PNC STAR: PNC Systematic Tactical Asset Rotation
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1 September 2013 E. William Stone, CFA CMT Managing Director, Investment & Portfolio Strategy Chief Investment Strategist Ryan Whidden Senior Portfolio Strategist Paul J. White, PhD, CAIA Director of Portfolio Strategy PNC STAR: PNC Systematic Tactical Asset Rotation The race is not always to the swift, nor the battle to the strong, but that's how the smart money bets Damon Runyon Introduction Momentum is a strategy that has many adherents in the asset management community and academia. First on the academic scene were Jegadeesh and Titman in They found that zero-cost portfolios formed from buying past winners and selling past losers realized significant abnormal returns. In 1997, Carhart added their newly discovered factor as a fourth factor to the Fama-French three-factor model and found that positive exposure to momentum was a significant positive influence in the best portfolios and significant negative influence in the worst. Extensive additional research has expanded on the various iterations of the momentum theme (Rouwenhorst in 1998, Grinblatt in 2004). And in 2006, Bhojraj presented evidence on the existence of momentum for indexes. Moskowitz et al in 2012 document significant strong and consistent momentum performance across many diverse asset classes over 25 years, including for equity index, currency, commodity, and bond futures. Also in 2012, Hurst et al expanded upon their research to show momentum has delivered strong positive returns and realized a low correlation to traditional asset classes each 2 decade for more than a century. In 2013, Asness et al found that momentum is a good complement to value. While both value and momentum strategies have been vetted academically for decades, they were the first to look at value and momentum strategies together instead of each in isolation. They found that by combining a momentum strategy with a value strategy in a portfolio, Sharpe ratios and average return increased, as a result of the two strategies being negatively correlated and each having positive expected returns. It is easy to understand why the two strategies are negatively correlated when it is considered that: with value, an investor wants to buy stocks that have become cheaper and have relatively lower prices, and with momentum, the investor wants to buy stocks whose prices have risen over the past year and become more expensive. However, current price is not the sole determinant of what constitutes a value or momentum stock, which is why the two strategies are not contradictory and can both have positive expected returns. 1 Referenced research is listed in the References section on page Brian Hurst, Yao Hua Ooi, and Lasse H. Pedersen, A Century of Evidence on Trend-Following Investing, AQR Capital Management, working paper (Fall 2012): 1. pnc.com
2 PNC STAR smart beta is an approach that attempts to enhance the return from an asset class by systematically deviating from the traditional marketcapitalization-weighted approach. Quantitative analysis has shown that some portion of outperformance by active managers comes from investment processes that can be identified and replicated systematically. Many reasons have been proposed for the existence of abnormal returns for momentum in the marketplace. Behavioral biases and arbitrage difficulty generally top the list. Investors often overreact to news or information and behavioral analysts point out fear and greed play a role; investors are more inclined to buy recent winners and sell recent losers, regardless of the underlying fundamental picture. Recent performance also confirms previously held convictions and causes investors to buy or sell more of a stock. Anchoring is another behavioral bias in which individuals latch onto outdated prices and beliefs and are hesitant to update their views until some later time. And even in a world of high-frequency trading and rapid-fire information, absorption of information is still slow to propagate through the mass of investors. As more investors absorb the new information, they will make buy and sell decisions that will affect the price of a security. Finally, since momentum strategies generally have a high amount of turnover, transactions costs make it difficult to arbitrage away the momentum effect, especially for baskets involving hundreds of securities. Momentum is a form of smart beta that tilts the portfolio to include some exposure to a factor that does not exist in a static, passive portfolio. Traditional beta portfolios weigh constituents by market capitalization, but PNC STAR re-weights sectors and styles dynamically from month to month, depending on which have strength behind them. Smart beta provides a way to capture some of the exposure to an outperformance factor that can be systematically recreated but often is accredited to active management. The PNC STAR Strategy The PNC STAR strategy is a combination of momentum and trend following at the index level. It does not use individual stock baskets representing thousands of stocks as most momentum strategies do, but instead uses a small subset of sector and international exchange-traded funds (ETFs) as its representative universe. Moskowitz and Grinblatt found in 1999 that industry momentum accounts for most of the abnormal returns gained through the classic momentum strategy, and Chen et al in 2012 found that style indexes exhibit strong price momentum. Therefore, the PNC STAR strategy is not disadvantaged by using ETFs and instead gains some advantages, including reduced trading costs and prevention of overrepresentation of illiquid securities. We use total return 3 price return history collected from Bloomberg for 15 ETFs that PNC Investment Advisor Research (IAR) has approved for the 3 We also examined simple price history with the dividends stripped out and came to similar conclusions. 2 September 2013
3 Systematic Tactical Asset Rotation platform 4, collectively referred to as the model universe: 14 tactical ETFs 9 representing the U.S. sectors, 2 representing domestic small- and mid-cap stocks, 1 representing international smallcap stocks, 1 for emerging markets, and 1 for EAFE 5 stocks and, for allocation when the model is agnostic, the SPDR S&P 500 ETF. We include international and smaller market capitalization funds because the U.S. sector funds represent only domestic large-cap stocks; the additional funds increase the reach of the strategy. Our back-testing process showed that the strategy is most successful when expanding the breadth of domestic and international options and providing momentum exposure to size and international factors. PNC STAR may be expanded to include more investment options in the future. Table 1 shows the current investment options amongst which PNC STAR allocates. Methodology PNC STAR is a proprietary model with a two-stage process that is rebalanced monthly. First, all ETFs under consideration (Table 1) must be in a positive price trend. Second, the three top performing ETFs over the past 12 months are equally weighted. If fewer than three ETFs pass the first screen, then the remaining ETFs are equally weighted. If no ETFs pass the first screen, the allocation stays in the benchmark, the S&P 500. Currently, three ETFs are chosen, but in the future, we may expand the eligible ETF universe, and the number of choices may change as a result. Table 1 Current PNC STAR Investment Options Ticker XLY XLP XLE XLF XLV XLI XLB XLK XLU IJR IJH SCZ EEM EFA Results Table 2 (page 4) shows some of the results from a Pertrac analysis provided by IAR against the S&P 500 Total Return index benchmark. The annualized return since 1990 has been 14.74% with a standard deviation of 16.50%, bringing the Sharpe Ratio to The table also shows that annualized alpha over the back-test period was 5.34%, with 73% of the return explained by the benchmark. The up capture ratio of 200% and down capture ratio of 99% shows that outperformance for the strategy historically came from the upside, which is a natural consequence of a momentum strategy. The active premium Description Consumer Discretionary Select Sector SPDR Fund Consumer Staples Select Sector SPDR Fund Energy Select Sector SPDR Fund Financial Select Sector SPDR Fund Health Care Select Sector SPDR Fund Industrial Select Sector SPDR Fund Materials Select Sector SPDR Fund Technology Select Sector SPDR Fund Utilities Select Sector SPDR Fund ishares Core S&P Small-Cap ETF ishares Core S&P Mid-Cap ETF ishares MSCI EAFE Small-Cap ETF ishares MSCI Emerging Markets ETF ishares MSCI EAFE ETF 4 SPDR MidCap 400 ETF (MDY) and SPDR Small Cap 600 ETF (SLY) were also tested and can be used in place of or in conjunction with IJH and IJR. 5 International sector ETFs exist, but have been trading only for about five years. 3
4 PNC STAR Table 2 Returns and Statistics Annualized Sharpe Annualized Tracking S&P 500 Return Ratio Alpha Alpha Beta R R Squared Error Return 14.74% % 5.34% % 9.83% Standard Gain/Loss Treynor Jensen Active Information Up Down S&P 500 Deviation Ratio Ratio* Alpha** Premium Ratio Capture Capture Std Dev 16.50% % 0.42% 4.93% % 99.01% 14.85% *Treynor Ratio = (Portfolio Return - Risk Free Rate) / Portfolio Beta **Jensen's Alpha = Portfolio Return [Risk Free Rate + Portfolio Beta * (Market Return Risk Free Rate)] Active Premium = Annualized Portfolio Return Annualized Benchmark Return Investment Advisor Research of just under 5% is the annualized advantage of this strategy compared with the benchmark. And finally, the tracking error comes in at just under 9%. This is not unexpected, given that the strategy rotates into different sectors and international indexes each month and matches only about a third of the benchmark in any given month. We believe risk and tracking error can be managed with tactical position sizing. The total return wealth curves are shown in Chart 1. Chart 1 Strategy versus S&P 500 Chart 2 Strategy versus S&P 500 Since back-tested inception, the strategy has returned more than 20 times the original investment compared with the benchmark S&P 500 Total Return index return of 8 times. The strategy moved mostly in lockstep with the benchmark during a strong bull market until 1999, when it broke away from the underlying index. Perhaps coincidentally, this is also the time when the ETFs started trading on the market (prior to this date, the back-test uses the underlying index returns). Chart 2 shows the strategy returns from 1999 onward, after the ETFs started trading. From this we can see that the strategy has returned more than 4 times the original investment compared with less than 2 times for the benchmark. 4 September 2013
5 Systematic Tactical Asset Rotation Table 3 Top Drawdowns Length PNC STAR S&P 500 Total Return (months) Peak Valley Depth Recovery Depth Recovery 16 10/07 2/ % % /00 9/ /98 8/ /00 5/ /94 6/ /05 10/ Chart 3 PNC STAR Holdings across Time Table 3 shows the largest historical drawdowns. For the largest two drawdowns over the 23-year period, PNC STAR had a softer landing. For the technology bubble recession of 2000, the recovery to old highs took less than half the time as it did for the S&P 500 Total Return index. For three of the four remaining drawdowns, recovery to prior highs took the same number of months as the benchmark. For the bottom four drawdowns in Table 3, PNC STAR underperforms because of the short duration of the drawdowns. The strategy cannot perfectly time peaks or troughs and, coupled with the monthly rebalance period, there will usually be an underperformance on the dips and turning points for short drawdown periods. Chart 3 shows the holdings across time. Some of the classic historical momentum themes are exemplified in this chart, including the tech bubble of the late 1990s and the emerging markets boom of the mid-2000s. Turnover from a dynamic strategy is expected, but as one can infer from Chart 3, since PNC STAR follows a trend, turnover is not excessive by any means, as shown in Table 4. In fact, only one or fewer changes are made from month to month 90% of the time. As Table 5 (page 6) shows, the average trade length is about four months long. Only in 3% of the months does the model make a full three changes. However, tax efficiency should Table 4 Monthly Turnover Changes Frequency 37.73% 51.65% 7.69% 2.93% 5
6 PNC STAR Table 6 Long-Term Trades Table 5 Individual Trade Analysis Average Return Percentage Number Length Mean Minimum Maximum Profitable Long Term % 4.74% % 100.0% Short Term Total Length Start End (Months) Name Return 8/98 8/00 24 Information Technology % 8/94 11/96 27 Health Care /04 5/06 23 Energy /94 3/96 21 Information Technology /03 3/05 19 Small International /97 7/99 20 Health Care /05 12/06 22 Emerging Markets /96 1/98 16 Financials /90 2/92 17 Health Care /03 6/04 14 Emerging Markets /06 5/07 12 EAFE /96 12/97 13 Information Technology /92 10/93 13 Financials /93 8/94 16 EAFE /07 6/08 13 Materials 4.74 Chart 4 Density of Short-Term Returns not be expected, even for long trends, because there are many breaks in the segments as evidenced in Chart 3 (page 5) and shown in Table 5. Table 5 also shows the breakdown of the individual trades. Of the 192 total trades completed, about 69% were profitable. Only 8% of the trades classified for long-term capital gains, but these trades had the largest return, which would be expected when a trend is being followed for a long period of time. Every long-term trade was profitable, with an average return of 59% over an average period of 18 months. The average short-term trade length was less than three months with 66% of them being profitable and a mean return of just under 4%. Table 6 shows all of the long-term capital gains trades completed over the back-test period. The largest gain of 169% was a result of riding a twoyear Information Technology trend and the second-largest gain of 100% was from riding a two-year Health Care trend in the 1990s. About half of the longterm trends ended in the 2000s, and the last long-term trend that was captured was in This coincides with the earlier discussion involving Table 3 (page 5) about capturing peaks and troughs, since the market has whipsawed quite a bit since the March 2009 trough and the model has not been able to lock on to a consistent longterm trend. There are too many short-term trades to list, so instead we provide a distribution of past round trip trade performance (Chart 4). The density shows that the distribution is skewed to the right with a positive mean return, which is what we would hope to find. 6 September 2013
7 Additional Discussion We use a 12-month price return as the core of our momentum strategy. However, nothing is particular to the 12-month time period that we use. In fact, our testing showed that other periods from 3 to 15 months lead to similar outcomes. We settled on 12 months because: a year is a natural unseasoned time period that investors generally use to gauge relative performance; most of the academic literature also focuses on the 12-month period; we wanted to mitigate any data mining through over-optimizing the dataset; and turnover is reduced for longer time periods. Furthermore, in 2010, Hancock showed price momentum performance results for the 1- to 15-month periods for and found that holding periods between 5 and 15 months led to abnormal returns, but that 12 months was the period with peak outperformance 6. Like most strategies, there can be periods of underperformance for the PNC STAR strategy because performance tends to wax and wane; most strategies do not work at all times. Momentum has been known to suffer when the overall market reaches an inflection point and peaks. Our findings are consistent with those of Wilson (2010) that the past several years have not been as profitable as in the more distant past for momentum. For PNC STAR, it is not absolute performance that has suffered the strategy has still continued to show positive returns on average, but PNC STAR has not been able to match the relative strong performance of the benchmark since the recession. For a graphical representation of the monthly performance, Chart 5 exemplifies this. Each column represents the monthly performance relative to the benchmark and the blue line is the rolling six-month average. The relative performance has dipped since the 2008 recession, but is starting to make a comeback. However, it should be noted that this underperformance is not unique to PNC STAR. A momentum index by AQR Capital Management has shown similar underperformance relative to the benchmark. Chart 6 shows the AQR momentum Index compared with the S&P 500 Total Return index. Underperformance for this index has been about 25%. Over the same time period, PNC STAR has underperformed by a much lower 7%. Another performance metric we find informative is the rolling alpha and beta chart. Alpha and beta are defined in the traditional CAPM sense, where a strategy s excess Systematic Tactical Asset Rotation Chart 5 Relative Performance: PNC STAR versus S&P 500 Chart 6 S&P 500 versus AQR Momentum Index Source:Bloomberg L.P., PNC 6 No statistics of significance were provided for comparison between the neighboring months. 7
8 PNC STAR Chart 7 Three-Year Rolling Alpha and Beta Chart 8 One-Year Rolling Alpha and Beta return above the risk-free rate is regressed against the benchmark s excess return. Beta shows how the strategy moves with the market and alpha shows the part of the return not correlated with the market. Over the full sample, the robust beta is and the robust alpha is 39 basis points per month. Chart 7 shows the robust regression using a three-year rolling window across time. In the chart the alpha dipped in the late 90s (while the general market was roaring) and after 2011 (capturing years ). However, if the rolling window is shortened, it can be seen that the alpha is slowly turning positive again (Chart 8). Chart 9 10% PNC STAR/90% S&P 500 Combination Total Return The Case for Momentum Investing We believe adding a small allocation of the PNC STAR strategy to a portfolio can increase return without increasing risk (and with small allocations can marginally reduce risk). Table 7 shows the return and standard deviation of the combined portfolio. Return increases by approximately 0.5% per year, but the standard deviation marginally decreases. Over a long investment holding period, the return impact can be significant, as shown in Chart 9. The S&P 500 Total Return index turns $1 dollar into $8 over the 21-year investment holding period, while the 10% PNC STAR/ 90% S&P portfolio turns $1 into more than $9, reflecting an approximate 12% increase in total return over the benchmark. Table 7 10% PNC STAR and 90% S&P 500 Combination PNC STAR S&P 500 TR Combined Annualized Return 14.74% 9.83% 10.35% Annualized Std Dev % 14.85% 14.80% 8 September 2013
9 Systematic Tactical Asset Rotation Conclusion Adding momentum exposure to a portfolio has been shown to be a good diversifier to portfolios. The PNC STAR strategy uses broad ETFs to apply momentum exposure to industries, size, and international factors in a systematic way. It has shown excess returns with a level of volatility similar to the benchmark S&P 500, resulting in a higher Sharpe Ratio. While past performance is not indicative of future performance, historically this model has led to alpha of just under 0.40% per month. In addition, the drawdown analysis has shown that the strategy has handled periods of crisis better than the benchmark index and was usually quick to recover. Furthermore, to reduce risk, PNC STAR has a built in a safeguard that considers for rotation only the indexes that are in an uptrend, and the overall positions in the portfolios will be sized appropriately by Investment Strategy. Momentum performance has dipped since the recession, but appears to be coming back. If momentum continues to work in the future as it has historically, the strategy may lead to excess returns that will improve the tactical allocation portfolios. 9
10 PNC STAR References Asness, Clifford S., Tobias J. Moskowitz, and Lasse H. Pedersen, Value and Momentum Everywhere. The Journal of Finance 68, no. 3 (2013): Bhojraj, Sanjeev, and Bhaskaran Swaminathan, Macromomentum: Returns Predictability in International Equity Indices. The Journal of Business 79, no. 1 (2006): Carhart, M. Mark, On Persistence in Mutual Fund Performance. The Journal of Finance 52, no.1 (1997): Chen, Linda H., George J. Jiang, and Kevin X. Zhu, Momentum Strategies for Style and Sector Indexes. The Journal of Investment Strategies 1, no. 3 (2012): Grinblatt, Mark and Tobias J. Moskowitz, Predicting Stock Price Movements from Past Returns: The Role of Consistency and Tax-Loss Selling. Journal of Financial Economics 71, no. 3 (2004): Hancock, Tom, Momentum A Contrarian Case for Following the Herd. GMO white paper (2010). Hurst, Brian, Yao Hua Ooi, and Lasse H. Pedersen, A Century of Evidence on Trend-Following Investing. AQR Capital Management, working paper (2012). Jegadeesh, Narasimhan, and Sheridan Titman, Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency. The Journal of Finance 48, no. 1 (1993): Moskowitz, Tobias J., and Mark Grinblatt, Do Industries Explain Momentum? The Journal of Finance 54, no. 4 (1999): Moskowitz, Tobias J., Yao Hua Ooi, and Lasse H. Pedersen, Time Series Momentum. Journal of Financial Economics 104, no. 2 (2012): Rouwenhorst, K. Geert, International Momentum Strategies. The Journal of Finance 53, no.1 (1998): Wilson, Scott M., Are Momentum Strategies Still Profitable For U.S. Equity? University of Texas, working paper (2010). The PNC Financial Services Group, Inc. ( PNC ) provides investment and wealth management, fiduciary services, FDIC-insured banking products and services and lending of funds through its subsidiary, PNC Bank, National Association, which is a Member FDIC, and provides certain fiduciary and agency services through PNC Delaware Trust Company. This report is furnished for the use of PNC and its clients and does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific investment objectives, financial situation or particular needs of any specific person. Use of this report is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client s individual account circumstances. Persons reading this report should consult with their PNC account representative regarding the appropriateness of investing in any securities or adopting any investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. The information contained in this report was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness or completeness by PNC. The information contained in this report and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. Neither the information in this report nor any opinion expressed herein constitutes an offer to buy or sell, nor a recommendation to buy or sell, any security or financial instrument. Accounts managed by PNC and its affiliates may take positions from time to time in securities recommended and followed by PNC affiliates. PNC does not provide legal, tax, or accounting advice. Securities are not bank deposits, nor are they backed or guaranteed by PNC or any of its affiliates, and are not issued by, insured by, guaranteed by, or obligations of the FDIC, the Federal Reserve Board, or any government agency. Securities involve investment risks, including possible loss of principal The PNC Financial Services Group, Inc. All rights reserved.
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