Note: This article is part of the ETF Trends Strategist Channel
Written by Giralda Advisors
In our prior articles in this series for the ETF Strategist Channel (see archive here), we introduced the concept of Risk-Managed Investing (RMI); outlined its alpha-adding potential, particularly in light of diminished prospects for other (i.e., non-equity) asset classes; and calibrated its tolerable cost. At this point, we suspect you may be eager to hear how RMI might be executed. In this and our next installment, we will outline two practical approaches to implementing RMI, and in the piece following these, we will conduct an overall review of RMI strategies in the marketplace.
Recall that RMI is the attempt to embed equity volatility dampening and/or downside risk mitigation directly into the equity investment itself, thereby lessening the portfolio’s reliance on other, non-equity, asset classes to do so indirectly and arguably less reliably. The first RMI approach we’ll examine is a tactical one — one that is based on using momentum to help reduce the downside risk associated with typical bear market declines in domestic large-cap equities.
Rebalancing Revisited
Let’s begin our examination by revisiting one of the bedrocks of professional investment management — portfolio rebalancing. Rebalancing is keeping your portfolio true to its intended asset allocation, and thus can be viewed a risk management device. Over time, an unrebalanced portfolio will likely see its asset allocation shift toward riskier assets and the portfolio will tend to drift inward, off the efficient frontier. Rebalancing prevents this, and the alpha-generating “rebalancing benefit” has been well documented in the literature.
What makes the rebalancing benefit work? Mean reversion, the flip side of momentum. One way to visualize the process is to think of each asset as tethered to its long-term trend line by an elastic leash. The asset can roam freely from its trend line to a degree, but if it strays too far, the leash gets stretched too tightly and pulls the asset back in the opposite direction. Tolerance-based rebalancing is implicitly assuming that the length of this leash is a predetermined constant. Once an asset’s allocation has reached this threshold, you are assuming that momentum is near its end and mean reversion is about to take over. In the real world of asset behavior, the leash is of indeterminate — and changing — length and elasticity. How do you deal with that? By actually measuring momentum.
Measuring Momentum
The most common way to measure momentum of an asset is by calculating a moving average (MA) of the asset’s return stream. MAs have been shown to be effective in separating information from noise and, in an investment context, they can be used to generate buy/sell signals. In its simplest form, when an asset index crosses below its own MA, this can be a signal to exit that asset. Conversely, when the index crosses back above its MA, this can be a reentry signal. The degree of stability and responsiveness of an MA signal can be varied just by changing the period over which it is measured. The longer the period, the more stable, but less responsive, the signal. The degree of stability versus responsiveness of an MA signal need not be static and may change based on market conditions. We have developed a formula that uses the current level of asset volatility to dynamically adjust the MA period, thereby making the signal more or less responsive automatically.
[related_stories]Another common signaling strategy uses two MAs — one over a shorter period and one over a longer period. Instead of comparing the index itself to the MA, you invest in the asset if the shorter-period MA is greater than the longer-period MA. This is called a moving-average-crossover (MAC) strategy A third, less common, signaling strategy is to look at the trend in (i.e., the first derivative of) the MA. When the MA is increasing, you invest in the asset; when it is decreasing, you stay out.
We have developed and tested dozens of types of momentum strategies. What we found was that no single momentum strategy was perfect, but there were several that had unique strengths under different market circumstances. For example, some proved more reliable as exit signals, while others were more dependable for reentry. Therefore, we constructed a multi-faceted signal wherein each strategy has a role to play under the circumstances when it is most likely to succeed.
An Illustrative Sector Rotation RMI Strategy
To illustrate an MA-based RMI strategy, we subdivided the domestic large-cap equity universe into the ten Global Industry Classification Standard (GICS) industry sectors that are tracked by the S&P 500 sector indexes. We optimized the strategy’s parameters separately for each sector. This sectorization allows us, when we receive an exit signal for a particular sector, to redeploy the proceeds into the remaining sectors and thereby remain fully invested (at least until a critically large number of sectors “turn off,” at which point we would begin moving incrementally to cash). In the absence of buy and sell signals, sector allocation was kept stable by periodic re-balancing to the target weights of the sectors.
This strategy can be implemented using exchange traded funds (ETFs) as an effective way to gain sector exposure. Sector ETFs provide immediate diversification across stocks within the sector, thereby reducing the idiosyncratic risks of investing in individual stocks. These ETFs allow you to capture trends efficiently without the worry of selecting stocks in each sector.
It is important to note that a momentum-based strategy is “trend following.” It does not attempt to predict turning points; it strives to identify trends as early as possible in their development, and to suggest appropriate action. The overall objective of our illustrative sector rotation RMI strategy is to mitigate losses during protracted equity market downturns and to fully participate in the market otherwise. It is not designed to outperform the equity market when the market is doing well. As documented in our earlier piece on Alpha Generation through Risk-Managed Investing, this approach has the potential to significantly outperform market indexes over full bull/bear market cycles.
An illustration of the strategy on a pro forma basis is shown below, compared to the S&P 500 Total return Index. Both indexes are gross of expenses.
Of particular note is the strategy’s performance during the 2000-2002 bear market when it actually experienced a healthy increase. Since the market’s decline was largely due to a single sector (technology), the sector rotation strategy was able to withdraw early from that sector and redeploy funds to other sectors that performed well. Note also that the only significant decline for the strategy, during late 2008/early 2009, is less than half the percentage decline in the S&P 500 over that period (as can be seen clearly in the log scale version of the above graph). The strategy was less effective at minimizing losses during this period than during 2000-2002 because the 2008-2009 decline happened quite suddenly whereas in 2000-2002 it occurred over a protracted period, thereby giving the momentum signals ample time to react. To more fully protect portfolios against declines of all types, including sudden market crashes such as in 2008-2009, we believe this strategy should be supplemented by one specifically designed for crash protection, i.e., “tail risk hedging,” which we will take up in our next installment.
This article was written by the team at Giralda Advisors, a participant in the ETF Strategist Channel.
Disclosure Information
This material is for informational purposes only. Nothing in this material is intended to constitute legal, tax, or investment advice. Investing involves risk including potential loss of principal.
Giralda Advisors, located in New York City, is an asset management firm that focuses on providing risk-managed exposure to the equity markets with a goal of limiting asset depreciation during both protracted and catastrophic market downturns while allowing substantial asset appreciation in up-trending markets. The Giralda Advisors team welcomes your inquiries. Call (212) 235-6801 or visit us at http://www.giraldaadvisors.com/.