9/5/2015 Tactical Asset Allocation 1 Tactical Asset Allocation session 5 Andrei Simonov

04/19/23Tactical Asset Allocation1

Tactical Asset Allocation Tactical Asset Allocation sessionsession 5 5

Andrei Simonov


AgendaAgenda

What is tactical asset allocation? Mean-variance perspective on TAA and SAA Predictability

– January dummy

– Business cycle variables

– Explaining risk premia: US, World, Sweden.

– Currency risk premia

– Caveats: data snooping, statistical issues.


What is TAA?What is TAA? Exists since early-to-mid- 80-ies. By now $100-200 bln are under management by TAA

managers A TAA managers’s investment objective is to obtain

better-than-expected return with (possibly) lower-than-benchmark volatility by forecasting the returns of two or more asset classes and varying asset class exposure in systematic manner (Phillips, Rogers & Capaldi, 1996)

Can TAA funds be interpreted as stand-alone asset class?


Conditioning Information and Portfolio Conditioning Information and Portfolio AnalysisAnalysis

Er

Vol

Add conditioninginformation and weightschange through time. Frontier shifts.


Optimal portfolio for risk-averse investorOptimal portfolio for risk-averse investor

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Equilibrium and TAAEquilibrium and TAALet us assume that there exists long-term

expected returns vector e. However, due to predictability of asset returns, eE(R)

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How to do it?How to do it?

We need a model that explains the connection between today’s variables and tomorrow returns.

Candidates: economic business cycle variables and Jan. Effect.


Example: Incredible January EffectExample: Incredible January Effect

Excess returns associated with small firms w.r.t. Large-cap stocks

Ritter: Tax effect. Is it so?Incredibly Shrinking January Effect

(William J. Bernstein ).


Example: dividend yieldExample: dividend yield

Fama-French (1988). 1927-1986 Holding period

Coeff. t(coeff) R2

M 0.21 1.40 0.00 Q 1.07 2.10 0.01

1 2.47 1.27 0.01 2 7.38 2.04 0.09 3 9.94 2.21 0.13 4 12.86 2.43 0.19

• May not be sustained out of sample


Risk and return over the business cycleRisk and return over the business cycle mtmtmttm RrRE var, ? ? ? ?

G - 7 o u t p u t , 1 9 7 3 Q 2 t o 1 9 9 6 Q 2 o u t p u t l e v e l

p o t e n t i a l l i n e

e n d . r e c e s s b e g . e x p a n e n d . e x p a n b e g . r e c e s s A v e r a g e r e t u r n s

1 5 . 2 3 % 1 0 . 3 6 % 6 . 9 6 % 2 . 8 6 %

R e t u r n v o l a t i l i t y

1 2 . 5 9 % 1 0 . 6 3 % 1 6 . 8 5 % 2 6 . 9 8 %


Evaluation of Recent Evaluation of Recent RecessionRecession In July 2000, the Yield Curve inverted forecasting

recession to begin in June 2001. Official NBER Peak is March 2001 (Yield Curve within

one quarter accurate). In March 2001, the Yield Curve returned to normal

forecasting the end of the recession in November 2001. On July 17, 2003 the NBER announced the official end of

the recession was November 2001.


Exhibit 1

Lead Lag Analysis in Months

NBER Peak

NBER Trough

Length of Cycle Inversion Lead Normal Lead

Length of Inversion

Dec-69 Nov-70 11 Oct-68 14 Feb-70 9 16Nov-73 Mar-75 16 Jun-73 5 Jan-75 2 19Jan-80 Jul-80 6 Nov-78 14 May-80 2 18Jul-81 Nov-82 16 Oct-80 9 Oct-81 13 12Jul-90 Mar-91 8 May-89 14 Feb-90 13 9

Average last four 11 11 7 15

Recent RecessionMar-01 Nov-01 8 Jul-00 8 Mar-01 8 8

Business Cycle 5-Year Yield Spread

Next couple of slides are due to Cam Harvey


Exhibit 2

Forecast evaluation

Term Structure Inversion Date

Average Lead to Recession

Forecast Beginning of Recession

Actual Recession Begins Error

Jul-2000 11 Jun-2001 Mar-2001 3

Term Structure Normal Date

Average Lead

Forecast End of Recession Actual End Error

Mar-2001 8 Nov-2001 Nov-2001 0


Yield Curve Inverts Before Last Six RecessionsYield Curve Inverts Before Last Six Recessions(5-year Treasury note minus 3-month Treasury bill yield-secondary)(5-year Treasury note minus 3-month Treasury bill yield-secondary)

-6

-4

-2

0

2

4

6

8

% Real annual GDP growth

Yield curve

RecessionCorrect 2 Recessions

Correct

RecessionCorrect

Yield curve accuratein recent recession

RecessionCorrect

Annual GDP growthor Yield Curve %

Data though April 11, 2006

Source: Campbell R. Harvey.

Recent flattening


Yield Curve Inverts Before Last Six RecessionsYield Curve Inverts Before Last Six Recessions(5-year Treasury note minus 3-month Treasury bill yield – constant maturity)(5-year Treasury note minus 3-month Treasury bill yield – constant maturity)

-6

-4

-2

0

2

4

6

8

% Real annual GDP growth

Yield curve

RecessionCorrect 2 Recessions

Correct

RecessionCorrect

Yield curve accuratein recent recession

RecessionCorrect

Annual GDP growthor Yield Curve %


Source: Campbell R. Harvey.

Recent flattening


Recent Annualized One-Quarter GDP Growth Recent Annualized One-Quarter GDP Growth (10-year and 5-year Yield Curves-secondary market)(10-year and 5-year Yield Curves-secondary market)

-4

-2

0

2

4

6

8

-2

-1

0

1

2

3

4% Real annualized one-quarter GDP growth

Annualized 1-quarter GDP growth

Both curvesinvert 2000Q3

10-year

5-year

Yield curve



Recent Annualized One-Quarter GDP Growth Recent Annualized One-Quarter GDP Growth (10-year and 5-year Yield Curves-constant maturity)(10-year and 5-year Yield Curves-constant maturity)

-4

-2

0

2

4

6

8

-2

-1

0

1

2

3

4% Real annualized one-quarter GDP growth

Annualized 1-quarter GDP growth

Both curvesinvert 2000Q3

10-year

5-year

Yield curve

Data though April 2006


What shall we expect now?What shall we expect now?US yield curves, 2006

4

4.2

4.4

4.6

4.8

5

5.2

5.4

1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr

1/3/2006

4/3/2006

7/3/2006

8/29/2006

May 2007: Practically flatMay 2007: Practically flat


August 2007August 2007



Current Situation: Economic growthCurrent Situation: Economic growth•The economy expanded at an annual pace of 4.1%, the most in more than a year, according to the median estimate of 81 economists surveyed by Bloomberg News. The Commerce Department last month calculated the growth rate at 3.4%. • But the outlook for the second half of 2007 has soured in recent weeks as the subprime mortgage crisis has restricted access to credit. The Federal Reserve this month said risks to growth had ``increased appreciably'' and economists at JPMorgan and Lehman are among those that have reduced forecasts. •There are growing signs of a housing slowdown; new home sales down, housing prices down, and homeowners with ARMs facing much higher interest rates.


Current SituationCurrent Situation

Inflation perceptions. The long-term rate is a combination of expected inflation, expected real interest rates and an inflation risk factor. Long-term inflation expectations have decreased mainly due to the glut of cheap labor resulting from globalization.



Strong buying of long-term bonds by foreigners. For the past few years, strong buying by Asian central banks have pushed up the Treasury bond prices. However, there is a debate as to whether this has had a large impact on bond prices. In addition, this buying has flattened out recently. A recent Fed study estimated that the foreign buying pushed yields down by 150bp. Subprime crisis does not end buying of T-debt by foreigners. Demand for 5yr TB last week was very high.



Hedge funds. There has been a recent increase in demand for U.S. bonds from the Caribbean area indicating hedge fund activity. With long-rates above short rates, many managers do “carry trades” (borrow short-term and buy long-term bonds hoping the relation between rates remains stable). As the term structure flattens, many of these managers increase their leverage which means more buying pressure on the long-term bonds.



Demographic forces. As the population ages, more money is allocated into fixed income and long-term bond yields may decrease.

Inflation risk. The long-rate rates contain expected inflation, expected real rates and an inflation risk factor. It is widely perceived that inflation risk (an unexpected episode of inflation turbulence) has decreased.


Annual Real Economic Growth After Annual Real Economic Growth After Yield Curve InversionsYield Curve Inversions

0.00%0.50%1.00%1.50%2.00%2.50%3.00%3.50%4.00%4.50%

Up to one year afterinversions

Other quarters


Stock Returns and U.S. Yield CurveStock Returns and U.S. Yield Curve

-0.5

0

0.5

1

1.5

2

2.5

3

AU AT BECA DK FR DE

HK IT JP NLNO SG ES SE CH

UK USW

O

Inversion Normal

Average Monthly Returns in %

Data throughNovember 2000


Average Monthly Stock Returns After Average Monthly Stock Returns After Yield Curve InversionsYield Curve Inversions

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

After first month ofinversion

Normal

Equally weighted

Value weighted

Based on 19 countries.

Trader’s calendar Trader’s calendar (from thestreet.com)(from thestreet.com)


Time (EST)

Indicator (click for definition)

Source (click for press release)

Actual ForecastPrevious (revised)

Previous (original)

Monday, May 21No releases.

Tuesday, May 229 a.m. ICSC-UBS Weekly Chain Store Sales Snapshot for

the week ended May 19 International Council of Shopping Centers and UBS

-1.5% n.a. +0.8% +0.8%

9 a.m. Johnson Redbook Retail Sales Index for the week ended May 19, vs. April

Redbook Research +2.0% n.a. +2.2% +2.5%*

Wednesday, May 239 a.m. Mortgage Applications Survey for the week ended

May 18 -- Market Composite Index Mortgage Bankers Association-- n.a. -- 675.5

Purchase Index -- n.a. -- 432.39 a.m. Consumer Comfort Index for the week ended May

20 ABC News and Washington Post -- n.a. -- -7

Thursday, May 248:30 a.m. Initial Jobless Claims for the week ended May 19

Labor Department-- +305,000 -- +293,000

Four-week average -- n.a. -- +306,0008:30 a.m.

Durable goods orders for April Census Bureau

-- +0.9% -- +3.7%

Ex-transportation -- n.a. -- +1.5%

10 a.m. New home sales for April Census Bureau -- .860M -- .858M

2:30 p.m.

Treasury auction announcementBureau of the Public Debt

The Treasury announces the size of its next monthly two-year note auction, next Tuesday.

Friday, May 25 10 a.m. Existing Home Sales for April National Association of Realtors -- 6.10M -- 6.12M

10:30 a.m. Weekly Leading Index for the week ended May 18 Economic Cycle Research Institute -- n.a. -- +6.1%


What variables matter?What variables matter?

Methodology: 1. Exploratory: regressing

returns at t on informational variables at t-1

2. ”Correct one”: first finding economic risk premia (a la APT) and then regressing it on informational variables at t-1


Do informational variables have Do informational variables have predictive ability?predictive ability? Info variables:

– January dummy

– Past excess return on Equally weighted CRSP index

– Spread between 1 and 3 mo T-bills

– Dividend yield

– Spread between Baa and Aaa corporate bonds

– 1-mo T-bill rate


Here how it looks like...


Performance & Business CyclePerformance & Business Cycle

-30

-20

-10

0

10

20

30

Expansion geometric mean Recession geometric mean

Average Annual Returns During U.S. Business Cycle Phases

Data through June 2002


Performance & Business Cycle (2)Performance & Business Cycle (2)

0

10

20

30

40

50

60

Australi

a

Austria

Belg

ium

Canad

a

Den

mar

k

Finlan

d

France

Ger

man

y

Hong K

ong

Irelan

d It

aly

Japan

Nether

lands

New

Zea

land

Norway

Portugal

Spain

Swed

en

Switzer

land

UK USW

orld

World

ex-U

S

EAFE

Expansion std.dev. Recession std.dev.

Average Annual Volatility During U.S. Business Cycle Phases



Performance & Business Cycle (3)Performance & Business Cycle (3)

-0.2

0

0.2

0.4

0.6

0.8

1

Australi

a

Austria

Belg

ium

Canad

a

Den

mar

k

Finlan

d

France

Ger

man

y

Hong K

ong

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Japan

Nether

lands

New

Zea

land

Norway

Portugal

Spain

Swed

en

Switzer

land

UK USW

orld

World

ex-U

S

EAFE

Expansion correlation with US Recession correlation with US

Correlations During U.S. Business Cycle Phases



3. Performance & Business Cycle (4)3. Performance & Business Cycle (4)

0

5

10

15

20

25

30

35

40

45

Australi

a

Austria

Belg

ium

Canad

a

Den

mar

k

Finlan

d

France

Ger

man

y

Hong K

ong

Irelan

d It

aly

Japan

Nether

lands

New

Zea

land

Norway

Portugal

Spain

Swed

en

Switzer

land

UK US

World

World

ex-U

S

EAFE

Expansion covariance with US Recession covariance with US

Covariances During U.S. Business Cycle Phases



How important are global factors?How important are global factors? Based on Ferson-Harvey RFS95 Question here is: what is more important, local or global

factors for predictability of asset returns. Global Informational variables: : ”old friends”: 1 mo t-bill, div.

Yield on MSCI World index, spread between 10yr and 3 mo T-bills, Eurodollar/US treasury spread, lagged market return, January dummy.

Local informational variables: Country x div. Yield, 30-day t-bill rate, term spread, lagged MSCI country x market return.

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So, what So, what matters?matters?

”Global only” model is already good enough

Adding local factors increases explanatory power of the model


Changes in Changes in vs changes in risk premium vs changes in risk premium

Only 2-4% of variation is due to beta’s.

)()'(

)()'('

EZEVarE

EZEVarEZEVar


Sweden (Robertsson, 2000):Sweden (Robertsson, 2000):

Swedenbond bill mat def fx irs ey mb irw R2

Market Index –2.05 –1.02 –0.42 3.19 1.26 1.24 0.35 0.01 –6.50 6.1-1.09 -0.64 -0.62 -2.27 -0.5 -0.58 -0.29 -0.03 -11.5 [0.00]

Small Stocks –2.91 –0.75 1.19 0.65 –0.05 –0.02 –0.67 0.08 –13.6 16.8-1.27 -0.5 -0.65 -2.17 -0.58 -0.61 -0.34 -0.05 -10 [0.00]

Bond Index –1.18 0.37 0.02 0.7 0.14 0.32 0.1 –0.01 4.19 13.1-0.32 -0.18 -0.13 -0.56 -0.14 -0.14 -0.08 -0.01 -2.41 [0.00]


What about currency risk premium?What about currency risk premium?

Currency specificiyy: zero-sum gameDumas-Solnik: currency risk premia

exists. It is time-varying and predictable


Caveats:Caveats:

Data snooping– Foster, Smith and Whaley (98): by choosing to

max R2 via choice of instruments one can get significance when there is none.

– Not clear how to use as list of instruments already exists...

In-sample vs. Out-of-sample validation


Caveats(2)Caveats(2)

Statistical biases: autocorrelation, heteroscedastisity (via Monte-Carlo simulations).

Non-normality, excess skewness and kurtosis


How to deal with statistical issues?How to deal with statistical issues?

Bootstrap methodology:– Form empirical distribution of returns – Generate time series of returns (length T).– Perform the regression of interest– See how many times there exists significance

on level .


U.S. Risk PremiumU.S. Risk Premium

Survey BackgroundSurvey Background

Graham/Harvey: Survey CFOs every quarter Q2 2000 through Q4 2003 (15 quarters) Current survey attracts about 400 respondents

Why CFOs? – We know from previous surveys and interviews that the

CFOs use the risk premium for their capital budgeting

– Hence, they have thought hard about risk premium

– Should not be biased the way that analyst forecasts might be



One-Year PremiumOne-Year Premium One-year risk premium variable. Currently, about 7%

0

1

2

3

4

5

6

7

8

Mea

n pr

emiu

m

A. One-year risk premium

Jun., Sept., Dec., Mar., Jun., Sept., Dec., Mar., Jun., Sept., Dec., Mar., Jun., Sept., Dec., 00 00 00 01 01 01 01 02 02 02 02 03 03 03 03



Ten-Year PremiumTen-Year Premium Ten-year risk premium is stable. Currently, about 3.7%

0

1

2

3

4

5

6

7

Mea

n pr

emiu

m

Jun., Sept., Dec., Mar., Jun., Sept., Dec., Mar., Jun., Sept., Dec., Mar., Jun., Sept., Dec., 00 00 00 01 01 01 01 02 02 02 02 03 03 03 03

B. Ten-year risk premium



Momentum in Expectations for 1-year Momentum in Expectations for 1-year PremiumPremium

y = 0.1912x + 3.8912

R2 = 0.5242

0

1

2

3

4

5

6

7

8

-15 -10 -5 0 5 10 15

Excess S&P 500 return in previous two months

Mea

n on

e-ye

ar p

rem

ium



Extreme Returns Cause DisagreementExtreme Returns Cause DisagreementA. Disagreement over the one-year premium and past returns

y = -0.0614x + 3.9079R2 = 0.1684

y = 0.0194x2 + 0.0247x + 3.3696

R2 = 0.5892

0

1

2

3

4

5

6

-15 -10 -5 0 5 10

Past one-month excess S&P 500 return

Dis

agre

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t ove

r th

e on

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Positive Relation Between Disagreement Positive Relation Between Disagreement and Expected 10-year Returnsand Expected 10-year Returns

B. Ten-year premium and disagreement

y = 0.9777x + 1.5936R2 = 0.3165

0

1

2

3

4

5

6

7

8

1.5 1.7 1.9 2.1 2.3 2.5 2.7 2.9

Disagreement of ten-year premium forecasts

Mea

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n-ye

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Example Confidence Intervals: September 16, Example Confidence Intervals: September 16, 20022002

MeanStandard deviation

95% Confidence

Interval Median Min Max TotalOver the next 10 years, I expect the averageannual S&P 500 return will be: There is a 1-in-10 chance it will be less than: 3.65 2.35 3.40 - 3.89 4 -3 10 351

Over the next 10 years, I expect the averageannual S&P 500 return will be: Expected return: 7.81 2.19 7.58 - 8.03 8 0 15 373

Over the next 10 years, I expect the averageannual S&P 500 return will be: There is a 1-in-10 chance it will be greater than: 11.5 3.33 11.15 - 11.84 11 4 20 355

Over the next year, I expect the averageannual S&P 500 return will be: There is a 1-in-10 chance it will be less than: -2.98 6.86 -3.7 - -2.26 0 -20 10 348

Over the next year, I expect the averageannual S&P 500 return will be: Expected return: 4.95 2.78 4.66 - 5.24 5 0 12 345

Over the next year, I expect the averageannual S&P 500 return will be: There is a 1-in-10 chance it will be greater than: 9.96 4.56 9.47 - 10.44 10 0 20 343

Notes: 10-year bond yield 3.9%; 1-year bill yield 1.6%. Confidence interval based on standard deviation of the mean.


Conclusion:Conclusion:

TAA can be an important tool in asset allocation methodology.

It is based on time variation of real economic risk premia.

Selection of predictors is important.We are still in ”top-down” paradigm.Devil is in the details= implementation

matters.

Documents

9/5/2015 Tactical Asset Allocation 1 Tactical Asset Allocation session 5 Andrei Simonov