The End of Asset Allocation?

  • Jim Lee

If you find yourself reacting to the news… you might not be doing it right. It is much more useful (and profitable) to anticipate trends in advance than it is to respond to the morning’s headlines.

When people talk about investments at cocktails parties or social gatherings, the conversation almost always veers towards “How do you believe that X will influence Y?”
The “X” in this case is always the hottest news item, and “Y” is typically the investment that is receiving the most press coverage.

Watching CNBC or Bloomberg News, you’ll get a good sense of the market’s mood for that moment . Market commentators will scramble to explain why today’s big story is moving the markets. When a story occurs for several days (or weeks) in a row, it becomes a source of public obsession. Eventually, that story becomes the most important thing moving the markets. Everyone becomes an expert in understanding the topic at hand, until the issue is resolved and the markets move to a new narrative.

It is worth mentioning that portfolio managers have relatively little control over client returns. If it was easy to control returns, we would always choose to generate spectacular profits. Right? Investing would become tedious, because everyone would have equally amazing performance.

What can be controlled is exposure to opportunity and risk. And the traditional way of doing this is through something called "asset allocation", which is part of a much bigger framework known as Modern Portfolio Theory (MPT).

The principle is fairly straightforward. By putting together a portfolio of non-correlated assets, you can hypothetically create smoother returns for investors.

Asset Class Returns 004

In the example above, we compare the performance of the S&P 500 index (dark blue) with the 20-year U.S. Treasury Bond (light blue). The middle line represents a balanced portfolio which is equally invested in both. The time period illustrated is 1956-1962, shortly after Modern Portfolio Theory was developed by Harry Markowitz in The Journal of Finance.

It was a beautiful and elegant idea. Asset allocation created a new standard for the industry and is still in use today.

One of the useful things about asset allocation was that it enabled financial advisors to be agnostic about the financial markets. It was no longer considered necessary to anticipate (or respond) to the news. All the advisor needed to do was "stay the course" and periodically rebalance portfolios to a target allocation.

Meanwhile, investors had less portfolio volatility. Mutual funds had lower asset turnover, because investors stayed invested for longer periods of time.

This was the real genius behind asset allocation. It kept everyone happy (for a while).

The Limits of Asset Allocation

As a portfolio manager, I started to see the limitations of asset allocation during the Financial Crisis of 2008-2009. During that period not only did the S&P 500 lose half its value, but bonds were down, real estate was down, and commodities were down. "Winning" simply meant "losing less." The only major asset class that didn't lose value was... cash.

Now that the S&P 500 is over 10% off from its peak levels earlier this year, we are seeing similar parallels. Many traditional asset classes are becoming correlated - right when we want the benefits of diversification.

Asset Class Returns 1 Yr 002

In the chart above, all major financial asset classes show some correlation to the S&P 500. There is a slightly negative correlation between the Barclays Aggregate Bond index and the MSCI Emerging Market index. Beyond that, everything else "sinks or swims" together.

Furthermore, the S&P 500 consistently outperformed most other asset classes over the past five years (and for the first half of this year). Attempts to diversify against U.S. market risk have generally produced performance lag, especially for those portfolios holding exposure to international and emerging market stocks. Bonds have lagged more recently, as a result of higher interest rates.

Asset Class Returns

Asset Class Returns 005

Asset Class Returns 003

Source: www.novelinvestor.com

This isn't saying that asset allocation is dead. If the current market correction evolves into a typical bear market, investors using some form of asset allocation may see less downside.

My sense is that asset allocation may be inadequate on a stand-alone basis. People are starting to figure this out. There are other useful tools of risk management, and these include style/sector rotation, investment selection, hedged strategies, and market timing. This is a benefit of having an independent investment advisor for your portfolio, as traditional index funds don't do any of these things.

Jim Lee, CFA, CMT, CFP ®

 Disclosure: Information contained herein is for educational purposes only and is not to be considered a recommendation to buy or sell any security or investment advice. Securities listed herein are for illustrative purposes only and are not to be considered a recommendation.

 

Rock Paper Scissors

Investing used to be simple. You would go out and buy and index fund, and then forget about it for the next ten years. It’s easy and inexpensive. This is called a “passive” strategy because you really didn’t need to do anything, beyond making the initial decision.

But not all index funds are created equal. While the Vanguard S&P 500 Index is still the largest mutual fund in the known multi-verse, there has been an explosion in what can be described as “enhanced” index funds. These are based on a few simple principles that have been shown to generate out-performance over time.

Enhanced index funds exist in something of a gray zone between “passive” and “active” strategies known as “factor” investing. It is an approach that fits well with the rising trend of robo-advisors coming into the marketplace today.

Based on Morningstar research, there are now 1,500 single-factor ETFs on the market. These can be categorized into five basic varieties….

Factor Boxes 007

Once a factor is identified, a custom index can be built by screening for stocks that satisfy the selected definition.

I’m beginning to see your eyes glaze over… but wait, this is really interesting stuff!

Looking back at almost 40 years of data, these five factors do appear to generate some outperformance over time, mostly in the 0.3% to 1.5% per year range.

Factor Boxes 008

The Size factor generally seems to provide the best returns, in exchange for the greatest risk. Meanwhile, the Low Volatility factor doesn’t seem to outperform over time, but does offer great protection during down periods. Both seem to be good, but each one is best under different circumstances. Furthermore, no single factor performs best every single year.

What ends up happening is a fairly highbrow game of “rock, paper, scissors.” You never know which one is going to win, so many portfolio managers choose a mixed strategy of factors. That means doing a little bit of each.

The key difference here is that unlike the original game, the investing version tends to play the same hand sequentially. Meaning, if Momentum has outperformed last year, the odds are good that Momentum will outperform this year, as well. This may occur until Momentum is so overpriced that it eventually fails. Sometimes, it fails badly.

While you might want to follow one-year trends in factor performance, following 5-year trends can be hazardous to your portfolio. In short, you can run the risk of becoming too predictable for your own good. Spend too much time playing with scissors, and you’ll eventually get crushed by a rock.

So, how do you know which factors to play?

The guys at Oppenheimer Funds put together an actively managed index strategy that allocates between the five basic factors, based on the business cycle. The timing for the business cycle is determined by watching key economic indicators and what they refer to as “global risk appetite.”

Factor Boxes11

And the back-tested results are looking quite good, generating annualized out-performance in the +5% range. Please keep in mind the fact that most new strategies look pretty amazing in hindsight.

Factor Boxes 009

 At the end of 2017, a new ETF was released that follows this active allocation approach. The Oppenheimer Russell 1000 Dynamic Multifactor ETF (ticker: OMFL) is off to a great start. It may be one of the few new ETFs that you can buy, hold, and then forget about for ten years.

Can it be possible that index investing is simple again?

Jim Lee, CFA, CMT, CFP®

Disclosure: Information contained herein is for educational purposes only and is not to be considered a recommendation to buy or sell any security or investment advice. The advisor holds shares of the Oppenheimer Russell 1000 Dynamic Multifactor ETF in client accounts. Securities listed herein are for illustrative purposes only and are not to be considered a recommendation.

 

The Disruption of Finance

  • Jim Lee
Depositphotos 54085067 l 2015
 
As a futurist, I spend much of of my time thinking about "what happens next?"  In this article, I'll share an insider's view of the finance industry. Much has changed in the past 25 years, and it's been exciting to watch.
 
Let's start with the existing trends first, followed by some of the new stuff:
 
1) Rise in popularity of index investing. There is extreme price compression going on in commoditized asset management. It truly is a race to the bottom. Some index funds now carry annualized fees as low as 0.04%. This is beginning to translate into fee compression for traditional active managers.
 
This is also translating into so-called "economies of scale" - bigger companies are getting more competitive, in part, because they can charges lower fees.
 
Meanwhile, conventional mutual funds are bleeding assets, while the bulk of new inflows are going to a handful of Index providers, primarily those offering Exchanged Traded Funds (ETFs).
 
Index and Ownership
Source:FactSet, P&I and Simfund as of 03/31/2018.
 
The irony here, is that big fund companies such as Vanguard and Blackrock may be the ultimate beneficiaries from the rise of robo-advisors (which tend to rely heavily on index funds). The top ten asset managers now own roughly 30% of all the companies represented in the S&P 500 index.
 
2) Because of the dominance of indexing strategies, stock selection is going somewhat out of favor for the general public. Investment management is becoming more about understanding and tracking the exposures that your companies correlate to, and less about the companies themselves. Think about that.
 
For sophisticated investors, privately managed equity portfolios continue to offer tax efficiency, along with the ability to customize accounts according to individual preferences.
 
3) Automation disrupted the investment research world a while ago. I run into quite a few former analysts / portfolio managers that were outsourced to algorithms. A regional bank a few blocks away from the StratFI office almost entirely liquidated its staff of analysts back in the mid 2000's.
 
Just last January, the AI Powered Equity ETF (ticker: AIEQ) was introduced, using IBM's Watson to actively manage stock selection. This will be fascinating to watch.
 
4) Indexing -> smart indexing -> active management of smart indexing strategies
 
A few years ago, we saw a boom in smart beta ETFs, which focus on various "factors" (value, momentum, quality, etc.) that appear to provide superior performance characteristics over time. As any expert would tell you, these factors come and go out of favor.
 
Cropped Multifactor
 
So, the new, new thing would be strategies that actively switch between those factors. Oppenheimer funds started its own Oppenheimer Russell Dynamic Multifactor ETF (OMFL) and Vanguard is following up with its own multifactor ETF (VFMF).
 
These strategies blend active management with algorithmic enhancement to traditional indexed strategies. How "meta" is that?
 
5) The headaches of regulatory oversight are contributing to a decline in the number of publicly-traded companies within the U.S. These figures peaked shortly before the adoption of Regulation FD (2000) and Sarbanes-Oxley (2002).
 
It is much more appealing to be a privately owned and funded company now, especially with an abundance of venture capital. Easy money, less regulation, what's not to like?
 
Many companies are waiting much longer before having their IPO, with initial public offerings now more of an exit strategy than a funding mechanism. The result is a narrower set of opportunities for public investors. 
 
Listed U S Company Count
 
6) Blockchain technologies pose a competitive threat to traditional financial institutions. Blockchain/crypto-currencies already provide alternatives for funding, trading, and cash transfer. Financial intermediaries run the risk of becoming disintermediated.
 
Initial Coin Offerings (ICOs), those bizarre love children of crowdfunding and IPOs, have already raised more than $9B this year. While crypto-currencies boomed in a "Wild-West" environment, further adoption will necessitate some further regulatory oversight.
 
(Trends #6 and #7 highlight the problems of "too much" vs. "too little" regulation, and the complexities of managing change.)
 
7) When the stock market (eventually) goes into bear mode - index funds are likely to get sold first. It is how flash-crashes happen. Many ETFs are not going to be as liquid as people think, periodically trading at steep discounts to net asset value. This will create a counter-trend opportunity for active managers.
 
8) The future of advice. You'll want to be sure that your financial advisor can keep up with the times.
 
The trend seems to be moving towards bigger money managers offering a less personalized experience. Some financial advisors are going into full "robo" mode, while others are more focused on "soft" services such as life coaching. At StratFI, we provide leading-edge investment advice with personal access.
 
Our offerings continue to evolve rapidly. Feel free to give us a call or send an email if you'd like to learn more.
 
James H. Lee, CFA, CMT, CFP®
(302) 884-6742
 
Disclosure: Information contained herein is for educational purposes only and is not to be considered a recommendation to buy or sell any security or investment advice. The advisor may hold shares of OMFL and AIEQ within client accounts. Securities listed herein are for illustrative purposes only and are not to be considered a recommendation. 

Lessons from Vacation

  • Jim Lee
Moab Trail Resized
 
Earlier this month, I took a two-week vacation to Moab, Utah. What’s in Moab? Dirt, rocks, and some of the best mountain biking in the world. What used to be a burned-out uranium town is now a world-class destination for people who enjoy the outdoors. Moab is the home of legendary trails such as Porcupine Ridge, Slickrock, and Bull Run.
  
We just keep going back....
 
After biking for twenty years, I learned a few things along the way.
  1. Where you focus is where you lean
  2. You are less likely to have an accident if you are well-balanced
  3. Everything is easier with momentum (except for making turns!)
  4. Over-steering is like micro-managing. It only slows you down.
  5. Keep your hands off the brakes, and let the hills do the work for you.
  6. Everyone learns faster when leadership is shared.
  7. Keep your eyes on the trail at least 20 feet ahead of you. More time to react.
  8. Switch gears before absolutely necessary.
  9. Everything is better with friends.
  10. The best views usually follow the longest climbs.
Some of these lessons have useful analogies for investing. As I get older, I’m beginning to learn the value of avoiding injury. Sometimes, winning means simply being able to hit the trails again the next day.  
 
Investing (like staying fit) provides it's own rewards and sense of achievement. If you want to get better, the key is to push yourself just a little while still playing it safe. It's OK (and even fun) to take a few small risks. Just keep them survivable so that you can wake up tomorrow and do it again.
 
Work hard, have fun, be excellent - and enjoy Memorial Day weekend!
 
James H. Lee, CFA, CMT, CFP

Thinking Fast and Slow

  • Jim Lee
I’ve been doing a lot of research lately on the future of real estate. This is an easy and popular topic – so much of it is tangible and visually interesting.
 
One thing really stands out. We’ve had some radical shifts in how we think, act, and organize. Yet, our physical world has been relatively unchanged for decades. We have the same streets, the same buildings, and the same forms of transportation. Cities change slowly. Parts grow, parts fade away. Yet the “bones” often remain across the generations.
  
Understanding why change doesn’t happen is almost as interesting was why it does.  One of my favorite explanations comes from Stewart Brand, of the Long Now Foundation. He writes about this in his book How Buildings Learn.  
 
Brand noticed that while collective change is now a given, not everything adjusts at the same rate.
 
Pace Layers
 
This is a layered view of the world that we live in. Brand refers to this as "pace layer thinking."
  • Fashion and technology move very quickly.  Every few months, there are trendy new lines of clothing, movies to watch, and music to follow. Our language is surprisingly adaptable.
  • Commerce and businessdo their best to keep up with the times, rolling out new offerings and updating existing ones. The start-up period between idea and reality is quickening, but it can still take years to introduce an entirely new product.
  • Infrastructure projects take significant planning, and often require a decade or more to build out. Part of this relates to the red-tape involved in obtaining approvals, and the need to raise massive amounts of capital.  
  • At the layer of governance, building codes and zoning regulations can last a century or more. 
  • Culture is not so much about fashion as it is about core values and traditions. The time frame for change can be hundreds (if not thousands) of years.
  • And in the end, nature has the final word. It will last longer than civilization.
Between each of these layers, you’ll have an element of turbulence and friction. This is where public discussion frequently happens. The faster moving layers get all the attention, while the slower moving layers have the power.  
 
Pace Layers 004
 
Pace layer thinking explains why cities and our built environment tend to change slowly over time. It provides insights to why the market for hydrogen fuel is so small (infrastructure), or why crypto-currencies might not hit ever reach the mainstream (governance). Cultural considerations are also significant. We may have some of the technology needed for genetic engineering, yet are reluctant to embrace it.
  
So, next time you encounter a new investment concept, take some time to consider why it might work out (or not). Think fast. Think slow.  
 
Jim Lee CFA, CMT, CFP® 
Founder, StratFI.
 
Disclosure:  Information contained herein is for educational purposes only and is not to be considered a recommendation to buy or sell any security or investment advice. Securities listed herein are for illustrative purposes only and are not to be considered a recommendation.

Trading the Hype

  • Jim Lee

Riding the Hype Cycle

You'll find the second and third floors of our house completely loaded with books. My wife and I both just love to read. For Steph, it is mostly literary and historical fiction. I'm an avid reader of business books, trends, philosophy, and sci-fi. Maybe 40-50 titles per year for each of us.

As a professional investor, it feels like 2017 was a year of tremendously hyped stories. Artificial intelligence, autonomous vehicles, blockchain, immuno-oncology, and marijuana legalization all had their moments in the spotlight.

Billions of dollars were made, billions of dollars will be lost.

But how do you analyze a speculation with no history and no profits? There are some explosive opportunities in the markets, and many of these defy any reasonable financial analysis. (I run into this problem with biotech stocks all the time.)

This month, I'll outline a process for evaluating some of these "story stocks."

What is the story? Why is it compelling? Is it easy to explain? If you can, write down a synopsis of why this is the next big thing.

How big is the story? What's the upside here? Will this be just a niche market, or is it a technology/service/product with broad implications? Also, what is a size of the company relative to the opportunity?

Is it real? Would this story be shelved in the "fiction" or "non-fiction" category? Do the main characters (an organization, its founders, and key personnel) appear to have both depth and realism?

Who knows the story? Some stories have been around forever. Others are comparatively new. The fresher the story, the higher its conversational value. The best stories are often unknown to most people.

Are there alternative narratives? What is the competition? Are there more compelling stories out there? What could go wrong?

When does the climax happen? Are there expectations leading to a key event, such as an FDA approval, a big earnings report, or legislation? Key events can add to the hype and excitement, only to be followed by realism. As the saying goes, "buy the rumor, sell the news." By the time that news becomes completely public, the best opportunity may have already passed.

How does this story end? It is usually a good idea to determine this before making a trade. What is your exit strategy? Do you have an upside target price where you'll take profits? Also, do you have a stop-loss to limit your downside and signal that you need to move on?

Position sizing is important here. That means not making any big bets when there is a lot of risk involved. (I prefer to keep my mistakes small.)

When done well, understanding the story behind a speculation can take just as much time and effort as research done using a classic textbook approach.

Jim Lee, CFA, CMT, CFP®
Founder, StratFI

Disclosure:  Information contained herein is for educational purposes only and is not to be considered a recommendation to buy or sell any security or investment advice. Securities listed herein are for illustrative purposes only and are not to be considered a recommendation.