4106 Advanced Investment Management Tactical Asset Allocation session

4106 Advanced Investment Management Tactical Asset Allocation session 4 Andrei Simonov Tactical Asset Allocation 1 1/3/2022

Agenda l l l 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. Tactical Asset Allocation 2 1/3/2022

What is TAA? l l 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-thanbenchmark 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? Tactical Asset Allocation 3 1/3/2022

Optimal portfolio for risk-averse investor Tactical Asset Allocation 4 1/3/2022

Equilibrium and TAA l Let us assume that there exists long-term expected returns vector e. However, due to predictability of asset returns, e E(R) Tactical Asset Allocation 5 1/3/2022

How to do it? We need a model that explains the connection between today’s variables and tomorrow returns. l Candidates: economic business cycle variables and Jan. Effect. l Tactical Asset Allocation 6 1/3/2022

Example: Incredible January Effect Excess returns associated with small firms w. r. t. Large-cap stocks l Ritter: Tax effect. Is it so? l Incredibly Shrinking January Effect (William J. Bernstein ). l Tactical Asset Allocation 7 1/3/2022

Example: dividend yield • May not be sustained out of sample Tactical Asset Allocation 8 1/3/2022

Risk and return over the business cycle Tactical Asset Allocation 9 1/3/2022

Yield Curve Inverts Before Last Six Recessions (5 -year Treasury bond - 3 -month Treasury bill) Annual GDP growth or Yield Curve Next couple of slides are due to Cam Harvey % Real annual GDP growth Yield curve Recession Correct 2 Recessions Correct Tactical Asset Allocation Recession Correct Yield curve accurate in recent forecast Data though 1/12/03 10 1/3/2022

Tactical Asset Allocation 11 1/3/2022

Update January 2003 l l 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. NBER has not dated the end of the recession. However, forecast looks good. Tactical Asset Allocation 12 1/3/2022

Recent Annualized One-Quarter GDP Growth (10 -year and 5 -year Yield Curves) Annualized 1 -quarter GDP growth Yield curve % Real annualized one-quarter GDP growth 10 -year 5 -year Both curves invert 2000 Q 3 Data though 1/12/03 Tactical Asset Allocation 13 1/3/2022

Annual Real Economic Growth After Yield Curve Inversions Tactical Asset Allocation 14 1/3/2022

Stock Returns and U. S. Yield Curve Average Monthly Returns in % Data through November 2000 Tactical Asset Allocation 15 1/3/2022

Average Monthly Stock Returns After Yield Curve Inversions Equally weighted Value weighted Based on 19 countries. Tactical Asset Allocation 16 1/3/2022

Stock returns and the business cycle: the trader’s calendar http: //www. thestreet. com/markets/ click on “Economic calendar” Monday, Jan. 20 No releases due to Martin Luther King, Jr. Day. Tuesday, Jan. 21 8: 30 a. m. Housing starts for Dec. Census Bureau Building permits 1. 835 M 1. 880 M 1. 680 5433. 4 355. 3 n. a. +0. 3 % +1. 5 % $4. 37 B -27 n. a. 381, 0 00 386, 5 00 n. a. +0. 1 % unch gd. 1. 710 M 1. 747 M 1. 738 M 1. 697 M 5786. 4 358. 0 5786. 4 +0. 3 % +2. 0 % $26. 6 B -21 +0. 3% 363, 0 00 388, 5 00 360, 000 +0. 5 % +0. 7% 1. 738 M Wednesday, Jan. 22 7 a. m. Mortgage Applications Survey for the week ended Jan. 17 -- Mortgage Bankers Association Refinancing Index Purchase Index 9 a. m. BTM-UBSW Weekly Chain Store Sales Index for the week ended 9 a. m. Jan. 18 Retail Average for the month through Jan. 18, vs. Dec. Redbook 2 p. m. 6: 30 p. m. Federal budget for Dec. FY '03 Consumer Comfort Index for the week ended Jan. 18 Bank of Tokyo-Mitsubishi and UBS Warburg LJR Redbook Treasury Department Money Magazine and ABC News n. a. $5. 0 B n. a. 358. 0 +2. 0%* $26. 6 B (Dec. FY '02) -21 Thursday, Jan. 23 8: 30 a. m. Initial Jobless Claims for the week ended Jan. 18 Labor Department Four-week average 10 a. m. Leading economic indicators for Dec. Tactical Asset Allocation Conference Board n. a. 387, 500 17 1/3/2022

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 Tactical Asset Allocation 18 1/3/2022

Do informational variables have predictive ability? l Info variables: – January dummy – Past excess return on Equally weighted CRSP index – Spread between 1 and 3 mo Tbills – Dividend yield – Spread between Baa and Aaa corporate bonds – 1 -mo T-bill rate Tactical Asset Allocation 19 1/3/2022

l Tactical Asset Allocation Here how it looks like. . . 20 1/3/2022

Stock returns and the business cycle: Average Returns NBER Expansions and Contractions January 1970 -March 1997 Tactical Asset Allocation 21 1/3/2022

Stock returns and the business cycle: Volatility NBER Expansions and Contractions January 1970 -March 1997 Tactical Asset Allocation 22 1/3/2022

Stock returns and the business cycle Correlation with MSCI U. S. NBER Expansions and Contractions January 1970 -March 1997 Tactical Asset Allocation 23 1/3/2022

How important are global factors? l l Based on Ferson-Harvey RFS 95 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 10 yr and 3 mo Tbills, Eurodollar/US treasury spread, lagged market return, January dummy. Local informational variables: Country x div. Yield, 30 -day tbill rate, term spread, lagged MSCI country x market return. Tactical Asset Allocation 24 1/3/2022

So, what matters? ”Global only” model is already good enough l Adding local factors increases explanatory power of the model l Tactical Asset Allocation 25 1/3/2022

Changes in b vs changes in risk premium l Only 2 -4% of variation is due to beta’s. Tactical Asset Allocation 26 1/3/2022

Sweden (Robertsson, 2000): Tactical Asset Allocation 27 1/3/2022

What about currency risk premium? Currency specificiyy: zero-sum game l Dumas-Solnik: currency risk premia exists. It is time-varying and predictable l Tactical Asset Allocation 28 1/3/2022

Caveats: l Data snooping – Foster, Smith and Whaley (98): by choosing to max R 2 via choice of instruments one can get significance when there is none. – Not clear how to use as list of instruments already exists. . . l In-sample vs. Out-of-sample validation Tactical Asset Allocation 29 1/3/2022

Caveats(2) Statistical biases: autocorrelation, heteroscedastisity (via Monte-Carlo simulations). l Non-normality, excess skewness and kurtosis l Tactical Asset Allocation 30 1/3/2022

How to deal with statistical issues? l 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 a. Tactical Asset Allocation 31 1/3/2022

Alternative ways of determining risk premia: Surveys l Graham/Harvey: Survey CFOs every quarter l l l Q 2 2000 through Q 3 2002 (ten 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 Tactical Asset Allocation 32 1/3/2022

U. S. Risk Premium One-Year Premium l One-year risk premium quite variable. Currently, about 3% Tactical Asset Allocation 33 1/3/2022

U. S. Risk Premium Ten-Year Premium l Ten-year risk premium is stable. Currently, about 4% Tactical Asset Allocation 34 1/3/2022

U. S. Risk Premium Asymmetry l CFOs believe the downside is much more likely than the upside Tactical Asset Allocation 35 1/3/2022

Conclusion: TAA can be an important tool in asset allocation methodology. l It is based on time variation of real economic risk premia. l Selection of predictors is important. l We are still in ”top-down” paradigm. l Devil is in the details= implementation matters. l Tactical Asset Allocation 36 1/3/2022