- Active strategies are often defined by the factor tilts they take on.
- For factor tilts to continue to out-perform the market over the long-run, they must exhibit premium volatility that causes short-term under-performance.
- Since alpha is zero-sum, investors that fold during periods of under-performance are passing the relative performance to investors with the stomach to hold.
- To truly benefit from active strategies, investors should treat them as long-term allocations and not short-term trades.
We’ve never met an active manager that’s claimed they could beat the market every year.
Behind closed doors and away from the earshot of their investors, most managers will admit that their performance in the short-run often has more to do with whether their process is in vogue with the market or not.
What does that mean?
Consider the numerous tables of asset class returns that get published every quarter. A consistent take away is that no asset class out-performs in all market environments.
Similarly, no active strategy out-performs in all market environments.
Now, many studies have shown that there are numerous characteristics that can deliver superior risk-adjusted returns over time. The most popular include value, size, momentum, trend-following, quality, low-volatility and high yield.
Most active managers tend to align their portfolios one, or several, of these factors.
None of these characteristics, however, out-performs in all markets. In the short-run, their relative out-performance to the market can vary considerably.
A value tilt, for example, has historically delivered an average 2-year return premium of 547 basis points (“bp”) over the broad US equity market. In the short run, it has seen periods ranging between -4046bp and +5753bp.
As we’ve said before, investors do not experience “average.” They experience under-performing the market by -40% over two years before they experience out-performing the market by 57%, assuming they did not sell and go to a different manager.
Before we explore why they vary, it is worth asking why these factors exist in the first place. Traditionally, answers fall in one of two camps: risk and behavioral.
The risk camp believes that the premium earned by an investor is compensation for bearing a certain market risk. For example, the premium earned by buying cheap stocks (the value factor) may be due to higher default probabilities; the premium earned by buying smaller-capitalization companies (the size factor) may be due to their relative illiquidity.
Holders of these securities therefore act like insurance companies: they bear the risk of the bad events and collect a premium for it. The open question is whether the premium earned is fair compensation for the risks (i.e. the expected value of loss from the risk being realized equals the premium) or whether the market has mispriced the risks, overpaying for protection because it overestimated the probability or the magnitude of the risks.
The behavioral camp argues that the premiums exist because investors exhibit behavioral biases that cause them to act irrationally. These irrational actions can be exploited by rational agents to generate return premiums. For example, loss aversion may account for the value premium, while over- and under-reaction may account for the momentum premium.
In either case, there is an argument for the existence of the premium. So why, then, do they vary so significantly over time?
Alpha is a zero-sum game. The excess return generated by one investor is at the detriment of another. The simple answer for why the premiums must be time-varying is that if they were not they would be viewed as free, which would cause an influx of investment, driving up prices and driving down forward return expectations to the point where there would be no premium.
In other words, volatility in the premium itself causes weak hands to fold, passing the premium to the strong hands that remain.
While this may be a philosophical argument for why they must vary, it does not explain the mechanics of what causes them they vary.
We posit that the mechanics for why they vary is behavioral. It has been well established that investor flows tend to chase performance. Superior past performance is rewarded with new money inflows while inferior performance is punished by money outflows. The relationship between performance and flows has been documented as asymmetric and convex, with good performance leading to higher inflows and bad performance only leading to low outflows.
We believe premiums could be driven by this performance chasing behavior:
- Short-term out-performance of a factor attracts inflows.
- These inflows cause a short-term self-fulfilling cycle of further out-performance.
- Excess inflows cause return premiums to turn negative.
- Negative returns lead to out-flows.
- Out-flows cause a short-term self-fulfilling cycle of further out-flows.
- Excess out-flows cause return premiums to turn positive.
Based on this framework, those investors that sold their value managers in 1999 helped drive valuations even cheaper for the investors that held on. We can see this behavior manifested in price-to-book value for value stocks in the following graph from Research Affiliates:
The dot-com bubble peaked March 11th, 2000. At this point in the above graph, we can see that value stocks were trading at a significant discount to their long-term average price-to-book ratio. In other words, performance chasers who ditched value for the go-go growth stocks of the era only helped make value stocks more attractive.
When valuations reverted over the next several years, those that had the fortitude to stick with the allocation benefited to the detriment of those who folded.
Conversely, those who bought back in after the reversion – chasing the strong performance of value stocks – only bought in at elevated valuation levels, suppressing their forward expected returns.
The typical mutual fund equity investor holds a fund for an average of 3.3 years. That’s just long enough to buy after good performance, hold through a few years of suppressed performance, and sell. Go back to the graph on the first page and notice how the majority of the big premium swings too place over 2-to-4-year periods.
We believe this behavior drives the premiums of the styles themselves. Note in the graph (again, from Research Affiliates) that it is the out-of-favor funds (low inflows) that do best while the in-favor strategies (high inflows) do the worst.
We could very well be seeing cause-and-effect in action. Inflows have to be invested. The investment of inflows drives up prices. All else held equal, higher prices mean higher valuations. Higher valuations mean lower forward expected returns.
Most investors understand this logic already. They understand that stocks don’t always go up, despite having a long-term positive expected risk premium. They buy bonds, therefore, to diversify their exposure. They’ve seen the periodic table of asset class returns. They have internalized the benefits of asset class diversification.
Yet they don’t do the same with active managers. Value, size, quality, momentum, trend-following, low-volatility and high yield are all methods that have consistently demonstrated the ability to out-perform the market on a risk-adjusted basis over full market cycles. Yet investors continue to jump to the active strategy du jour, to their own detriment.
Staying put is easier said than done, of course. We can look at some popular factor tilt premiums over the last 20 years (1995-2015) and see that they went through significant and prolonged drawdowns relative to the S&P 500. Can we blame investors who gave up on a value tilt after under-performing the market by 31.90%? That relative drawdown, from peak-to-recovery, took 8 years.
|Relative Max Drawdown
|Max Drawdown Length
See important disclosures at the end of this document.
Like asset classes, we are best off diversifying across active strategies and recognizing that active under-performance does not necessarily mean a strategy is broken, but rather that it is simply out of favor.
When a strategy is out of favor, we have to resist the temptation to fold. Otherwise, we only transfer the premium to investors who have the fortitude to endure.
Consider managed futures strategies. In a sweeping generalization, these strategies take a diversified, trend-following approach to a broad set of global asset classes, including equities, rates, and commodities. In 2008, when the S&P 500 was down -37%, the Societe General CTA and Trend indices were up 13.07% and 20.88% respectively.
Needless to say, the strategy came into vogue. It is worth noting that BarclaysHedge reportedoutflows in 2008 as investors scrambled to raise cash and significant inflows only later on in 2009.
As assets climbed, the approach suffered an extended 3-year drawdown from 2011 to 2014.
It was only when commodities began crashing in mid-2014 and the “long duration” trade materialized that managed futures were able to dig out of their hole. From June 2014 to April 2015 the SG Trend Index rallied over 30%.
Source: Societe Generale. Index results are hypothetical. The equity curves do not represent any strategy offered by Newfound Research. For more information, seehttps://cib.societegenerale.com/en/sg-prime-services-indices/.
Trend following seeks to take advantage of investor over- and under-reaction to new information. By systematically entering each and every emerging trend, trend following seeks to exploit market re-valuations that either do not happen quickly enough, or extend beyond fair value.
Like any other method that has historically demonstrated long-term out-performance potential, its premium must too vary over time. If not, and the premium were consistent, excess money would flow into the approach. Then, as trend followers tried to enter trades, they would make significant market impact, driving prices up (or down, depending on the direction of the trade), eating into their potential return. If the approach hit capacity, trades would drive price immediately to fair value, or even beyond, and the premium of the approach would converge towards zero.
So again, it is the weak hands that cannot stomach the volatility of the premium – those that sold out in 2012 or 2013 – that enable the strong hands to continue to benefit from the systematic approach.
The takeaway here is simple: whether value or trend following, active strategies that are tied to a specific premium will always vary in their performance. To reap their benefits over time, investors must treat them like an asset class in their portfolio: an allocation, not a trade.
In analysis of the value tilt going back to 1963, the portfolio is a value-weighted portfolio of the 30% of highest book-to-market stocks, provided by the Kenneth French data library.In analysis from 1995-2015, Value is represented by the Guggenheim S&P 500 Pure Value ETF (ticker: RPV) and the underlying index prior to the ETF’s launch. Minimum volatility is represented by the iShares MSCI USA Minimum Volatility ETF (ticker: USMV) and the underlying index prior to ETF launch. Momentum is represented by the iShares MSCI USA Momentum Factor ETF (ticker: MTUM) and the underlying index prior to ETF launch. Dividend Growth is represented by the ProShares S&P 500 Dividend Aristocrats ETF (ticker: NOBL) and the underlying index prior to ETF launch. Size is represented by Vanguard Small-Cap Index Fund (ticker: NAESX). The S&P 500 is represented by the SPDR S&P 500 ETF (ticker: SPY).This document (including the hypothetical/backtested performance results) is provided for informational purposes only and is subject to revision. This document is not an offer to sell or a solicitation of an offer to purchase an interest or shares (“Interests”) in any pooled vehicle. Newfound does not assume any obligation or duty to update or otherwise revise information set forth herein. This document is not to be reproduced or transmitted, in whole or in part, to other third parties, without the prior consent of Newfound.Certain information contained in this presentation constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations or comparable terminology. Due to various risks and uncertainties, actual events or results or the actual performance of an investment managed using any of the investment strategies or styles described in this document may differ materially from those reflected in such forward-looking statements or in the hypothetical/backtested results included in this presentation. The information in this presentation is made available on an “as is,” without representation or warranty basis.
There can be no assurance that any investment strategy or style will achieve any level of performance, and investment results may vary substantially from year to year or even from month to month. An investor could lose all or substantially all of his or her investment. Both the use of a single adviser and the focus on a single investment strategy could result in the lack of diversification and consequently, higher risk. The information herein is not intended to provide, and should not be relied upon for, accounting, legal or tax advice or investment recommendations. You should consult your investment adviser, tax, legal, accounting or other advisors about the matters discussed herein. These materials represent an assessment of the market environment at specific points in time and are intended neither to be a guarantee of future events nor as a primary basis for investment decisions. The hypothetical/backtested performance results and model performance results should not be construed as advice meeting the particular needs of any investor. Past performance (whether actual, hypothetical/backtested or model performance) is not indicative of future performance and investments in equity securities do present risk of loss. The ability to replicate the hypothetical or model performance results in actual trading could be affected by market or economic conditions, among other things.
Investors should understand that while performance results may show a general rising trend at times, there is no assurance that any such trends will continue. If such trends are broken, then investors may experience real losses. No representation is being made that any account will achieve performance results similar to those shown in this presentation. In fact, there may be substantial differences between backtested performance results and the actual results subsequently achieved by any particular investment program. There are other factors related to the markets in general or to the implementation of any specific investment program which have not been fully accounted for in the preparation of the hypothetical/backtested performance results, all of which may adversely affect actual portfolio management results. The information included in this presentation reflects the different assumptions, views and analytical methods of Newfound as of the date of this presentation.
Performance during the backtested period is not based on live results produced by an investor’s actual investing and trading, but was achieved by the retroactive application of a model designed with the benefit of hindsight, and is not based on live results produced by an investor’s investment and trading, and fees, expenses, transaction costs, commissions, penalties or taxes have not been netted from the gross performance results except as is otherwise described in this presentation. The performance results include reinvestment of dividends, capital gains and other earnings. As the information was backtested, it does not reflect contemporaneous advice or record keeping by an investment adviser. Actual, live client results may have materially differed from the presented performance results.
The Hypothetical Information and model performance assume full investment, whereas actual accounts and funds managed by an adviser would most likely have a positive cash position. Had the Hypothetical Information or model performance included the cash position, the information would have been different and generally may have been lower. While Newfound believes the outside data sources cited to be credible, it has not independently verified the accuracy of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information.
This document contains the opinions of the managers and such opinions are subject to change without notice. This document has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This document does not reflect the actual performance results of any Newfound investment strategy or index. This purpose of this document is to explain Newfound’s beliefs that: there is no holy grail investment style that will out-perform in all market environments; being systematic and disciplined in use of active strategies is the best way to capture out-performance because we don’t know when the out-performance will happen; and diversifying across several active approaches – all of which have independently proven to add value in different market environments – can help smooth out short-term underperformance of a single approach.
The investment strategies and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation.
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