Proven Tactical Allocation Strategy Driven by Behavioral Crowds

You say that you use behavioral factors. What does that mean? What are the signals? Are they related to sentiment?

We measure deep behavioral currents by means of our three market barometers. We have identified the self-declared strategies being pursued by roughly 2,000 U.S. and 800 International active equity mutual funds domiciled in the US. These have been organized into 10 U.S. and international strategy peer groups that span the equity markets.

Our barometers capture how investors are rewarding each of these strategies over the last year relative to their long-term performance. In this way we capture the deep behavioral investor preferences for one strategy relative to another which can drive market returns. You can think of these in the same way as you do about the deep ocean currents that drive global weather.

Our market barometers represent a “put your money where your mouth is” behavioral measure as compared to the more typical “how are you feeling about…” sentiment surveys. At Athena, we only use the former type of measure to proxy for investor and fund manager behavior.

How frequently do you measure the signals and how frequently do you trade?

We measure signals monthly and trade if need be. We typically hold our ETF positions six to nine months on average.

You mentioned that the fund is tactical. Most advisors associate tactical investing with market timing and have a dim view of the likelihood that it will generate risk-adjusted outperformance. How do you respond to that concern?

My own research confirms the difficulty of generating superior returns when trading over very short time periods. Our research has naturally led us away from this type of short trading and instead we focus on a medium to long-term signals and trends. This is the behavioral sweet spot for us.

We trade based on deep behavioral currents in the market rather than on the daily surface chop upon which so many others focus. The actual signal, its frequency, persistence and reliability are the key points.

What investment vehicles do you use to implement the strategy and why?

At any one time we are invested in a single ETF representing the best market based on our barometers. We can invest in the S&P 500, Russell 2000, and EAFE ETFs and their 2X equivalents. We can also go to cash, if our barometers signal very weak markets.

You are both opportunistic and defensive. Can you explain that?

If a market signal is strong enough, we go double long in that market. We have been double-long about half of the months since GTs September 2010 inception. On the other hand, if our barometers signal weak markets, we move into cash since that would be the market with the highest expected return. We think of this as a catastrophic insurance signal, that is, when expected stock market returns are low or even negative.

You say you use only one ETF? Isn’t that a highly concentrated position?

We use only broad-market ETFs, so the portfolio is holding hundreds of stock positions at any one time. Our research shows that taking a single high-conviction position in the highest expected return market, based on our barometers, generates the highest returns.

And you mention that you use leveraged ETFs? Isn’t that risky?

Yes, we take 2X leverage positions in broad market ETFs over extended periods, which have contributed strongly to our outperformance. Our own research, as well as research by others,confirms that holding leveraged ETFs over long time periods works very well assuming that you use the correct level of leverage. Using inverse or highly levered ETFs such as 3x or 4x can create volatility drag that will destroy returns if held for extended periods of time.

Use of leverage needs to be done carefully and should be rules based. I think the regulations are aimed at controlling speculative applications and potential misuse.

How do you manage risk in the strategy? How do you view risk versus volatility?

As I mentioned above, we do invest 100% in cash when our barometers signal very weak equity markets. However, we do not respond to frequently occurring short-term drawdowns.

We do not view volatility as risk when building long-horizon wealth. We view real risk as underperformance and ending up with insufficient funds at the end of your investment horizon. If you had invested $10,000 in Global Tactical at inception September 1, 2010, your portfolio would be worth $39,038 (after fees, before taxes) on June 30, 2018. The MSCI ACWI benchmark would have produced a portfolio worth $21,312 over the same period. The fact that you ended up with roughly half as much money by investing in the benchmark rather than GT is the true investment risk in this situation.

Volatility is a measure of emotions that drive day-to-day behaviors in the market. It is not a risk when building long-horizon wealth.

You can go to 100% cash, when do you do that and how often has it happened? What is your cash position now? Can investors infer anything about your opportunity set based on your cash position?

Since GTs 2010 inception, while we have come close at times, we have not gone to 100% cash. Our research back to 1980 shows that our objective, rules-based decisions would have invested the portfolio in cash in about half of the early 2000s Dot Com bust and for all but a couple of months of the 2007-09 market crash. So, our signals don’t have us respond to the frequent market drawdowns, but instead to true bear market crashes.

We currently have no cash in the portfolio. We are either 0% or 100% cash. For the former, the inference is that equity market expected returns are attractive. We only go to cash when expected returns are either low or even negative.

You currently have an eight-year track record. Have you tested how this strategy will work historically and how robust is that test?

The objective trading rules of this portfolio were tested from 1980 through 2009. The model worked quite differently but quite well in each decade. In the 80’s, the portfolio was often invested in 2X EAFE, in the 90’s it was mostly invested in the S&P 500, and in the 00’s it spent time alternating between 2X and cash positions. As I mentioned earlier, the portfolio was in cash for about half of the Dot Com bust and all but a couple of months for the 2007-09 market crash.

GTs actual returns since 2010 closely match the roughly 20% average return experienced during the 1980-2009 test period.

It looks like small-cap stocks are breaking out to new highs and outperforming large cap. Do you see the strategy shifting into small caps soon?

Our large-cap market barometer has been strengthening in recent months while our small-cap barometer has remained flat. From our perspective, we do not see a behavioral shift happening at this point.

How does your global tactical strategy fit in client portfolios?

We suggest it as an underweight/overweight, 20% to 30% allocation of an overall portfolio. We then execute the underweight/overweight trade in the designated portion. In that way the entire portfolio does not have to be traded to respond to changing market conditions. Most of our advisors use our Global Tactical strategy in this way for their client portfolios. It can also be used as an alpha generating strategy in a strategy-diverse portfolio.

Read more articles by Robert Huebscher