)
  • RBC Wealth Management (MAP Platform)
  • Raymond James (Outside Manager Platform)
  • Stifel Nicolaus
  • Kovack Securities
  • Deutsche Bank
  • Charles Schwab Institutional
  • Sterne Agee
  • Scott & Stringfellow
  • Envestnet
  • Placemark
  • Scottrade Institutional
  • Janney Montgomery Scott
  • Robert W. Baird
  • Wedbush Morgan
  • Prospera
  • Oppenheimer (Star Platform)
  • SunTrust
  • Lockwood

Different Portfolios for Different Objectives: Descriptions of our seven managed accounts strategies are shown below.  All managed accounts use relative strength as the primary investment selection factor.

Aggressive:  This Mid and Large Cap U.S. equity strategy seeks to achieve long-term capital appreciation.  It invests in securities that demonstrate powerful relative strength characteristics and requires that the securities maintain strong relative strength in order to remain in the portfolio.

Core:  This Mid and Large Cap U.S. equity strategy seeks to achieve long-term capital appreciation.  This portfolio invests in securities that demonstrate powerful relative strength characteristics and requires that the securities maintain strong relative strength in order to remain in the portfolio.  This strategy tends to have lower turnover and higher tax efficiency than our Aggressive strategy.

Growth:  This Mid and Large Cap U.S. equity strategy seeks to achieve long-term capital appreciation with some degree of risk mitigation.  This portfolio invests in securities that demonstrate powerful relative strength characteristics and requires that the securities maintain strong relative strength in order to remain in the portfolio.  This portfolio also has an equity exposure overlay that, when activated, allows the account to hold up to 50% cash if necessary.

International: This All-Cap International equity strategy seeks to achieve long-term capital appreciation through a portfolio of international companies in both developed and emerging markets.  This portfolio invests in those securities with powerful relative strength characteristics and requires that the securities maintain strong relative strength in order to remain in the portfolio.  Exposure to international markets is achieved through American Depository Receipts (ADRs).

Global Macro: This global tactical asset allocation strategy seeks to achieve meaningful risk diversification and investment returns.  The strategy invests across multiple asset classes: Domestic Equities (long & inverse), International Equities (long & inverse), Fixed Income, Real Estate, Currencies, and Commodities.  Exposure to each of these areas is achieved through exchange-traded funds (ETFs).

Balanced: This strategy includes equities from our Core strategy (see above) and high-quality U.S. fixed income in approximately a 60% equity / 40% fixed income mix.  This strategy seeks to provide long-term capital appreciation and income with moderate volatility.

Tactical Fixed Income: This strategy seeks to provide current income and strong risk-adjusted fixed income returns.   The strategy invests across multiple sectors of the fixed income market:  U.S. government bonds, investment grade corporate bonds, high yield bonds, Treasury inflation protected securities (TIPS), convertible bonds, and international bonds.  Exposure to each of these areas is achieved through exchange-traded funds (ETFs).

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To receive fact sheets for any of the strategies above, please e-mail Andy Hyer at andy@dorseywright.com or call 626-535-0630.  Past performance is no guarantee of future returns.  An investor should carefully review our brochure and consult with their financial advisor before making any investments.

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Is Sector Rotation a Crowded Trade?

January 16, 2014

As sector ETFs have proliferated, more and more investors have been attracted to sector rotation and tactical asset allocation strategies using ETFs, whether self-managed or implemented by an advisor.  Mark Hulbert commented on sector rotation strategies in a recent article on Marketwatch that highlighted newsletters using Fidelity sector funds.  All of the newsletters had good returns, but there was one surprising twist:

…you might think that these advisers each recommended more or less the same basket of funds. But you would be wrong. In fact, more often than not, each of these advisers has tended to recommend funds that are not recommended by any other of the top five sector strategies.

That’s amazing, since there are only 44 actively managed Fidelity sector funds and these advisers’ model portfolios hold an average of between five and 10 funds each.

This suggests that there is more than one way of playing the sector rotation game, which is good news. If there were only one profitable sector strategy, it would quickly become so overused as to stop working.

This is even true among those advisers who recommend sectors based on their relative strength or momentum. Because there are so many ways of defining these characteristics, two different sector momentum strategies will often end up recommending two different Fidelity sector funds.

Another way of appreciating the divergent recommendations of these top performing advisers is this: Of the 44 actively managed sector funds that Fidelity currently offers, no fewer than 22 are recommended by at least one of these top five advisers. That’s one of every two, on average, which hardly seems very selective on the advisers’ part.

Amazing, isn’t it?  It just shows that there are many ways to skin a cat.

Even with a very limited menu of Fidelity sector funds, there was surprisingly little overlap.  Imagine how little overlap there would be within the ETF universe, which is much, much larger!  In short, you can safely pursue a sector rotation strategy (and, by extension, tactical asset allocation) with little concern that everyone else will be plowing into the same ETFs.

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Price Persistence At the Asset Class Level

January 9, 2014

Leuthold’s January Green Book includes a simple, yet compelling study about applying momentum at the asset class level:

While even academics now acknowledge the existence of a “price persistence” effect at the stock and industry group level, it is less well known that the phenomenon exists at the broad asset class level.  We’ve examined a few simple approaches in which allocation decisions are based purely on the prior year’s total return performance of seven asset classes: Large Caps, Small Caps, Foreign Stocks, REITs, Commodities, Gold and U.S. Treasury Bonds.  Contrarians might be surprised to learn that a turnaround strategy of buying last year’s laggards (the #5, #6 and #7 performers), has been a consistently poor approach for the last 40 years.  Meanwhile, a naive, momentum-surfing strategy of buying last year’s #1 or #2 performer (or both) has soundly beaten the S&P 500 since 1973.  (We suspect these results are especially humbling to those who spend the rest of the year building and monitoring elaborate tools that track valuations, the economic cycle, investor sentiment, etc.)

Leuthold Table 1

(printed with permission from Leuthold)

Bottom line: momentum also works well at the asset class level.  Click here for a white paper written by John Lewis that also confirms that momentum can be successfully applied to a group of asset classes.

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A Reminder About Real Return

November 20, 2013

The main thing that should matter to a long-term investor is real return.  Real return is return after inflation is factored in.  When your real return is positive, you are actually increasing your purchasing power— and purchasing goods and services is the point of having a medium of exchange (money) in the first place.

A recent article in The New York Times serves as a useful reminder about real return.

The Dow Jones industrial average broke through 16,000 on Monday for the first time on record — well, at least in nominal terms. If you adjust for inflation, technically the highest level was on Jan. 14, 2000.

Adjusting for price changes, the Dow’s high today was still about 1.3 percent below its close on Jan. 14, 2000 (and about 1.6 percent below its intraday high from that date).

There’s a handy graphic as well, of the Dow Jones Industrial Average adjusted for inflation.

Source: New York Times/Bloomberg

(click on image to enlarge)

This chart, I think, is a good reminder that buy-and-hold (known in our office as “sit-and-take-it”) is not always a good idea.  In most market environments there are asset classes that are providing real return, but that asset class is not always the broad stock market.  There is value in tactical asset allocation, market segmentation, strategy diversification, and other ways to expose yourself to assets that are appreciating fast enough to augment your purchasing power.

I’ve read a number of pieces recently that contend that “risk-adjusted” returns are the most important investment outcome.  Really?  This would be awesome if I could buy a risk-adjusted basket of groceries at my local supermarket, but strangely, they seem to prefer the actual dollars.  Your client could have wonderful risk-adjusted returns rolling Treasury bills, but would then also get to have a lovely risk-adjusted retirement in a mud hut.  If those dollars are growing more slowly than inflation, you’re just moving in reverse.

Real returns are where it’s at.

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From the Archives: Market Anxiety Disorder

September 24, 2013

A recent article in the Personal Finance section of the Wall Street Journal had a prescription for anxious investors that Andy has been talking about for more than a year: consider asset allocation funds.  Our Global Macro separate account has been very popular, partly because it allows investors to get into the market in a way that can be conservative when needed, but one that doesn’t lock investors into a product that can only be conservative.

The stock market’s powerful rally over the past year has gone a long way toward reducing the losses that many mutual-fund investors suffered in late 2007 and 2008.

But the rebound—with the Standard & Poor’s 500-stock index up 74% from its March 9, 2009, low—has done nothing for one group of investors: those who bailed out of stocks and have remained on the sidelines. Some of these investors have poured large sums into bond funds, even though those holdings may take a beating whenever interest rates rise from today’s unusually low levels, possibly later this year. Some forecasters, meanwhile, believe that stocks may finish 2010 up as much as 10%.

So, for investors who want to step back into stocks but are still anxious, here’s a modest suggestion: You don’t have to take your stock exposure straight up. You can dilute it by buying an allocation fund that spreads its assets across many market sectors, from stocks and bonds to money-market instruments and convertible securities.

While the WSJ article is a good general introduction to the idea, I think there are a few caveats that should be mentioned.

There’s still a big difference between a strategic asset allocation fund and a tactical asset allocation fund.

Many [asset allocation funds] keep their exposures within set ranges, while others may vary their mix widely.

Your fund selection will probably depend a lot on the individual client.  A strategic asset allocation fund will more often have a tight range or even a fixed or target allocation for stocks or bonds.  This can often target the volatility successfully–but can hurt returns if the asset classes themselves are out of favor.  Tactical funds will more often have broader ranges or be unconstrained in terms of allocations.  This additional flexibility can lead to higher returns, but it could be accompanied by higher volatility.

One thing the article does not mention at all, unfortunately, is that you also have a choice between a purely domestic asset allocation fund or a global asset allocation fund.  A typical domestic asset allocation fund will provide anxious investors with a way to ease into the market, but will ignore many of the opportunities in international markets or in alternative assets like real estate, currencies, and commodities.  With a variety of possible scenarios for the domestic economy, it might make sense to cast your net a little wider.  Still, the article’s main point is valid: an asset allocation fund, especially a global asset allocation fund, is often a good way to deal with a client’s Market Anxiety Disorder and get them back into the game.

—-this article originally appeared 4/7/2010.  Investors still don’t like this rally, even though we are a long way down the road from 2010!  An asset allocation fund might still be a possible solution.

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Finance Theory vs. Portfolio Reality

August 30, 2013

Index Universe carried an interview with Tad Rivelle, the chief investment officer at Trust Company of the West, that touched on the difference between finance theory and the reality in the markets.  Mr. Rivelle is mainly a bond guy and the interview mostly discussed interest rates and so on, but it contained this gem:

IU.com: We’re hearing projections of 3.5 percent rates by next year, 4.5 percent by 2015. What happens if the bond market decides to rush there at once rather than to gradually get to those levels? Could it derail the economic recovery?

Rivelle: Yes. In fact, that’s precisely what we saw when we had that taper tantrum back in May and June. It was catalyzed by Bernanke’s statement to the effect that the Fed was carefully considering an initiation of a taper late this year, and the bond market sold off horrifically in a very short period of time. It was a generalized deleveraging. I think it frightened the Fed, and consequently they walked those comments back.

The conflict here is that the Fed tends to approach things from a model-driven academic perspective—what’s supposed to happen in theory versus the realities of the marketplace. When people are looking to front-run one another to offload risk before the next guy does, these models basically go out the window.

How the bond market will respond is absolutely unknown, but it’s more typical for the bond market to move very rapidly, to gallop to what it believes is the next point of equilibrium and not to sell off gradually. I’ve never seen that happen.

I put the fun part in bold—in a real market, academic models go out the window and human behavior takes over.  Mr. Rivelle points out that markets trade on perception, and often make adjustments abruptly when perceptions change.

To me, this is the real strength of tactical asset allocation driven by relative strength.  As perceptions change, different securities or asset classes come to the forefront and others fade away.  As relative strength investors, we don’t have to predict what these changes might be.  We simply have to adapt our portfolio as the changes occur.  Relative strength adapts to changes in human behavior, not some elusive equilibrium proposed by academics.

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Correlation and Expected Returns

July 31, 2013

Modern portfolio theory imagines that you can construct an optimal portfolio, especially if you can find investments that are uncorrelated.  There’s a problem from the correlation standpoint, though.  As James Picerno of The Capital Spectator points out, correlations are rising:

A new study from the Bank of International Settlements (BIS) raises doubts about the value of commodities as a tool for enhancing portfolio diversification. The paper’s smoking gun, so to speak, is that “the correlation between commodity and equity returns has substantially increased after the onset of the recent financial crisis.”

Correlations are a key factor in the design and management of asset allocation, but they’re not the only factor. And even if we can find assets and strategies with reliably low/negative correlations with, say, equities, that alone isn’t enough, as I discussed last week. You also need to consider other factors, starting with expected return. It may be tempting to focus on one pair of assets and consider how the trailing correlation stacks up today. But that’s hardly the last word on making intelligent decisions on how to build a diversified portfolio.

As more investors pile into commodities, REITs, hedge funds, and other formerly obscure corners, the historical diversification benefits will likely fade. Granted, the outlook for expected diversification benefits fluctuates through time, and so what looks unattractive today may look considerably more compelling tomorrow (and vice versa). But as a general proposition, it’s reasonable to assume that correlations generally will inch closer to 1.0. That doesn’t mean that diversifying across asset classes is destined to become worthless, but the expected payoff is likely to dim with the passage of time.

Mathematically, any two items that are not 100% correlated will reduce volatility when combined.  But that doesn’t necessarily mean it’s a good addition to your portfolio—or that modern portfolio theory is a very good way to construct a portfolio.  (We will set aside for now the MPT idea that volatility is necessarily a bad thing.)  The article includes a nice graphic, reproduced below, that shows how highly correlated many asset classes are with the US market, especially if you keep in mind that these are 36-month rolling correlations.  Many asset classes may not reduce portfolio volatility much at all.

Source: The Capital Spectator  (click on image to enlarge)

As Mr. Picerno points out, optimal allocations are far more sensitive to returns than to correlations or volatility.  So even if you find a wonderfully uncorrelated investment, if it has a lousy return it may not help the overall portfolio much.  It would reduce volatility, but quite possibly at a big cost to overall returns.  The biggest determinant of your returns, of course, is what assets you actually hold and when.  The author puts this a slightly different way:

Your investment results also rely heavily on how and when you rebalance the mix.

Indeed they do.  If you hold equities when they are doing well and switch to other assets when equities tail off, your returns will be quite different than an investor holding a static mix.  And your returns will be way different than a scared investor that holds cash when stocks or other assets are doing well.

In other words, the return of your asset mix is what impacts your performance, not correlations or volatility.  This seems obvious, but in the fog of equations about optimal portfolio construction, this simple fact is often overlooked.  Since momentum (relative strength) is generally one of the best-performing and most reliable return factors, that’s what we use to drive our global tactical allocation process.  The idea is to own asset classes as long as they are strong—and to replace them with a stronger asset class when they begin to weaken.  In this context, diversification can be useful for reducing volatility, if you are comfortable with the potential reduction in return that it might entail.  (We  generally advocate diversifying by volatility, by asset class, and by strategy, although the specific portfolio mix might change with the preference of the individual investor.)  If volatility is well-tolerated, maybe the only issue is trying to generate the strongest returns.

Portfolio construction can’t really be reduced to some “optimal” set of tradeoffs.  It’s complicated because correlations change over time, and because investor preferences between return and volatility are in constant flux.  There is nothing stable about the portfolio construction process because none of the variables can be definitively known; it’s always an educated approximation.  Every investor gets to decide—on an ongoing basis—what is truly important: returns (real money you can spend) or volatility (potential emotional turmoil).  I always figure I can afford Maalox with the extra returns, but you can easily see why portfolio management is overwhelming to so many individual investors.  It can be torture.

Portfolio reality, with all of its messy approximations, bears little resemblance to the seeming exactitude of Modern Portfolio Theory.

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From the Archives: Perfect Sector Rotation

June 4, 2013

CXO Advisory has a very interesting blog piece on this topic.  They review an academic paper that looks at the way conventional sector rotation is done.  Typically, various industry sectors are categorized as early cycle, late cycle, etc. and then you are supposed to own those sectors at that point in the business cycle.  Any number of money management firms (not including us) hang their hat on this type of cycle analysis.

In order to determine the potential of traditional sector rotation, the study assumes that you get to have perfect foresight into the business cycle and then you rotate your holdings with the conventional wisdom of when various industries perform best.  A couple of disturbing things crop up, given that this is the best you could possibly do with this system.

1) You can squeak by with about 2.3% annual outperformance if you had a crystal ball.  If you are even a month or two early or late on the cycle turns, your performance is statistically indistinguishable from zero.

2) 28 of the 48 industries studied (58.3%) underperformed during the times when they were supposed to perform well.  There’s obviously enough noise in the system that a sector that is supposed to be strong or weak during a particular part of the cycle often isn’t.

CXO notes, somewhat ironically:

Note that NBER can take as long as two years after a turning point to designate its date and that one business cycle can be very different from another.

In other words, it’s clear that traditional business cycle analysis is not going to help you.  You won’t be able to forecast the cycle turning points accurately and the cycles differ so much that industry performance is not consistent.

Sector rotation using relative strength is a big contrast to this.  Relative strength makes no a priori assumptions about which industries are going to be strong or weak at various points in the business cycle.  A systematic strategy just buys the strong sectors and avoids the weak ones.  Lots of studies show that significant outperformance can be earned using relative strength (momentum) with absolutely no insight into the business cycle at all, including some studies done by CXO Advisory.  Tactical asset allocation is finally coming into its own and various ways of implementing are available.  Business cycle forecasting does not appear to be a feasible way to do it, but relative strength certainly is!

—-this article originally appeared 3/30/2010.  Although the link to CXO Advisory is no longer live, you can get the gist of things from the article.  Things don’t always perform in the expected fashion, and paying attention to relative strength can be some protection from the problem.  Instead of making assumptions about strong or weak performance, relative strength just adapts.

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The Pullback in Japan

May 23, 2013

In light of Thursday’s 7.3% drop in the Nikkei 225, we wanted to review Japan from a trend and relative strength perspective.  Performance over the last two years is show below.  The explosive move higher in Japanese equities has been driven in large part by expectations for Prime Minister Shinzo Abe’s plan which can be summed up in his own words, “With the strength of my entire cabinet, I will implement bold monetary policy, flexible fiscal policy and a growth strategy that encourages private investment, and with these three policy pillars, achieve results.”

 

Japan

Source: Yahoo! Finance (click to enlarge)

A longer-term view of the Nikkei 225 reveals just how poor the performance for Japanese equities has been since its 1989 peak:

Japan2

Source: Yahoo! Finance (click to enlarge)

As expected from a trend following methodology, Japan also started to rise to the top of our relative strength ranks in recent months.  In fact, the iShares MSCI Japan ETF (EWJ) was added to the Arrow DWA Tactical Fund (DWTFX) in April of this year.  The strength in EWJ is just one of the reasons that DWTFX is currently outperforming 98% of its peers in the Morningstar World Allocation Category YTD.  The relative strength of Japan can also be seen in the Dorsey Wright Fund Score Rank:

fund score

 

Source: Dorsey Wright (click to enlarge)

So, let’s get to the question on everyone’s mind: What happens from here?  Will Japan bounce back and resume its explosive move higher or is it the beginning of a trend reversal?  Unfortunately, we don’t have the answer to that.  As we do with every trade, we buy strength and stay with it as long as it remains strong.  If a position weakens sufficiently in our relative strength ranks we will replace it with a stronger security.

However, I do think it is interesting to note the potential comparison to a position in China that we had in the Arrow DWA Balanced Fund from 2006 to 2008.  That transaction had a cumulative return of 103% from its initial purchase, but during the start of this magical ride there was a 21% correction.  This is documented in the chart below.

China

Source: Arrow Funds (click to enlarge)

The mere fact that Japan is back on the radar for relative strength strategies is a powerful reminder of the need to remain adaptive.  New themes are constantly developing and relative strength is adept at capitalizing on these trends.  There are plenty of pundits who are betting that Japan will continue its move higher, including Marc Faber.  This could well be a good opportunity to get exposure to DWTFX during a temporary period of weakness after the fund has climbed over 13% YTD.

Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.  See www.arrowfunds.com for more information.  A list of all holdings for the trailing 12 months is available upon request.

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Financial Repression Primer

May 1, 2013

Research Affliliates published a very nice primer on financial repression on Advisor Perspectives.  It’s well worth reading to get the lay of the land.  Here’s how they define financial repression:

Financial repression refers to a set of governmental policies that keep real interest rates low or negative and regulate or manipulate a captive audience into investing in government debt. This results in cheap funding and will be a prime tool used by governments in highly indebted developed market economies to improve their balance sheets over the coming decades.

When you hear talk about “the new normal,” this is one of the features.  Most of us have not had to deal with financial repression during our investment careers.  In fact, for advisors in the 1970s and early 1980s, the problem was that interest rates were too high, not too low!

There are disparate views on the endgame from financial repression.  Some are expecting Japanese-style deflation, while others are looking for Weimar Republic inflation.  Maybe we will just muddle through.  In truth, there are many possible outcomes depending on the myriad of policy decisions that will be made in coming years.

In our view, guessing at the outcome of the political and economic process is hazardous.  We think it makes much more sense to be alert to the possibilities embedded in tactical asset allocation.  That allows you to pursue returns wherever they can be found at the time, without having to have a strong opinion on the eventual outcome.  Relative strength can often be a very useful guide in that process.

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February Arrow DWA Funds Review

March 7, 2013

February 28, 2013

The Arrow DWA Balanced Fund (DWAFX)

At the end of February, the fund had approximately 44% in U.S. Equities, 25% in Fixed Income, 17% in International Equities, and 12% in Alternatives.  This is little changed from the allocations to the different asset classes as of the end of January.  However, we did have some changes within the Alternative asset class: Our position in gold was removed and replaced with real estate.  The balance of the Alternative exposure is to the currency carry trade.  Our biggest overweight continues to be U.S. equities.

DWAFX gained 0.23% in February and is up 3.72% through 2/28/13.  Much of the best performance for the month came from our exposure to domestic equities (small and mid caps in particular), while international equities pulled back over the course of the month.  Our fixed income exposure also modestly advanced in February.  Although interest rates declined in February, the overall trend of rates has been higher since the middle of last year.  Our exposure to fixed income can range from approximately 25 to 65 percent and right now it is at its lower limit.

We believe that a real strength of this strategy is its balance between remaining diversified, while also adapting to market leadership.  When an asset class is weak its exposure will tend to be towards the lower end of the exposure constraints, and when an asset class is strong its exposure in the fund will trend toward the upper end of its exposure constraints.  Relative strength provides an effective means of determining the appropriate weights of the strategy.

The Arrow DWA Tactical Fund (DWTFX)

At the end of February, the fund had approximately 62% in U.S. Equities, 28% in International Equities, and 9% in Real Estate.  Over the course of February, we added to our U.S. Equity exposure, and reduced our exposure to International Real Estate.  When this bull market in U.S. equities began nearly four years ago, there were not many who projected the impressive gains that we have ultimately seen.  In fact, without a disciplined approach to following trends, it may have been psychologically difficult to overweight this asset class.  However, this continues to be our biggest overweight.  Our U.S. equity exposure remains in areas that have shown some fairly stable leadership, such as Consumer Discretionary, Financials, and Healthcare.  Stable leadership is very helpful for trend following strategies and Consumer Discretionary stocks have been fairly persistent leaders for the last 5 years.  Notably absent from our exposure is commodities, which have been particularly weak for the last couple of years.  Commodities were among the best performing asset classes over the past decade, but that strength has not so far carried over to this decade.  Again, we see the benefits of being adaptive.

DWTFX was flat in February and is up 3.79% through 2/28/13.  Much of the best performance for the month came from our exposure to domestic equities, while our exposure to European equities pulled back over the course of the month.

This strategy is a go-anywhere strategy with very few constraints in terms of exposure to different asset classes.  The strategy can invest in domestic equities, international equities, inverse equities, currencies, commodities, real estate, and fixed income.  Market history clearly shows that asset classes go through secular bull and bear markets and we believe this strategy is ideally designed to capitalize on those trends.  Additionally, we believe that this strategy can provide important risk diversification for a client’s overall portfolio.

Of interest to Wells Fargo Advisors: The Arrow DWA Tactical Fund is currently among the funds on the Wells Fargo Advisors Mutual Fund Recommended List.

Please see www.arrowfunds.com for more information about The Arrow DWA Balanced Fund and The Arrow DWA Tactical Fund.  Holding for the trailing 12 months is available upon request.  Past performance is no guarantee of future returns.

 

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Target Date Fund Follies

March 7, 2013

Target date and lifecycle funds have taken off since 2006, when they were deemed qualified default investment alternatives in the Pension Protection Act.  I’m sure it seemed like a good idea at the time.  Unfortunately, it planted the idea that a glidepath that moved toward bonds as the investor moved toward retirement was a good idea.  Assets in target date funds were nearly $400 billion at the end of 2011—and they have continued to grow rapidly.

In fact, bonds will prove to be a good idea if they perform well and a lousy idea if they perform poorly.  Since 10-year future returns correlate closely with the current coupon yield, prospects for bonds going forward aren’t particularly promising at the moment.  I’ve argued before that tactical asset allocation may provide an alternative method of accumulating capital, as opposed to a restrictive target-date glidepath.

A new research paper by Javier Estrada, The Glidepath Illusion: An International Perspective, makes a much broader claim.  He looks at typical glidepaths that move toward bonds over time, and then at a wide variety of alternatives, ranging from inverse glidepaths that move toward stocks over time to balanced funds.  His findings are stunning.

This lifecycle strategy implies that investors are aggressive with little capital and conservative with much more capital, which may not be optimal in terms of wealth accumulation. This article evaluates three alternative types of strategies, including contrarian strategies that follow a glidepath opposite to that of target-date funds; that is, they become more aggressive as retirement approaches. The results from a comprehensive sample that spans over 19 countries, two regions, and 110 years suggest that, relative to lifecycle strategies, the alternative strategies considered here provide investors with higher expected terminal wealth, higher upside potential, more limited downside potential, and higher uncertainty but limited to how much better, not how much worse, investors are expected to do with these strategies.

In other words, the only real question was how much better the alternative strategies performed.  (I added the bold.)

Every strategy option they considered performed better than the traditional glidepath!  True, if they were more focused on equities, they were more volatile.  But, for the cost of the volatility, you ended up with more money—sometimes appreciably more money.  This data sample was worldwide and extended over 110 years, so it wasn’t a fluke.  Staying equity-focused didn’t work occasionally in some markets—it worked consistently in every time frame in every region.  Certainly the future won’t be exactly like the past, so there is no way to know if these results will hold going forward.  However, bonds have had terrific performance over the last 30 years and the glidepath favoring them still didn’t beat alternative strategies over an investing lifetime.

Bonds, to me, make sense to reduce volatility.  Some clients simply must have a reduced-volatility portfolio to sleep at night, and I get that.  But Mr. Estrada’s study shows that the typical glidepath is outperformed even by a 60/40-type balanced fund.  (Balanced funds, by the way, are also designated QDIAs in the Pension Protection Act.)   Tactical asset allocation, where bonds are held temporarily for defensive purposes, might also allow clients to sleep at night while retaining a growth orientation.  The bottom line is that it makes sense to reduce volatility just enough to keep the client comfortable, but no more.

I’d urge you to read this paper carefully.  Maybe your conclusions will be different than mine.  But my take-away is this: Over the course of an investing lifetime, it is very important to stay focused on growth.

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From the Archives: Was It Really a Lost Decade?

February 28, 2013

Index Universe has a provocative article by Rob Arnott and John West of Research Affiliates.  Their contention is that 2000-2009 was not really a lost decade.  Perhaps if your only asset was U.S. equities it would seem that way, but they point out that other, more exotic assets actually had respectable returns.

The table below shows total returns for some of the asset classes they examined.

 Was It Really a Lost Decade?

click to enlarge

What are the commonalities of the best performing assets? 1) Lots of them are highly volatile like emerging markets equities and debt, 2) lots of them are international and thus were a play on the weaker dollar, 3) lots of them were alternative assets like commodities, TIPs, and REITs.

In other words, they were all asset classes that would tend to be marginalized in a traditional strategic asset allocation, where the typical pie would primarily consist of domestic stocks and bonds, with only small allocations to very volatile, international, or alternative assets.

In an interesting way, I think this makes a nice case for tactical asset allocation.  While it is true that most investors–just from a risk and volatility perspective–would be unwilling to have a large allocation to emerging markets for an entire decade, they might find that periodic significant exposure to emerging markets during strong trends would be quite acceptable.  And even assets near the bottom of the return table like U.S. Treasury bills would have been very welcome in a portfolio during parts of 2008, for example.  You can cover the waterfront and just own an equal-weighted piece of everything, but I don’t know if that is the most effective way to do things.

What’s really needed is a systematic method for determining which asset classes to own, and when.  Our Systematic Relative Strength process does this pretty effectively, even for asset classes that might be difficult or impossible to grade from a valuation perspective.  (How do you determine whether the Euro is cheaper than energy stocks, or whether emerging market debt is cheaper than silver or agricultural commodities?)  Once a systematic process is in place, the investor can be slightly more comfortable with perhaps a higher exposure to high volatility or alternative assets, knowing that in a tactical approach the exposures would be adjusted if trends change.

—-this article originally appeared 2/17/2010.  There is no telling what the weak or strong assets will be for the coming decade, but I think global tactical asset allocation still represents a reasonable way to deal with that uncertainty.

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From the Archives: Rob Arnott and the Key to Better Returns

February 21, 2013

Rob Arnott is a thought leader in tactical asset allocation, currently well-known for his RAFI Fundamental Indexes.  In his recent piece, Lessons from the Naughties, he discusses how investors will need to find return going forward.

The key to better returns will be to respond tactically to the shifting spectrum of opportunity, especially expanding and contracting one’s overall risk budget.

It’s a different way to view tactical asset allocation–looking at it from a risk budget point of view.  The general concept is to own risk assets in good markets and safe assets in bad markets.

It turns out that systematic application of relative strength accomplishes this very well.  The good folks at Arrow Funds recently asked us to take a look at how the beta in a tactically managed portfolio changed over time.  When we examined that issue, it showed that as markets became risky, relative strength reduced the beta of the portfolio by moving toward low volatility (strong) assets.  When markets were strong, allocating with relative strength pushed up the beta in the portfolio, thus taking good advantage of the market strength.

 Rob Arnott and the Key to Better Returns

click to enlarge

Using relative strength to do tactical asset allocation, the investor was not only able to earn an acceptable rate of return over time, but was able to have some risk mitigation going on the side.  That’s a pretty tasty combination in today’s markets.

—-this article originally appeared on 2/26/2010.  Amid all of the publicity given recently to risk parity, Arnott’s approach, which is to vary the risk budget over time depending on the opportunities available, has been largely ignored.  I think this is unfortunate.  His approach, although perhaps not easy, has merit.  Tactical asset allocation driven by relative strength is one way to do that.

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Bonds and Risk Parity

February 13, 2013

I had risk parity in mind when I noted that a recent article at Financial Advisor quoted long-time awesome bond manager Dan Fuss on the state of the bond market:

Dan Fuss, whose Loomis Sayles Bond Fund beat 98 percent of its peers in the last three years, said the fixed-income market is more “overbought” than at any time in his 55-year career as he prepares to open a fund to British individual investors.

“This is the most overbought market I have ever seen in my life in the business,” Fuss, 79, who oversees $66 billion in fixed-income assets as vice chairman of Boston-based Loomis Sayles & Co., said in an interview in London. “What I tell my clients is, ‘It’s not the end of the world, but for heaven’s sakes don’t go out and borrow money to buy bonds right now.’”

The reason this intrigues me is the strong institutional interest in “risk parity” portfolios at the moment.  The base idea behind risk parity is that in a typical investment portfolio, equities provide most of the volatility.  A risk parity portfolio typically tries to equalize the volatility contribution of different asset classes, which often means reducing the equity allocation—and also often leveraging the bond allocation.  (Equating volatility with risk is a whole different discussion.)  In other words, risk parity portfolios often borrow money to buy bonds, just the thing Dan Fuss is urging his clients to avoid right now.

To me, the marker of a bubble is irrational behavior.  By that standard, bonds are in a bubble.  Consider that at the end of last week the 10-year Treasury could be purchased with a yield of about 2.00%.  Yet, the 10-year breakeven yield was about 2.57%, indicating that a buyer of 10-year Treasurys expected a negative real return.

Is it rational to buy something with the expectation of a negative return?  Think about it this way:  Imagine telling a prospective client, “If you buy this stock portfolio, we expect that you’ll lose about a half percent a year for the next decade.”  Think you would have any buyers?  Would people bid at auction to get a piece of the action?

Expectations, of course, could be wrong.  Maybe bonds will continue to do well for an extended period of time, or maybe buying with the expectation of a slight negative return will turn out to be a genius move because every other asset class does much worse.

The problem with bubbles is not really that they exist.  Bubbles are great for investors and for the economy on the way up.  Bubbles often have an evolutionary financial purpose as well—probably the foundation for many later businesses was laid during the internet bubble.  Much of the first internet generation might have died off, but their offspring populate Silicon Valley now.  We’ll always have bubbles, human nature being what it is.

The more specific problem with bubbles concerns the investors trapped in them as they deflate—and the absolute impossibility of determining when that might happen.  It’s way easier to identify a bubble than to guess when it will pop.  Trends of all types, including bubbles, can go on for a lot longer than people think.

The most practical way to handle bubbles, I think, is to use some type of trend following tactical approach.  You’ll never be out at the top, of course, but you might be able to be along for much of the ride and be able to exit without extensive damage.  If you’re a bond market investor today that might be one way to think about your exposure.  Committing to bonds as a permanent part of a risk parity strategy, especially with leverage, is a different animal.

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From the Archives: Getting Torched By Expert Opinion

January 29, 2013

Barry Ritholtz has posted a 5 minute clip of some of Ben Bernanke’s public comments between 2005-2007 on the housing market and the broader economy.  The point of me posting this is not to say that Bernanke is a complete moron because I have little doubt that he is one of the brightest financial minds in the country.  However, talk about being dead wrong!  If you relied on these opinions in order to make investment decisions, you likely got torched.  If you can’t rely on expert opinion when making investment decisions, then what options do you have?

This highlights the value of trend-following systems.   Trend following requires zero reliance on expert opinion; it simply allows the investor to adapt to whatever trends the market offers, whether or not experts expected things to play out in a given way.  With trend following, you’ll have plenty of losing trades, but you’ll also avoid sitting in losing trades for long periods of time.  Furthermore, systematic trend-following has an excellent track record (see here and here.)  Trend following allows you to cut your losses short and to hold on to your winners.  Frequently, the strongest trends end up being very different from what even the brightest experts predicted.

—-this article originally appeared 2/11/2010.  Well, heck, if you can’t trust Ben Bernanke, who can you trust?  The answer should be obvious: follow the price trend and forget about the random guessing of experts.

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Dealing With Financial Repression

January 28, 2013

James Montier, the investment strategist at GMO, published a long piece on financial repression in Advisor Perspectives in November 2012.  It’s taken me almost that long to read it—and I’m still not sure I completely understand its implications.  Financial repression itself is pretty easy to understand though.  Along with a humorous description of Fed policy, Montier describes it like this:

Put another way, QE sets the short-term rate to zero, and then tries to persuade everyone to spend rather than save by driving down the rates of return on all other assets (by direct purchase and indirect effects) towards zero, until there is nothing left to hold savings in. Essentially, Bernanke’s first commandment to investors goes something like this: Go forth and speculate. I don’t care what you do as long as you do something irresponsible.

Not all of Bernanke’s predecessors would have necessarily shared his enthusiasm for recklessness. William McChesney Martin was the longest-serving Federal Reserve Governor of all time. He seriously considered training as a Presbyterian minister before deciding that his vocation lay elsewhere, a trait that earned him the beautifully oxymoronic moniker of “the happy puritan.” He is probably most famous for his observation that the central bank’s role was to “take away the punch bowl just when the party is getting started.” In contrast, Bernanke’s Fed is acting like teenage boys on prom night: spiking the punch, handing out free drinks, hoping to get lucky, and encouraging everyone to view the market through beer goggles.

So why is the Fed pursuing this policy? The answer, I think, is that the Fed is worried about the “initial condition” or starting point (if you prefer) of the economy, a position of over-indebtedness. When one starts from this position there are really only four ways out:

i. Growth is obviously the most “popular” but hardest route.

ii. Austerity is pretty much doomed to failure as it tends to lead to falling tax revenues, wider deficits, and public unrest. 2

iii. Abrogation runs the spectrum from default (entirely at the borrower’s discretion) to restructuring (a combination of borrower and lender) right out to the oft-forgotten forgiveness (entirely at the lender’s discretion).

iv. Inflation erodes the real value of the debt and transfers wealth from savers to borrowers. Inflating away debt can be delivered by two different routes: (a) sudden bursts of inflation, which catch participants off guard, or (b) financial repression.

Financial repression can be defined (somewhat loosely, admittedly) as a policy that results in consistent negative real interest rates. Keynes poetically called this the “euthanasia of the rentier.”3  The tools available to engineer this outcome are many and varied, ranging from explicit (or implicit) caps on interest rates to directed lending to the government by captive domestic audiences (think the postal saving system in Japan over the last two decades) to capital controls (favoured by emerging markets in days gone by).

The effects of financial repression are easy to see:  very low yields in debt instruments, and the consequent temptation to reach for yield elsewhere.  Advisors see the effects in clients every day.

If you are feeling jovial, I highly recommend reading Montier’s whole piece as an antidote to your good mood.  His forecast is rather bleak—poor long-term returns in most all asset classes for a long period of time.  My take-away was a little different.

Let’s assume for a moment that Montier is correct and long-term (they use seven years) equity real returns are approximately equivalent to zero.  In fact, that’s pretty much exactly what we’ve seen during the last decade!  The broad market has made very little progress since 1998, a period going on 15 years now.  Buy-and-hold (we prefer the terminology “sit-and-take-it”) clearly didn’t work in that environment, but tactical asset allocation certainly did.  Using relative strength to drive the process, tactical asset allocation steered you toward asset classes, sectors, and individual securities that were strong (for however long) and then pushed you out of them when they became weak.

I have no idea whether Montier’s forecast will pan out or not, but if it does, tactical asset allocation might end up being one of the few ways to survive.  There’s almost always enough fluctuation around the trend—even if the trend is flat—to get a little traction with tactical asset allocation.

Source: Monty Python/Youtube

[In fact, might I suggest the Arrow DWA Balanced Fund and the Arrow DWA Tactical Fund as considerations?  You can find more information at www.arrowfunds.com.]

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Coping With the New Normal

November 28, 2012

The “new normal” is a phrase that strikes fear into the heart of many investors.  It is shorthand for the belief that the US economy will grow very slowly going forward, as opposed to resuming its typical growth rate.  For example, here is the Research Affliliates version of the new normal, as presented in a recent article from AdvisorOne:

Unless the U.S. makes politically difficult changes in immigration, employment and investment policies, Americans should expect a long-term “new normal” rate of growth of just 1%. So says investment management firm Research Affiliates, in a research note that brings a wealth of demographic and historic data to bear on current fiscal projections.

Christopher Brightman, the report’s author and head of investment management for the Newport Beach, Calif. Firm founded by indexing guru Rob Arnott, is critical of White House and Congressional Budget Office growth projections that assume 2.5% long-term growth.

Brightman argues the U.S. will find it nearly impossible to recapture the 3.3% average annual growth that prevailed from 1951 to 2000 as a result of negative trends in the key areas that affect GDP: population growth, employment rate growth and productivity.

PIMCO and other firms have also been exponents of the new normal view, and although the specifics may vary from strategist to strategist, the general outlook for sluggish growth is the same.

Investor response to date has been less than constructive and has mostly resembled curling up into the fetal position.  Although I have no idea how likely it is the new normal theory will pan out, let’s think for a moment about some of the possible implications.

  • if US economic growth is slow, it may slow growth overseas, especially when the US is their primary export market.
  • economies less linked to the US may decouple and retain strong growth characteristics.
  • inflation and interest rates may stay low, leading to better-than-expected bond returns (where default is not an issue).
  • ever more heroic measures to stimulate US economic growth may backfire, creating a debt bomb and high future inflation.
  • growth may be priced at a premium multiple for those stocks and sectors that are demonstrating strong fundamentals.  In other words, if growth is hard to find, investors may be willing to pay up for it.
  • slow economic growth may cause a collapse in multiples, as future growth is discounted at a much lower rate.

In other words, you can still get pretty much any investment scenario out of new normal assumptions.  It’s just about whether a particular strategist is feeling pessimistic or optimistic that day, or more cynically, whether they are talking their book.

To me, this is one of the best arguments in favor of tactical asset allocation driven by relative strength.  Relative strength lets the market decide, based on which assets are strong, what to buy.  At any given time it could be currencies, commodities, stocks, bonds, real estate, or even inverse funds.  And it might change over time, as new perceptions creep into the market or as policy responses and market consequences interact in a feedback loop.  Relative strength doesn’t make any assumptions about what will happen; it treats good performance favorably regardless of the source.  Tactical asset allocation, then, is just an attempt to extract returns from wherever they might be available.  That trait may come in handy in a tough market.

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Quote of the Week

November 14, 2012

Nervous energy is a great destroyer of wealth.—-Fayez Sarofim

This quote was embedded in an article written by Jim Goff, the research director at Janus.  Along with making the case for equities, he talks about how important it is to have a reasonable allocation that you can stick with—and then to leave it alone.

Mr. Goff talks about the way in which many investors undermine their returns:

The average investor is far from contrarian. I remember  vividly when a strategist from a top-tier investment firm in the mid-1990’s  told me that while the S&P 500 had grown at 13% per year over the prior 10  years, the realized equity returns of his firm’s retail client base, on  average, had compounded at only 5% per year. The S&P would have turned  $100,000 into $339,000 during that period, but their average investor ended  with $163,000.

Often this is caused by jumping in and out of an asset class, rather than by making tactical adjustments within the asset class.  There’s nothing wrong with tactical asset allocation as long as it’s done systematically.  Even a lousy version of strategic asset allocation—carried out effectively—will probably beat what most investors are doing!  Either way, undisciplined fiddling often ruins investment results.  Mr. Sarofim’s quote is something to take to heart.

There are a couple of points relevant to portfolio management.

  1. Think about a reasonable asset allocation for your situation, one you can stick with.
  2. Have a systematic process for making portfolio adjustments, not one that is undisciplined and responsive to the news environment.

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Oil Demand and the New World Order

October 25, 2012

Ed Yardeni of Dr. Ed’s Blog had an interesting chart of oil demand.  The interesting part was that he segmented the demand between Old World (US, Western Europe, and Japan) and New World (everyone else).  There really is a new world order, something that your portfolio needs to reflect.

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

In this case, a picture might be worth a few thousand words.  You can see pretty clearly that the growth rate in oil demand is far higher outside the Old World.  Up until 2004, aggregate demand was higher in the Old World, but that has changed too.  The big engine of oil demand is no longer the large developed economies.  The last recession created a downturn in oil demand in the Old World, but created barely a blip on the chart for the New World.  I was surprised when I saw this chart, and I’m probably not the only one.  I think most people in the investment industry would be surprised by this—and certainly many clients would be too.

To me, this is a good argument for global tactical asset allocation.  Yes, the economy is slow—but clearly not everywhere.  Based on oil demand, some economies are growing just fine.  Global tactical asset allocation allows you to go where the returns are, regardless of where they may be.  Relative strength is a good way to locate those returns.

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Invest for the Long Run?

October 18, 2012

“Invest for the long-run” can ring hollow for a recent retiree looking to carefully manage his or her nest egg.  Via an article in the New York Times by Paul Sullivan comes the following example:

How should people do the math to avoid dying broke? The answer depends as much on timing as spending.

Mark A. Cortazzo, senior partner at Macro Consulting Group, tells clients who ask this question about three fictional brothers. Each one retired with $1 million on Jan. 1 but three years apart — in 1997, 2000 and 2003. They all invested that $1 million in the Vanguard 500 Index Investor Fund.

Between when they retired and Aug. 31, 2012, each brother withdrew $5,000 a month. The brother who had been retired the longest had $1.14 million on Aug. 31. The one who retired most recently had $1.15 million left.

But the one in the middle, who began taking his monthly withdrawals in 2000, had only $160,568. The reason? The stock market went down for the first three years he was retired, and then plummeted again in 2008. He had to sell more shares to get $5,000 each month.

“Most clients say, ‘I don’t mind dying broke if I’m bouncing my last check to the undertaker,” Mr. Cortazzo said. “But I don’t want to run out at 80 if I’m going to live to 95.”

I can’t think of a better argument for employing our Global Macro strategy as part of the solution than this.  Global tactical asset allocation seeks to be adaptive enough to respond to these types of adverse market conditions.  The reality is that most recent retirees are in danger of running out of money in one of two ways: losing a substantial amount of money in a bear market or failing to earn enough of a return on their money to keep up with inflation.  I think Global Macro does an effective job of balancing those two risks.

To view a video on our Global Macro strategy, click here.

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

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Retirement Income Karma Boomerang

October 11, 2012

From time to time, I’ve written about karma boomerang: the harder you try to avoid getting nailed, the more likely it is that you’ll get nailed by exactly what you are trying to avoid.  This concept came up again in the area of retirement income in an article I saw at AdvisorOne.  The article discussed a talk given by Tim Noonan at Russell Investments.  The excerpt in question:

In [Noonan’s] talk, “Disengagement: Creating the Future You Fear,” he observed that lack of engagement in retirement planning is leading people toward the very financial insecurity they dread. What they need to know, and are not finding out, is simply whether they’ll have enough money for their needs.

I added the bold.  This is a challenge for investment professionals.  Individuals are not likely on their own to go looking for their retirement number.  They are also not likely to go looking for you, the financial professional.  They may realize they need help, but are perhaps intimidated to seek it—or fearful of what they might find out if they do investigate.

Retirement income is probably not an area where you want to tempt karma!  Retirement income is less secure than ever for many Americans, due to under-funded pension plans, neglected 401k’s, and a faltering Social Security safety net.  The only way to secure retirement income for investors is to reach out to them and get them engaged in the process.

Mr. Noonan, among other suggestions, mentioned the following:

  • “Personalization” is tremendously appealing. “Tailoring” may be an even more useful term, since “people don’t mind if the tailor reuses the pattern,” Noonan explained. They may even enjoy feeling part of an elite group.
  • “Tactical investing” is viewed positively. “People know they should be more adaptive, but they aren’t sure what of,” said Noonan. Financial plans should adapt to the outcomes they’re producing, not to hypothetical market forecasts.

Perhaps personalization and tactical investing can be used as hooks to get clients moving.  To reach their retirement income goals, they are going to need to save big and invest intelligently, but none of that will happen if they aren’t engaged in the first place.

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Inflation Also Rises

October 8, 2012

Inflation has been a big fear in the investment community for a few years now, but so far nothing has happened.  An article at AdvisorOne suggests that the onset of inflation can sometimes be rapid and unexpected.

Someday, in the possibly near future, you will suddenly be paying $10 for a gallon of milk and wondering how the heck it happened so fast.

That is the strange and terrible way of inflation, said State Street Global senior portfolio manager Chris Goolgasian in a panel talk on Thursday at Morningstar ETF Invest 2012. Inflation has a way of appearing to be a distant threat before it sneaks up suddenly and starts driving prices through the roof.

Quoting from Ernest Hemingway’s novel “The Sun Also Rises,” Goolgasian took note of a passage where a man is asked how he went bankrupt. “Two ways,” the man answered. “Gradually, then suddenly.”

“The danger is in the future, and it’s important to manage portfolios for the future,” Goolgasian concluded. “Real assets can give you some assurance against that chance.”

That’s good to know—but which real assets, and when?  After all, Japanese investors have probably been waiting for the inflation bogeyman for the last two decades.  This is one situation in which tactical asset allocation driven by relative strength can be a big help.  If you monitor a large number of asset classes continuously, you can identify when any particular real asset starts to surge in relative performance.

For example, on the Dorsey Wright database, the last extended run that gold had as a high relative strength asset class (ETF score > 3) was from 3/9/2011 to 12/21/2011.  Below, I’ve got a picture of the ETF score chart, along with a performance snip during that same period.  Perhaps because of investor concern about inflation—misplaced, as it turned out—gold outperformed fixed income over that stretch of time.

ETF Score for GLD

2011 Performance Snip

Source: Dorsey Wright  (click on images to enlarge)

There’s no guarantee that gold will be an inflation hedge, of course.  We never know what asset class will become strong when investors fear future inflation.  Next time around it could be real estate, Swiss francs, TIPs, or energy stocks—or nothing.  There are so many variables impacting performance that it is impractical (and impossible) to account for them all.  However, relative strength has the simple virtue of pointing out—based on actual market performance—where the strength is appearing.

Investment history sometimes seems to be a never-ending cycle of discredited themes, but those themes can drive the market quite powerfully until they are discredited.  (Remember the “new era” of the internet?  Or how “peak oil” was so compelling with crude at $140/barrel?)  It’s helpful to know what those themes are, whether you are trying to take advantage of them or just trying to get out of the way.

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The Inflation Mystery

September 17, 2012

Michael Sivy has a think piece on inflation in Time Magazine.  His premise is that, based on what economists think they know about deficit spending, economic stimulus, and money creation, we should be having serious inflation.  But so far that hasn’t happened.

The economy of the past three years has puzzled experts and policy makers in all  sorts of ways, but the greatest mystery has been the recent decline in the rate  of inflation. That may not seem remarkable in a stagnant economy, except that  all the major economic theories suggest that prices should now be rising at a  fast clip.

What’s most striking today is that all three of these factors are now at  extremes that should be fanning the flames of inflation. Deficits of more than a trillion dollars a year are the  highest in history. At close to zero, short-term interest rates are at their lowest level in more  than 30 years. And the Fed’s monetary base has been expanding at an  unprecedented rate. The remarkable thing is that none of this is translating  into serious inflation. Over the past three years, some volatile prices, such as  those for food and gasoline, have indeed gone up. But there still  haven’t been sustained widespread price increases throughout the economy.

Mr. Sivy has a preferred explanation for this inflation mystery, and also suggests what may happen when things change.

The explanation is that all the money in the world won’t push up prices unless  people are willing and able to spend it. So the dog that didn’t bark in this  story is the money that didn’t get spent.

The current stagnation may simply have to run its course. But once it does and  the economy really begins to rebound, it could well be accompanied by a  surprisingly fast resurgence of inflation.

I think his viewpoint is worth considering.  Inflation hasn’t been a problem so far, but that doesn’t mean it will never become a problem.  Investors, many with bond-heavy portfolios, may be ill-equipped to deal with a bout of inflation.  If inflation does occur, it may catch a lot of investors off guard, if only because they have seen declining inflation over their entire investing careers.

Relative strength might be a useful guide to solving the inflation mystery.  If traditional inflation-sensitive assets like commodities or energy and basic materials stocks start to pick up significant relative strength versus other asset classes, it might be time to focus on portfolio protection.

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Uncertainty and its Investment Implications

September 6, 2012

Uncertainty is usually problematic for investors.  If the economy is clearly good or decidedly bad, it’s often easier to figure out what to do.  I’d argue that investors typically overreact anyway, but they at least feel like they are justified in swinging for the fence or crawling into a bomb shelter.  But when there is a lot of uncertainty and things are on the cusp—and could go either way—it’s tough to figure out what to do.

The chart below, from the wonderful Calculated Risk blog, demonstrates the point perfectly.

Source: Calculated Risk  (click to enlarge)

You can see the problem.  The Purchasing Managers’ Index is hovering right near the line that separates an expanding economy from a contracting one.  There’s no slam dunk either way—there are numerous cases of the PMI dropping below 50 that didn’t result in a recession, but also a number that did have a nasty outcome.

So what’s an investor to do?

One possibility is an all-weather fund that has the ability to adapt to a wide variety of environments.  The old-school version of this is the traditional 60/40 balanced fund.  The idea was that the stocks would behave well when the economy was good and that the bonds would provide an offset when the economy was bad.  There are a lot of 60/40 funds still around, largely because they’ve actually done a pretty reasonable job for investors.

The new-school version is the global tactical asset allocation fund.  The flexibility inherent in a tactical fund allows it to tilt toward stocks when the market is doing well, or to tilt toward bonds if equities are having a rough go.  Many funds also have the potential to invest across alternative asset classes like real estate, commodities, or foreign currencies.

For a client that is wary of the stock market—and that might include most clients these days—a balanced fund or a global tactical asset allocation fund might be just the way to get them to dip their toe in the water.  They are going to need exposure to growth assets over the long run anyway and a flexible fund might make that necessary exposure more palatable.

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

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