How to Beat the Market, and Why Most Investors Don't

Despite the thousands of mutual funds and Advisors all purporting to offer a better approach to investing, it is universally acknowledged by practitioners and academics alike that two factors represent the most persistent and universal methods of capturing excess returns in markets:

• Value factor: Cheaper companies tend to outperform the market over the next 5 years or so.
• Momentum factor: Companies that have performed the best recently tend to outperform the market over the next few weeks or months. 

The chart below shows how the portfolios created using the traditional Value and Momentum factors have delivered above-average returns versus a buy and hold portfolio over the period from 1927 through 2011. Note that the momentum portfolio delivers excess returns of 3.9% per year while the value portfolio beats by 2.1%.

Source: Kenneth French Data Library

The research clearly shows that the momentum anomaly offers the greatest opportunity for outperformance. Further, this anomaly extends outside stocks to asset classes and even residential real-estate. The following chart from our two-page report on momentum shows how holding the top 2 and top 5 asset classes (out of 10 global asset classes) based on recent price performance (momentum) crushes portfolios consisting of the bottom 2 and 5 asset classes.

Source: Yahoo Finance, Butler|Philbrick|Gordillo & Associates

The overwhelming challenge for most investors is that, while these factors obviously work universally over time, they do not work all the time. In fact, as the chart below clearly shows, each of these factors periodically under-performs over periods as long as several years.

Source: Kenneth French Data Library, Butler|Philbrick|Gordillo & Associates

Unfortunately, it is very difficult to stick with a manager who under-performs despite the overwhelming evidence of the long-term efficacy of their value or momentum approach. This inevitably compels investors to move their portfolios from manager to manager chasing whichever factor has worked the best recently.

The following chart shows the average investor holding period for each category of mutual funds over the past 20 years. Note that the typical 3 to 4 year holding period shown below is generally insufficient to realize the majority of benefits from either a value or momentum approach, especially when most investors flock to a new strategy only after it has already delivered substantial recent outperformance.

Source: Dalbar, 2012

The negative impact of these portfolio switches to actual investor performance is staggering. The chart below, also from Dalbar shows how the average balanced investor has under-performed stocks by 5.69% per year and bonds by 4.38% over the past 20 years, and failed to keep up with inflation.

Source: Dalbar, 2012

It’s important to note that this tendency to herd is a universal human trait that can only be overcome with the acceptance that in markets, our instincts are ultimately destructive. As humans, we are hardwired to make the wrong investment decisions in the absence of a disciplined and systematic investment process. 

The lesson is quite simple: When you find a factor that is proven to work over the very long-term, and a manager who is committed to systematically harnessing that factor, stick with him through thick and thin!

For more information on the most persistent and pervasive excess return factor in markets, along with two other powerful techniques - volatility management and active diversification - just click the associated links!

Lots more at www.darwinstrategies.ca

Volatility Harvesting and the Importance Of Rebalancing

We have now written about the importance of observing historical volatility when making rebalancing decisions (see here, here and here) and the importance of keeping portfolio volatility low (see here).  This post will discuss the benefits inherent in volatility itself through the concept of “harvesting” the volatility of individual positions within a portfolio.


We can simplify the idea of volatility harvesting through a thought-experiment developed in the 1940s by Claude Shannon, renowned genius and investor, averaging 28% annually in his lifetime! (Source: W. Poundstone, (2005) Fortune’s Formula). His experiment, known as Shannon’s Demon, showed how it was possible to profit even from markets that were characteristic of a random walk, as long as they were volatile.

The experiment is simple: Imagine a stock that is highly jittery and either doubled or halved in value every day. You then invest half of your portfolio in the stock, while the rest remains in cash. At noon each day you rebalance the portfolio back to a 50-50 even split. So, if you started with $1,000 and the stock got cut in half, the following day your portfolio would be $750 ($250 in the stock $500 in cash). After rebalancing, the portfolio would have $375 in stock and $375 in cash. As the chart below shows that after rebalancing only 72 times our $1,000 initial investment is now worth just under $100,000! That is not a bad chunk of change given that we didn’t have to do any stock forecasting to make this profit! In fact, had you bought and held this stock you would make zero profit.

 Source: Butler|Philbrick|Gordillo and Associates*

    

How can this be? Well, the key is to understand that as long as there’s volatility in at least one of your holdings you will benefit from the most basic of concepts in portfolio theory: Rebalancing.

In the fictitious case above we are looking at a stock that is volatile but has no return. What if we were to do the same experiment and this time use two stocks that have low correlation to each other but both lose money in the long-run? This is exactly what was examined in a recent study done by Dempster, Evstigneev and Schenk-Hoppe in “The Joy of Volatility”. Their experiment assumed that Stock A would either gain +40% or lose -30% at each period and Stock B would either lose -20% or gain +15% at each period (randomly). The results were impressive:

Source: Dempster, Evstigneev and Schenk-Hoppe

The author puts it best by saying that “poverty is the inevitable fate of the passive investor.” However, the active investor achieves certain success through rebalancing.

When applying this to the real world the problem we face is in finding stocks that are actually uncorrelated to one another to that degree. In today’s macro news driven environment we find that most risky assets have become too highly correlated.

So let’s apply this concept to the real world, but instead of stocks let’s use two asset classes we know to generally have low-to-negative correlation to one another: stocks and bonds. Let’s work with the Japanese stock market (Nikkei 225), which has lost -48% since 1995, and combine them with Japanese government bonds. We will rebalance this portfolio quarterly using the dynamic volatility weighting method[i] (click here for a detailed article on this simple concept).

Source: Butler|Philbrick|Gordillo and Associates*, data from Bloomberg

This chart shows how the use of an uncorrelated asset class along with simple rebalancing can make a big impact on anyone’s investment success. The portfolio went from losing -48% and having a peak-to-trough maximum loss of -79% in the Nikkei, to making a profit of +138% and keeping the worst peak-to-though loss at a manageable -13.97%.  Though the result of this two asset class portfolio is impressive, we would in no way espouse this model as an optimal framework not least of which because the stock / bond diversification ignores the myriad of opportunities available from other markets and asset classes (Click here for more detail on how we deal with this).  

The most important point behind these examples is that one doesn’t necessarily have to be right about which stocks, sectors or other asset classes will do well in the future, as long as they all experience bouts of uncertainty (i.e. volatility), they are significantly uncorrelated to each other and you employ an active portfolio approach designed to harvest that uncertainty. The math will take care of the rest.

If you are an avid risk junky and have always thought bonds were for losers, this exercise may be a good way of helping you talk yourself into introducing some cash and bonds into your otherwise risky portfolio. But make sure to always follow the number one rule … don’t forget to rebalance!

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[i] This is important in order to keep the experiment in line with the Dempster study which requires us to keep the bet sizes the same in each rebalancing period. In the example of the two stock portfolio the odds are known in advance and the bet size is always constant. In the real world, bet sizes change with volatility. It is only by controlling the bet sizes through dynamic volatility sizing that we can come as close as possible to the results in the two stock study. Having said this, even if one decides to employ traditional equal dollar rebalancing quarterly we go from losing money in the Nikkei to making a profit of +41% and keeping the drawdown to only -33% (Click here for these results).

Demographic Blues

The Federal Reserve Bank of San Francisco published a fascinating piece of research on Monday relating U.S. stock market performance to demographic trends. The results are not encouraging for long-term 'Buy and Hold' type investors.

Boomer Retirement: Headwinds for U.S. Equity Markets?

By Zheng Liu and Mark M. Spiegel

Historical data indicate a strong relationship between the age distribution of the U.S. population and stock market performance. A key demographic trend is the aging of the baby boom generation. As they reach retirement age, they are likely to shift from buying stocks to selling their equity holdings to finance retirement. Statistical models suggest that this shift could be a factor holding down equity valuations over the next two decades.

Historical data suggests a strong relationship exists between the age distribution of the U.S. population and stock market performance. A key demographic trend is the aging of the baby boom generation. As they reach retirement age, Boomers are likely to shift from a bias toward saving and buying stocks, to selling their equity holdings to finance retirement. Statistical models suggest that this shift could substantially depress equity valuations over the next 15 years or more.

Without belaboring the mechanics of the study, the researchers analyzed trends in the proportion of middle-aged workers in the U.S. economy relative to the proportion of retired workers to forecast future stock market valuations. This research follows other studies which found that the booming markets of the 1980s and 1990s were largely attributable to the bulge bracket of baby boomers who were entering their prime saving and investing years during those decades.

In contrast, the current Federal Reserve study finds that, as the ratio of middle aged workers to retired persons is forecast to fall persistently through 2025 as the bulk of baby boomers retire, these same boomers will be withdrawing savings from stock and bond markets, thereby exerting slow but steady downward pressure on prices of financial assets, including stocks, for the foreseeable future.

The specific demographic ratio analyzed in the study is the M/O ratio, which is the population ratio of those aged 40 - 49 to those aged 60 - 69. This ratio broadly captures the number of people in prime saving and investing years relative to the number of people who are beginning to withdraw from savings to fund retirement. From 1981 to 2000 this ratio increased from 0.18 to 0.74 at the same time stock valuations rose from roughly 8 times earnings to almost 30, and the main U.S. stock market index exploded from 150 to almost 1500.

Source: Stockcharts.com

Sadly, the U.S. Census Bureau is forecasting exactly the opposite dynamic to play out over the next 15 years as boomers retire. As this demographic scenario unfolds, the Federal Reserve Bank's model suggests that stock prices will enter a persistent decline until 2021. Further, stocks are not expected to exceed their 2010 levels until 2027, after adjusting for inflation.

Key findings:

• The M/O ratio explains about 61% of the movements in the P/E ratio during the sample period. In other words, the M/O ratio predicts long-run trends in the P/E ratio well.
• Given the projected path for P/E* and the estimated convergence process, we find that the actual P/E ratio should decline from about 15 in 2010 to about 8.3 in 2025 before recovering to about 9 in 2030.
• The model-generated path for real stock prices implied by demographic trends is quite bearish. Real stock prices follow a downward trend until 2021, cumulatively declining about 13% relative to 2010. 
• Inflation adjusted stock prices are not expected to return to their 2010 level until 2027.
• On the brighter side, as the M/O ratio rebounds in 2025, we should expect a strong stock price recovery. By 2030, our calculations suggest that the real value of equities will be about 20% higher than in 2010.

Source: Federal Reserve Bank of San Francisco

Interestingly, the conclusions from the Federal Reserve paper mirror the conclusions from our own proprietary 'Estimating Future Returns' models, which suggest investors should expect near zero returns after inflation for at least the next 15 years.

Source: Shiller (2011), DShort.com (2011), Chris Turner (2011), World Exchange Forum (2011), Federal Reserve (2011), Butler|Philbrick & Associates (2011)

While this outcome may appear inconceivable to many, I would urge you to examine the path of Japanese stocks from their peak in 1989 at almost 40,000 to their current price under 10,000. Japan suffered from too much debt and an unhealthy property sector, but these headwinds were amplified by another challenge which we in the West share (though not quite as badly): a declining share of working persons relative to retired persons.

Source: Stockcharts.com

Perhaps not surprisingly, U.S. stock markets have been tracking the performance of Japanese stocks since U.S. stocks peaked in 2000. When we overlay the two stock market indices and align their respective peaks, the resemblance is uncanny (and not a little bit shocking for 'Buy and Hold' investors). If we continue to track the Japanese experience, we may be setting up for another major drop, perhaps to new lows.
Source: Bloomberg, Ritholtz.com

You probably aren't hearing this message from pundits on TV or in the papers, or economists at the major banks or investment firms. However, I urge you to keep three thoughts in mind when you hear these experts speak:

1. If a person's job depends on them not knowing something, then they won't know it.

2. Investment firms make much higher margins from clients who hold or trade stocks or stock mutual funds than from clients who hold bonds or cash instruments like GICs or money market funds. As such, they have a strong incentive to keep clients invested in stocks and stock mutual funds at all times, per the 'Buy and Hold' approach.

So what is a person to do when long-term Canadian bonds are yielding 0.64% after inflation, and developed market stocks are likely to yield no returns (but probably typically high volatility) for the next 15 years or more?

At Butler|Philbrick & Associates, we have a plan. At its core, our approach embraces two major areas of differentiation:

1. Broaden the investment opportunity set for portfolios to include international and emerging market stocks, real estate, commodities,etc. Cash is an asset class!
2. Apply a proven process to decide which asset classes to own (including cash when markets are risky), and when to own them.

As a proof of the effectiveness of our approach in difficult markets, we published a study on how to profitably trade the Japanese bear market back in February (see here for full study). We have suspected for some time that the Japanese template was the most likely trajectory for developed stock markets over the next several years.

In the study, we applied our trend following approach to the Japanese stock market to see how it would have performed over its 21 year downhill roller coaster ride.

 

Source: Butler|Philbrick & Associates 

You can see in the chart that by taking advantage of both positive and negative trends using a simple timing system over this period, our technique delivered over 16% annualized investment performance, while never dropping more than 22.9% from any peak to trough (see "CAGR%" and "Max Total Equity DD" respectively in the table above the chart).

Pretty good results generally, but especially when they're compared with the 75% cumulative loss that most Japanese investors experienced by holding stocks over the past 20 years.

We are following a proven trend following model like the one above to deliver prospective returns for clients no matter what happens in markets. What are you (or your Advisor) doing to prepare for this potential investment outcome?

Adapt or Fail

The previous article in this series discussed the ebb and flow of stock markets as they move through long periods of strong and weak returns, often lasting 15 years or more at a time. As such, there are periods when investors can set their sails and ride the prevailing winds to a sunny investment horizon. Alternatively, there are long periods where markets go sideways or down, and where any growth in investment portfolios must necessarily come at the expense of someone else.

Unfortunately, our analysis suggests that we are in the early, or perhaps middle stages of a multi-year period of low market returns, where investors will need to ‘row’ their way to positive investment performance. During such ‘rowing’ periods it is important to consider active strategies that have the potential to provide substantial risk-adjusted returns in any type of market.

Heave Ho

One such rowing strategy was recently outlined in a paper entitled Optimal Momentum by Gary Antonacci. This paper has practical relevance because it closely mirrors the general principles we apply in our proprietary investment models for clients. In the study, Antonacci constructs an investment universe that broadly captures the set of global opportunities available to investors. We simplified the strategy presented in the paper slightly, and altered the investable universe in our study to accommodate the options available to Canadian investors by investing in Exchange Traded Funds (ETFs).

At any given time, our model was able to invest in any two of the asset classes below (in bold) via a corresponding ETF (in italics).

·      US Real Estate - iShares Cohen & Steer Realty REIT

·      Gold Bullion - SPDR Gold Shares

·      Japanese Stocks - iShares MSCI Japan Index Fund

·      European Stocks - iShares S&P Europe 350 Index Fund

·      Cash - Barclays Low Duration Treasury

·      Asian Stocks (ex-Japan) - iShares Pacific ex-Japan

·      US Treasury Bonds - iShares Barclay 7-10 Yr. Treasury - 7-8 Yr.

·      US Stocks - Vanguard MSCI Total U.S. Stock Market

ETFs trade on the major stock exchanges just like regular stocks, but they behave largely like very low-cost index mutual funds. That’s because each Exchange Traded Fund, or ETF, is constructed to deliver the same performance as a very broad index of underlying securities. For example, investors can purchase a single ETF to experience the exact returns of the entire S&P/TSX Index, the S&P 500, theNasdaq, gold, European stocks, or a wide variety of other asset classes or indices.

In his paper, Antonacci presents a strategy that ranks the investment opportunities above based on how each investment has performed over the prior six months. The concept is based on the well-documented phenomenon in markets called ‘Momentum’, whereby securities that have done well over the recent past have a high probability of continuing their positive performance over the subsequent 1 to 3 month period.

Accordingly, in our study we ranked the above basket of investments at the end of each month according to their relative price performance over the previous six months. At the end of each month, we altered the holdings of the portfolio so that the portfolio always held the two most highly ranked investments. In other words, the portfolio adapted at the end of each month to hold the most prospective investments over the following month based on our ranking criteria.

Table 1.
SYMBOL	EXCHANGE TRADED FUND (ETF)/ INVESTMENT MODEL
ICF	US Real Estate - iShares Cohen & Steer Realty REIT
GLD	Gold Bullion - SPDR Gold Shares
EWJ	Japanese Stocks - iShares MSCI Japan Index Fund
IEV	European Stocks - iShares S&P Europe 350 Index Fund
SHY	Cash - Barclays Low Duration Treasury
EPP	Asian Stocks (ex-Japan) - iShares Pacific ex-Japan
IEF	US Treasury Bonds - iShares Barclay 7-10 Yr. Treasury - 7-8 Yr.
VTI	US Stocks - Vanguard MSCI Total U.S. Stock Market

To illustrate the effect of this ranking and rotation into the most prospective markets each month, in the diagram below, we tracked our model’s holdings for each month of the year 2008 in Figure 1. to demonstrate how the ETF holdings of our model change over time. The numbers represent the monthly total returns for each investment, and coloured squares identify the months where our model actually held the investment.

You can see that our model rotated into gold (GLD) and U.S. bonds (IEF) for the first 7 months of 2008, and then moved out of gold and into cash (SHY) for the remainder of the year.

Figure 1: Highlighted Monthly Model Holdings in 2008

	January	February	March	April	May	June	July	August	September	October	November	December
VTI	-6.17%	-2.50%	-0.90%	4.89%	2.02%	-8.12%	-0.62%	1.46%	-9.24%	-17.48%	-8.01%	1.78%
IEV	-8.80%	-0.47%	1.18%	4.43%	0.41%	-9.34%	-2.57%	-3.97%	-12.36%	-21.25%	-6.72%	7.70%
EWJ	-4.29%	-1.49%	-1.28%	7.36%	1.96%	-7.47%	-3.77%	-4.92%	-6.57%	-15.57%	-3.78%	11.56%
EPP	-7.88%	-2.57%	-2.09%	7.76%	2.86%	-9.16%	-4.66%	-4.95%	-12.67%	-26.52%	-6.90%	9.45%
SHY	1.65%	1.03%	0.25%	-0.84%	-0.35%	0.24%	0.43%	0.47%	0.78%	1.10%	1.10%	0.56%
IEF	3.36%	1.24%	1.34%	-2.41%	-1.78%	1.14%	0.72%	1.53%	-0.14%	-0.87%	7.75%	5.15%
GLD	10.84%	5.23%	-6.00%	-4.16%	0.92%	4.52%	-1.44%	-9.29%	4.11%	-16.14%	12.57%	7.73%

   Source: Antonacci (2011), Butler|Philbrick & Associates (2011)

It Pays to Row


In terms of performance, our modified Antonacci Model achieved a 407% total return between 2003 and July 2011. In the same period, the S&P 500 index of the largest U.S. stocks returned 68% including dividends. This works out to an average annual return of 21.8% for our simple strategy versus 6.6% annualized for U.S. stocks. Further, while U.S. stocks were dropping over 50% in 2008 our Antonacci study portfolio delivered a positive return of 16.1% (see Figure 2 below). Figure 2. demonstrates the relative performance of our model in each calendar year relative to all of the available investments. Notice that from 2003 to 2011 our modified Antonacci Model never dropped out of the top half in terms of annual calendar-year performance, and never experienced a losing year.

Figure 2:

Source: Antonacci (2011), Butler|Philbrick & Associates (2011)

SYMBOL	EXCHANGE TRADED FUND (ETF)/ INVESTMENT MODEL
ICF	US Real Estate - iShares Cohen & Steer Realty REIT
EWC	Canadian Stocks - iShares MSCI Canada Index Fund
GLD	Gold Bullion - SPDR Gold Shares
EWJ	Japanese Stocks - iShares MSCI Japan Index Fund
IEV	European Stocks - iShares S&P Europe 350 Index Fund
SHY	Cash - Barclays Low Duration Treasury
SPY	US Large-cap Stocks - SPDR S&P 500 Index
ANT	Modified Antonnacci Model
EPP	Asian Stocks (ex-Japan) - iShares Pacific ex-Japan
IEF	US Treasury Bonds - iShares Barclay 7-10 Yr. Treasury - 7-8 Yr.
VTI	US Stocks - Vanguard MSCI Total U.S. Stock Market

Even more impressive, the modified Antonacci model’s worst full calendar year return was positive 10%, versus minus 35% or more for the major stock markets. In fact, the Antonacci model never dropped more than 10% from any peak to trough on its ride to the top, while markets dropped 50% or more!

The Long and Short

The take away from this study is that, if left alone, and especially during low-return periods, financial markets do not deliver returns in a consistent fashion.  As such, it is of paramount importance that any investment strategy be able to adapt over time as markets change - moving to bonds, cash or perhaps gold when markets are falling, or into the most prospective markets when markets are rising – rather than sticking with a constant allocation to one market or another over time, per the traditional approach.

After studying the performance of Antonacci’s momentum based strategy over the past decade and considering the returns that buy and hold investing delivered during the same period, it should be clear that a systematic adaptive investment strategy has the potential to add tremendous value in all types of market environments, and especially during highly uncertain and volatile times like today.

For more information about how adaptive, systematic strategies may work well for you, or to read our Estimating Future Returns piece, please visit us on the Web at  http://www.macquarieprivatewealth.ca/specialist/butlerphilbrick/case-studies .