Tactical Asset Allocation in Bull/Bear Markets Timothy J. Marchesi, CFA President, CEO & Co-CIO DeMarche Associates, Inc. DeMarche Associates, Inc. Agenda • Importance of Asset Allocation • Tactical vs. Conventional Approach • Economic & Market Environment • Supercycles • Dynamic Investment Strategies DeMarche 2 Associates, Inc. Importance of Asset Allocation • Studies estimate that asset allocation decision accounts for 91.5% of the variation between returns of different funds 1 • Asset mix optimization models mathematically seek maximum expected rate of return for a given level of risk (or minimization of risk for a given expected return) 2 1 Financial Analysts Journal, May/June 1991 – Brinson, Singer & Beebower 2Global Asset Allocation Techniques for Optimizing Portfolio Management, 1994 – Lummer & Riepe DeMarche 3 Associates, Inc. Review of Conventional Approach • Inputs based upon history • Typical models assume “average” future outcomes • Often ignore starting /ending market levels Large Capitalization Stocks Distribution of Returns Quarterly One-Year Returns 1926-2009 40 35 30 25 Number of 20 Occurrences 15 10 5 0 -50 -45 -40 -35 -30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50 Percent Return Source: S&P 500 Index Some returns are greater than 50% and less than -50% DeMarche 4 Associates, Inc. Review of Conventional Approach • Typical models assume “average” future outcomes (sample chart below) 12% Emerging Equities 10% Small Cap Equities Large Cap Equities 8% Hedge Fds 6% Bonds 4% 2% Today 2015 2020 2025 2030 DeMarche 5 Associates, Inc. One-Year Returns Are Volatile Models incorporate standard deviation to manage risk DeMarche 6 Associates, Inc. Model Optimization: The Efficient Frontier DeMarche 7 Associates, Inc. What is Tactical? Webster’s: • “Small-scale action to serving a larger purpose” In Investment Management: • Method of modifying asset allocation based upon valuation estimates and judgments of the future return of markets or sectors DeMarche 8 Associates, Inc. Time Horizon for Investment Objectives Asset Allocation Study has both a strategic perspective and a long-term secular perspective Investment Horizon Short Long Term Term Market Tactical Strategic Secular Timing Asset Asset Asset Allocation Allocation Allocation One Year Current Market Several Market Multiple Market Or Less Phase Cycle Phase Cycles Supercycles DeMarche 9 Associates, Inc. DeMarche Market Phases A typical market cycle has four distinct phases: Stock Corporate Total Tactical Market Phase Prices Earnings Return* Phase I – Early Bull 62.0% Phase II – Bull Market 20.8% Phase III – Late Bull/Early Bear 0.5% Phase IV – Bear Market -27.0% *Annualized cumulative returns of S&P 500 Index. Study based upon monthly data from 1/31/63- 9/30/11. The annualized cumulative return for the full study period was +9.5%. Source: DeMarche Research DeMarche 10 Associates, Inc. Markets Change Markets change over long periods of time • As markets change, relative value between asset classes changes • DeMarche research has acknowledged and identified these long wave markets as “Supercycles” • Multiple bull and bear markets exist within each “Supercycle” DeMarche 11 Associates, Inc. DeMarche Supercycle Study Bank Panics/ Market Cycles Supercycle Years Recessions (Bull/Bear Cycles) A. High Growth 1900 – 1929 8 8 B. Moderate Growth 1929 – 1942 3 5 C. High Growth 1942 – 1966 5 8 D. Moderate Growth 1966 – 1980 3 6 E. High Growth 1980 – 2000 2 5 F. Moderate Growth 2000 - Present 2 3 DeMarche 12 Associates, Inc. DeMarche Supercycle Study Supercycle Beginning End DJIA Price Return* A 1900 1929 +882% B 1929 1942 -75 C 1942 1966 +701 D 1966 1980 +2 E 1980 2000 +1,444 F 2000 Present* -5 *As of 3/31/2011. Cumulative returns are shown for each cycle (non-annualized). DeMarche 13 Associates, Inc. The Consumer in Supercycles Supercycles Environment A 1900 – 1929 High population growth B 1929 – 1942 High unemployment C 1942 – 1966 Baby boom / income growth D 1966 – 1980 Inflation E 1980 – 2000 Expansion of consumer credit F 2000 – ? Demographics & debt DeMarche 14 Associates, Inc. New Normal Macroeconomic Environment • Demographics “Boomers” retire or shift emphasis from consumption to saving • Consumers gradually improve their finances Paying down debt / increase savings DeMarche 15 Associates, Inc. New Normal Macroeconomic Environment (cont’d) • Unemployment • Wage growth remains slow • Less help from asset gains (wealth effect) • Higher taxes DeMarche 16 Associates, Inc. Strategic Implications of Current Supercycles • Stock returns likely to underperform mean • Bond returns likely to underperform mean • Policies need other strategies to improve expected risk/return outcomes DeMarche 17 Associates, Inc. Asset Allocation – Expected Returns Next 5 Year “Strategic” Period versus Long-Term “Secular” Time Horizon Source: DeMarche Associates. See notes on next slide. DeMarche 18 Associates, Inc. Asset Allocation – Expected Returns (cont.) • Notes for chart on prior page: • Represents geometric return estimates for the 5 years beginning January 2012, compared to long-term average geometric returns over multiple Supercycles (no specific beginning point). 5-year horizon utilizes an assumption of a moderate economic growth environment within the current Supercycle, as defined by DeMarche. • U.S. Fixed Income has poor E.R. over the strategic period. Such assets presently have very low current income yield and are at risk of principal value losses as interest rates rise. • Other asset classes are shown for comparison. DeMarche 19 Associates, Inc. Dynamic Investment Strategies • Hedge Funds • Global Tactical Asset Allocation (GTAA) Funds • Lifecycle or Target Date Fund (TDFs) • Intro to some assets used by dynamic strategies Commodities High Yield Bonds Emerging Market Bonds DeMarche 20 Associates, Inc. Brief Intro to Hedge Funds and GTAA Strategies • Different HF Fund of Funds approaches for clients Conservative – emphasis on diversification, lower volatility Strategic – more use of directional market bets, leverage • GTAA is long-only, relative valuation-based • Fees higher with HF • Limited transparency with HF • GTAA correlation is high (vs. stocks/bonds) • Wide variance across manager/strategies DeMarche 21 Associates, Inc. Sample Range of GTAA Fund Approaches Classic More Complex Comprehensive Asset Classes Used Cash X X X Domestic Equity X X X International Equity X X Emerging Markets Equity X X Domestic Bonds X X X International Bonds X X Emerging Markets Bonds X X High Yield Bonds X Inflation Protected (TIPS) X X Convertibles X Commodities X X Real Estate (REITs) X Listed Private Equity X Currency X X Typical Investments Mutual Funds X X X Closed-End Funds X X Exchange-Traded (ETFs) X X X Individual Securities X X X Derivatives X X DeMarche 22 Associates, Inc. What is a Target-Date Fund? • Description of TDF (or Lifecycle Fund): Diversified investment option Target a specific retirement year (2020, 2030, etc.) Professionally managed – Stock allocation reduced as retirement year nears – Disciplined rebalancing of underlying funds May use less-traditional investments DeMarche 23 Associates, Inc. Example of TDF Asset Allocation Fewer equities as participant retire date nears Source: PIMCO, compiled by MarketGlide. DeMarche 24 Associates, Inc. TDF Glidepaths Programs reduce equities over time; some have tactical range Glidepath Active Average vs Passive Average 100 80 Percentage Equity Allocation Passive 60 Manager Average Active Manager Average 40 Industry Max Industry Min 20 0 2055 2050 2045 2040 2035 2030 2025 2020 2015 2010 2005 2000 1995 DeMarche 25 Associates, Inc. Brief Intro: Commodities • Energy, Metals, Agriculture, Livestock • Weights differ among several indexes S&P has 65-75% Energy: others cap at 33% • Portfolio diversifier Hedge against unexpected inflation Slight negative correlation to stocks & bonds in past • Liquidity varies; fund choices very distinct • Key concerns: China, oil, gold Total return from commodities comes from combination of: rolling futures contracts (roll yield), yield from the cash collateral, and the spot price gain or loss. Derivatives use is widespread (active or passive). DeMarche 26 Associates, Inc. Brief Intro: High Yield & Emerging Market Bonds • Both have low correlations to U.S. Bonds • U.S. High Yield Bonds Quality ratings of “BB” or lower (below investment grade) Average maturities 3-10 years High level of current income payments Default risk rises in recessionary periods Higher volatility and potential losses than other fixed income • Emerging Market Bonds are investment grade Obligations of foreign government or corporation Average maturities 3-10 years Higher fees (management, transaction, custodial) Political, liquidity, and other risks differ from U.S. bonds Currency risk (some issued in U.S. dollars) DeMarche 27 Associates, Inc. Recommendations • Adjust asset allocation more frequently • Incorporate Supercycles • Emphasize liquidity • Diversify • Increase allocation to dynamic strategies DeMarche 28 Associates, Inc. Questions? Thank you! DeMarche 29 Associates, Inc.
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