Wealth Manager

The hazard convinces some to look to Mr. Market
for buy and sell signals in running a multiasset
class portfolio. The strategy falls under the
heading of rebalancing, although the variations
on the theme are numerous. A popular system
is setting strategic weights for asset classes and
rebalancing back to those weights when they’re
breached. In the June issue of Wealth Manager, we
spoke with one strategist who advocated rules
for when and how to rebalance in the quest for
superior results.

This month we visit with Mebane Faber, who
promotes a related strategy for capitalizing
on market volatility—albeit one that takes a
more aggressive tone on allocations. The portfolio manager
of Los Angeles-based Cambria Investment Management, Faber
says there are benefits to using market-momentum signals for
switching between all cash and long positions for each asset
class in a diversified portfolio. The main attribute is sharply
lowering risk, while maintaining a comparable level of return
relative to simply buying and holding the same assets.

The risk reduction flows from a rules-based strategy for an
equal-weighted mix of five major asset classes, Faber explains.
The tactical asset allocation model for a given asset class is one
of moving from a 100 percent weighting to all cash when— based
on month-end closing prices—the relevant index closes below its
trailing 10-month moving average. When the month-end index
closes above its moving average, the allocation for the asset class
swings back to 100 percent investment.

Simple but effective, argues Faber, who previously
worked as a quantitative analyst at a futures
broker/dealer and before that, as an equity
analyst at the Genomics Fund. He adds that the
strategy, when used for building a portfolio of
multiple, long-only betas, shares more than a
passing resemblance to a hedge fund of funds—
less the high fees, liquidity issues, etc.

Faber detailed his findings in a paper published
in the Spring 2007 issue of The Journal of
Wealth Management (“A Quantitative Approach
to Tactical Asset Allocation”). The paper’s basic
conclusion may or may not persuade, but it’s
still worth a read for its perspective on the relationships
between risk management, market momentum and
rebalancing/market timing in a multi-asset class context.
(For a statistical overview of his strategy, see table
at the end of this story.)

As for Faber’s motivation for undertaking the study, his inquiry
is only partly academic. He is managing director as well as portfolio
manager of the recently launched asset management arm
of the boutique investment bank Cambria Capital. As you might
expect, the portfolio strategy for Cambria Investment Management’s
high-net-worth clients is informed by Faber’s research.

But no matter how impressive the back-testing appears,
there’s always the threat of getting snookered by history. What
looks triumphant on paper is all too often disappointing when
deployed with real money going forward. Still, he is confident
that his findings transcend the pitfalls of data mining.

“A key check against data mining is a system that works across
a number of time periods as well as a number of different markets,”
Faber told Wealth Manager in a recent interview. “We tested
it in more than 20 markets and over numerous decades, and the
results were consistent.”
For a discussion of the strategy’s broader implications, read on.

Q: What have you learned about tactical asset allocation from your
research?

A: The first lesson is that diversification works, as per Markowitz, who
showed that owning a number of risky assets can create a portfolio
that’s much less risky [than the components in isolation].
In the paper, I use the indices of five asset classes—U.S. stocks,
foreign stocks, bonds, commodities and real estate. The last
two—commodities and real estate—are asset classes that most
people tend to exclude. But adding more risky asset classes
brings down the risk of the portfolio as a whole. Worldwide exposure
to market betas can form a highly diversified portfolio.
The second lesson is that using simple risk-management—in
this case, a price-based, trend following system—can vastly improve
risk-adjusted returns. It does that not by trying to beat the
market, necessarily, but by reducing risk as measured by volatility
and drawdowns [declines from a performance peak]. Overall,
the model improves the risk-adjusted returns of the portfolio
relative to a buy-and-hold approach.

Q: Can you put a number on the improvement?

A: n average, my timing model—using five asset classes—reduces
portfolio volatility as measured by standard deviation by about
35 percent compared to a buy-and-hold, equal-weighted strategy
with the same asset classes (see table below). The model
also reduces risk, measured by the maximum drawdown, by
around 50 percent.

When you’re dealing with retail investors, the main statistic
they look at when they think of risk is drawdown—how much
they’re losing or how much their account is down. They don’t
notice the day-to-day fluctuations as much; they care much more
about losing money. So drawdown, to me, is the most important
statistic when you’re thinking about a portfolio for individuals.

Q: Do the results of your tactical asset allocation (TAA) study support
or refute the Brinson study, which asserted asset allocation’s
influence on portfolios?

A: I think it agrees with it. A lot of people misquote the study,
saying that the majority of returns come from asset allocation; in
fact, it’s the variability of returns that are driven by asset allocation.
We agree with that. But I also like to say that most people
don’t include certain asset classes, especially commodities and
real estate, which add a heck of a lot of value in a diversified portfolio.
Excluding them can show how much you can improve your
portfolio results by using those asset classes. So, yes, we consider
[asset allocation] to be the biggest decision. Unfortunately, most
people don’t do it correctly.

Q: Your study considers tAA with an equal weighting of five broadly
defined asset classes. Does this strategy have any basis in
what’s practiced in the real world?

A: If you look at the portfolios of the Harvard and Yale endowments,
and strip out the private equity and hedge fund exposures that
private investors don’t have easy access to, the portfolio weightings
are roughly 20 percent for each of the five asset classes I
studied. Bonds are a little underweight, and foreign equities are
a little overweight, but overall it’s close to an equal weighting.

Q: Do you limit client portfolios to five broad asset classes?

A: For larger accounts, we identify as many as 40 asset classes, but I
kept the study as simple as possible. I wanted to examine the five
broadest asset classes, and readers can take it from there. In practice,
you want as many uncorrelated sources of beta as possible.
As the market evolves, as innovation delivers more products, a
lot of what was considered alpha in the past is getting commoditized
and reappearing as a low-cost source of beta.

Q: How do you come up with 40 asset classes?

A: For example, you could break U.S. equity up by size—large cap,
mid-cap. Or, you could break it out into the 10 sectors. Why? Because
utilities shouldn’t have a whole lot of correlation with say,
consumer staples or basic materials.

With bonds, you find the least amount of improvement by timing
the components, but that’s because fixed income is the least
volatile asset class overall. Of course, you could add high-yield
bonds or corporate bonds, in which case you might be able to
extract more alpha from timing.

Q: Your study doesn’t use emerging market equities. Do you exclude
developing market stocks for clients?

A: No, we use emerging markets. Generally, we use 10 asset classes
for smaller accounts, including foreign developed and foreign
emerging markets. For larger accounts, we time the top-10 country
components within the two foreign market buckets with ETFs
and closed-end funds. There are still a few holes in ETF coverage.
We’d like to see emerging market bonds, foreign developed market
bonds and municipals, for example.

Q: Is there a particular type of market that offers a better tailwind
for the tAA strategy reviewed in your paper?

A: Trending markets.

Q: And the worst climate?

A: A choppy, sideways market.

Q: Why? because it could generate a lot of false signals that trigger
trades?

A: Right. But it’s not as bad as it used to be because commissions are
low, and so the cost of getting out isn’t so much.

Q: How would taxes impact your tAA model in the real world?

A: One of the nice things about the model is that it’s relatively inactive.
As presented in the paper, it does less than one round trip
per asset class per year. And when you look at the return distribution
of the trades from the model, all of the losses were shortterm
losses and the majority of the gains were long-term gains.
So it’s fairly tax efficient from that perspective.

Ideally, you’d trade this in a tax-deferred account, as you
would any active strategy. But I doubt that the impact of trading
is going to be very significant for the TAA strategy compared to
a buy and hold.

Q: In another paper (“Comparing Returns: Market Timing Versus
Hedge Fund Indices,” March/April 2007, The Technical Analyst), you
write that your five-asset-class TAA portfolio is similar to a hedge
fund of funds strategy.

A: Comparing the timing model to hedge fund of fund and hedge
fund indices shows that a worldwide asset allocation strategy is
the same as hedge fund of fund indices. In fact, the returns of the
TAA model are superior to hedge fund of fund indices. One of the
biggest problems with the hedge fund space is fees. If you tack
on 2 percent and 20 percent [a typical hedge fund fee structure]
and another 1 and 10 [for the fund of funds fees], the underlying
portfolio has to return something like 18 percent or 19 percent
[a year] just to return what a buy-and-hold strategy for the five
conventional asset classes would return.

Q: Speaking of hedge fund indices, some say the investable kind—
which are set to become available as mutual funds and perhaps
ETFs at some point—are similar to owning a portfolio of the major
asset classes.

A: That’s basically our thesis, too. By doing something as simple
as just buying the five asset classes in the TAA strategy, you’ll do
as well as a hedge fund of funds, and you’ll avoid the headaches
and problems of investing in hedge funds, such as liquidity requirements
and the extra paperwork.

Note: Portfolio results for 1972-2005 using five indices: S&P 500, MSCI EAFE, US Government 10-year Bonds, Goldman Sachs Commodity Index and National Association of Real Estate Investment Trusts index. The "buy-and-hold" portfolio is equal weighted. The timing portfolio is equal weighted too, with additional rules: sell an asset class and move to 100% cash (90-day commercial paper) when its index closes below its trailing 10-month moving average, calculated from month-end data; buy when index rises above 10-month moving average, based on month-end data.