2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP, CLU, ChFC, RHU, REBC, CASL, CWPP

Transcription

1 Understanding Tactical Asset Allocation By: Michael E. Kitces, MSFS, MTAX, CFP, CLU, ChFC, RHU, REBC, CASL, CWPP Partner, Director of Research, Pinnacle Advisory Group Publisher, The Kitces Report, Blogger, Nerd s Eye View, The Current World of Portfolio Construction: Why Buy and Hold? You believe the theory You don t believe identifying active managers is possible You believe active management is a poor business model The Current World of Portfolio Construction 3 Input MPT model built in 1950 s Requires absolutely no understanding of markets or economics Results in one set of portfolio solutions for all economic environments Allows for emphasis on client relationships vs. market knowledge Buy and Hold: patience and belief are the major ingredients for success 1

2 Portfolio Management vs. Money Management Money Managers Portfolio Managers Typically specialize in one asset class Have easy to identify benchmarks Are constrained by investment style Experts at underlying securities Media darlings Invest in all asset classes Have arbitrary benchmarks Hire or invest in money managers Fixed mix of efficient asset classes (MPT) Explain money mgr. performance results Challenging Questions about Investment Strategy Does the scientific nature of discussions about MPT and CAPM create the illusion of professional money management? If selling technology and large cap stocks in 2000 constituted market timing, what is wrong with market timing? What good is an investment strategy where the value of what you buy doesn t matter? Challenging Questions about Investment Strategy Why will advisors do almost anything to avoid qualitative decisions about money management? If money management is art, then won t some of us be better artists than others? 2

3 The Two Unbreakable Rules of Investing Do Diversify Don t Buy Overvalued Assets even if you have time to wait The Impact of Valuation Source: Crestmont Research ( Sometimes, we never get back to average returns Secular market cycles 3

4 The Impact of Valuation Source: Improving Risk-Adjusted Returns Using Market-Valuation-Based Tactical Asset Allocation Strategies, by Solow, Kitces, & Locatelli, Journal of Financial Planning, December 2011 Different P/E environments have different return distributions Valuation trends aren t random Source: Ned Davis Research ( Valuation moves in long-term secular cycles Implications of buying at high prices 10-year annualized returns by valuation deciles, with probability of less-than-3% annualized growth Valuation Decile High Low Average Prob <3% gain % -4.83% 3.72% 36.17% % -2.42% 6.38% 14.18% % -0.79% 6.38% 17.61% % 0.01% 7.29% 13.38% % 0.83% 7.03% 14.79% % 1.43% 7.30% 11.27% % 3.08% 8.51% 0.00% % 4.01% 10.70% 0.00% % 4.12% 11.94% 0.00% % 3.45% 11.31% 0.00% 4

5 Tactical Asset Allocation: A process where the client s portfolio asset allocation is altered in response to changing future (investment) expectations. Strategic Asset Allocation Tactical Asset Allocation 5

6 Benefits of Being Tactical Source: Improving Risk- Adjusted Returns Using Market-Valuation-Based Tactical Asset Allocation Strategies, by Solow, Kitces, & Locatelli, Journal of Financial Planning, December 2011 Misunderstanding Markowitz The process of selecting a portfolio may be divided into two stages. The first stage starts with observations and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performance and ends with the choice of portfolio. This paper is concerned with the second stage. - Markowitz, Portfolio Selection,, 1952 Using MPT MPT was intended as a process to take the inputs (return, volatility, and correlation) to provide an output (the optimal allocation balancing risk and return) It does not address what those inputs should be in the first place, or how to determine them How should you develop the inputs to determine an appropriate portfolio? 6

7 Markowitz on MPT inputs To use the E-V rule in the selection of securities we must have procedures for finding reasonable [estimates of expected return and volatility]. These procedures, I believe, should combine statistical techniques and the judgment of practical men. My feeling is that the statistical computations should be used to arrive at a tentative set of [mean and volatility]. Judgment should then be used in increasing or decreasing some of these [mean and volatility inputs] on the basis of factors or nuances not taken into account by the formal computations Markowitz on MPT inputs (con t) One suggestion as to tentative [mean and volatility] is to use the observed [mean and volatility] for some period of the past. I believe that better methods, which take into account more information, can be found. - Markowitz The theory of the Strategic Approach Based on a rigorous quantitative model that requires subjective inputs!? Relies on theoretical assumptions No transaction costs to buy or sell. Liquidity is infinite. Investors are indifferent to tax consequences. Investors are rational and risk averse. Investors have the same investment time horizon. Investors all view risk the same way. All investors have the same information. Investors can lend or borrow at the risk-free rate Politics and investor psychology don t move the market. 7

8 Economic and Investment Uncertainty If the economic and investment environment is not stable, there cannot be one true solution. Source: H. Woody Brock, Strategic Economic Decisions Inc. Building Blocks of Tactical Asset Allocation Technical Analysis Market/Business Cycle Analysis Used to develop a Forecast, and the timing to implement it Traditional Valuation Measures Building Blocks of Tactical Asset Allocation Conviction in your forecast 8

9 Building Blocks of Tactical Asset Allocation Develop a Point of View Sector Rotation Telecommunications Energy Health Care Contraction Cons. Staples Utilities Industrials Financials Materials Expansion Technology Cons. Discretionary Building Blocks of Tactical Asset Allocation Develop a Point of View Fixed Income Credit Credit Corporate Bonds High Yield Mortgages Emerging Market Debt Interest Sensitive Treasury Bonds Foreign Government Bonds Interest Sensitive Expansion Neutral Contraction 9

10 Tactical Asset Allocation The crystal ball is murky but it s not opaque Tactical Allocation Changes: Not Market Timing Tactical Allocation Decisions Pinnacle Moderate Composite 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 4th Quarter 02 1st Quarter 03 2nd Quarter 03 3rd Quarter 03 4th Quarter 03 1st Quarter 04 2nd Quarter 04 3rd Quarter 04 4th Quarter 04 1st Quarter 05 Cash Bonds Stocks Alternatives 2nd Quarter 05 3rd Quarter 05 4th Quarter 05 1st Quarter 06 2nd Quarter 06 3rd Quarter 06 4th Quarter 06 1st Quarter 07 2nd Quarter 07 3rd Quarter 07 4th Quarter 07 Practical Implications of Tactical Asset Allocation Not a universal formula for success Cannot be done on a purely mathematical or quantitative basis Inputs and model design are still subjective! The importance of process Some planners will be better at it than others Requires more work Ongoing research is required! Additional information and resources may be needed! Can contrast or complement Morningstar style box investing Portfolio vs. Money Management 10

11 Practical Implications of Tactical Asset Allocation Viewed as a dynamic method to create MPT-style inputs? Fresh challenges in communicating to clients What does it mean to be wrong with your forecast? Managing downside and upside expectations Implications for financial planning success risk & return Implications for business retention Our education as planners does not train and prepare us for this type of analysis Some firms will hire to fill the void Independent research is crucial for firms without scale Some firms will choose to outsource Using Independent Research BCA Global Investment Strategy, BCA Research BCA Equity Sector Strategy, BCA Research The Bank Credit Analyst, BCA Research Ned Davis Research John Kosar, Asbury Research John Mendelson, Stanford Research Company Liz Ann Sonders, Charles Schwab and Co, Inc. John Roque, Natexis Bleichroeder, Inc. Jim Bianco, Bianco Research Brian Reynolds, MS Howells Bill King, M. Ramsey King Securities, Inc. Steven Roach, Morgan Stanley Dick Berner, Morgan Stanley John Mauldin, FrontLine Thoughts Jim Grant, Grant's Interest Rate Observer Gloom Boom & Doom report, Marc Faber Limited Ken Tower, Cybertrader Bill Gross, PIMCO Paul McCulley, PIMCO Van R. Hoisington, Lacy H. Hunt, Van Hoisington Investment Management Company Ed Yardeni, Oak Associates, ltd. Business Week Magazine Determining an economic outlook Consumer Spending The Fed 1 Personal Consumption Expenditures 1 Tips Spreads 2 Real Wages 2 NDR Timing Model 3 NAHB Index 3 OER 4 New Home Sales 4 ECRI - FIG 5 Building Permits 5 Money Supply 6 Ned Credit Conditions Index* 6 Utilization 7 Fed Funds 7 Unit Labor Costs 8 Labor Mkt Corporate Bond Market **. 9 Debt 1 Investment Grade Credit Default Swap 10 Dollar 2 High Yield Credit Default Swaps 11 Taylor Rule 3 Corporate Option Adjusted Spreads 12 Yield Curve - Fed Study 4 High Yield Option Adjusted Spreads 5 10 Year U.S. Dollar Swap Spreads Leading Indices 6 30 Day Nonfinancial Commercial Pape 1 Conference Board LEI 7 LIBOR minus T-Bill Yield 2 Coincident to Lagging Indicator 8 Deliquency Rates on C&I Loans 3 ECRI WLI 9 Debt/Net Worth of Nonfinancial Corp. 4 ISM Mfg Index 10 Net Interest/Corporate Cash Flow 11 Short Term Debt/Credit Market Debt 12 Liquid Assets/Short Term Liabilities 13 Senior Loan Survey - Lending Standards *NDR Consumer Credit Conditions index includes 9 components ** Components of NDR Business Credit Conditions index 11

12 Questions??? Michael E. Kitces, MSFS, MTAX, CFP, CLU, ChFC, RHU, REBC, CASL, CWPP Partner, Director of Research, Pinnacle Advisory Group Publisher, The Kitces Report, Blogger, Nerd s Eye View, michael@kitces.com 12