How do institutions approach global multiasset-class investing?

It’s all about asset allocation, manager selection and risk management.  Global multiasset-class investing is a team sport, whether you’re an endowment, sovereign wealth fund or foundation.  When you’re investing around the world, trying to bring professionals together to make judgments such as whether you should be overweight or underweight Europe, real estate or other asset classes, the more smart people you can bring into the tent who do what you do — and who can help provide opinions and spark ideas — the better.

As a quantitative manager, this description of how to ultimately determine an asset allocation is completely foreign.  Maybe it works great for some, but the idea of trying to get an edge on the market by seeking out “smart people” who can help provide opinions and spark ideas seems problematic.  We have no aversion to smart people, however we do have a strong preference for removing the role of judgement calls in the investment process.  For us, the asset allocation decision goes something like this.  We determine an investment universe that is comprised of a broad range of asset classes.  We determine the model constraints (i.e. how much we can overweight or underweight a given asset class), and then apply our relative strength methodology to ranking the different asset classes and each of the individual components of the investment universe.  Then, our weights to different asset classes and exact holdings are determined by a systematic relative strength model.  Likewise, sell decisions are also based on this relative strength ranking process.

Those interested in seeing just how effective this quantitative approach to asset allocation can be over time, can read Tactical Asset Allocation Using Relative Strength by John Lewis.  This approach is also working well this year, as discussed in DWTFX Tops Peers.

Past performance is no guarantee of future results.  Please click here and here for disclosures.

Last week’s performance (6/10/13 – 6/14/13) is as follows:

Interestingly, we have seen this corroborated by the performance of the Arrow DWA Tactical Fund, which employs a largely unconstrained application of relative strength to multiple asset classes. With YTD performance of 10.65% through 6/13/13, it is outperforming 99% of its peers in the Morningstar World Allocation category.

Past performance is no guarantee of future returns.

This strategy is available in the Arrow DWA Tactical Fund (DWTFX) and also as a separately managed account as our Global Macro strategy, which is available on a number of major platforms, including the Wells Fargo Masters and DMA platforms.

Please click here and here for disclosures.

Numbers shown are price returns only and are not inclusive of transaction costs.  Source: iShares

Liz Ann Sonders, the market strategist at Charles Schwab & Co., has an interesting piece on this apparent disconnect.  She writes:

Remember, the stock market (as measured by the S&P 500) is one of 10 sub-indexes in the Conference Board’s Index of Leading Indicators. Many investors assume it’s the opposite—that economic growth is a leading indicator of the stock market. For a compelling visual of the relationship, see the following pair of charts, which I’ll explain below.

The most compelling part of her article follow, in the form of her charts that show the GDP growth rate and peaks and troughs in the stock market.

Source: Charles Schwab & Co.  (click on images to enlarge)

More often than not, poor economic growth corresponds with a trough in the market.  Super-heated economic growth is usually a sign that someone is about to take away the punch bowl.

In truth, there is really no disconnect if you accept that the stock market usually leads the economy.  As Ms. Sonders points out, the S&P 500 is part of the Index of Leading Indicators.  A lot of investors have trouble wrapping their heads around that concept—and it continues to cost them money.

The contrast to economic forecasting (i.e., guessing) is trend following.  The trend follower is usually fairly safe in believing that if the market is continuing up that is economy is probably ok for the time being.  When the trend becomes uncertain or tilts down, it might be time to look for clues that the economy is softening.  You’re not going to be right all the time either way, but at least you’ve got the odds on your side if you let the market lead.

Be aware of what I call The Fallacy of Competency Transference. This occurs when someone successful in one field jumps in to another and fails miserably. The most widely known example is Michael Jordan, the greatest basketball player the game has ever known, deciding he was also a baseball player. He was a .200 minor league hitter.

I have had repeated conversations with Medical Doctors about this: They are extremely intelligent accomplished people who often assume they can do well in markets. (After all, they conquered what I consider a much more challenging field of medicine).

The problem they run into is that competency transference. After 4 years of college (mostly focused on pre-med courses), they spend 4 years in Medical school; another year as an Interns, then as many as 8 years in Residency. Specialized fields may require training beyond residency, tacking on another 1-3 years. This process is at least 12, and as many as 20 years (if we include Board certification).

What I try to explain to these highly educated, highly intelligent people is that they absolutely can achieve the same success in markets that they have as medical professionals — they just have to put the requisite time in, immersing themselves in finance (like they did in medicine) for a decade or so. It is usually around this moment that the light bulb goes off, and the cause of prior mediocre performance becomes understood.

To me, the funny thing is that competency transference mostly applies to the special case of financial markets.  For example, no successful stock market professional would ever, ever assume themselves to be a competent thoracic surgeon without the requisite training.  Nor would a medical doctor ever assume that he or she could play a professional sport  or run a nuclear submarine without the necessary skills.  (I think the Michael Jordan analogy is a poor one, since there have been numerous multi-sport athletes.  Many athletes letter in multiple sports in high school and some even play more than one in college.    Michael Jordan may have been wrong about his particular case, but it wasn’t necessarily a crazy idea.)

Nope, competency transference is mostly restricted to the idea that anyone watching CNBC can become a market maven.  (Apparently even talking heads on CNBC believe this.)  This creates no end of grief in advisor-client relationships if 1) the advisor isn’t very far up the learning curve, and 2) if the client thinks they know better.  You would have the same problem if you had a green medical doctor and you thought you knew more than the doctor did.  That is a situation that is ripe for problems!

Advisors need to work continuously to expand their skills and knowledge if they are to be of use to investors.  And investors, in general, would do well to spend their efforts vetting advisors carefully rather than assuming financial markets are a piece of cake.

The 10-day moving average of this indicator is 74% and the one-day reading is 74%.

…as a retirement nest egg, $1 million is relatively big. It may seem like a lot to live on.

But in many ways, it’s not.

Inflation isn’t the only thing that’s whittled down the $1 million. The topsy-turvy world of today’s financial markets — particularly, the still-ultralow interest rates in the bond market — is upending what many people thought they understood about how to pay for life after work.

“We’re facing a crisis right now, and it’s going to get worse,” said Alicia Munnell, director of the Center for Retirement Research at Boston College. “Most people haven’t saved nearly enough, not even people who have put away $1 million.”

The article proceeds to go through the math of low interest rates and increasing longevity.  This is not new, but sometimes it is difficult to get clients to focus on the big picture.

The big picture is not whether the most recent quarterly return on their balanced account was +6.3% or +6.4%, but whether that account balance was $300,000 or $3 million.

Since industry sources suggest that only 3% of retail accounts ever have balances over $2 million, it’s probably most important to focus on savings.  This might be particularly important with younger clients, who, by and large, do not have defined benefit pensions to supplement Social Security.  (In fact, it’s not clear how Social Security might be modified or eliminated by the time they get around to collect it.)  The one thing younger clients do have on their side is time—time to contribute steadily to their 401k and to an outside investment account. With enough nagging from a qualified investment advisor and a reasonable investment plan, there is no reason that clients shouldn’t succeed.