Tactical Asset Allocation session 5 Andrei Simonov Tactical

Tactical Asset Allocation session 5 Andrei Simonov Tactical Asset Allocation 1 9/10/2020

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 9/10/2020

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 9/10/2020

Conditioning Information and Portfolio Analysis Er Add conditioning information and weights change through time. Frontier shifts. Vol Tactical Asset Allocation 4 9/10/2020

Optimal portfolio for risk-averse investor Tactical Asset Allocation 5 9/10/2020

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 6 9/10/2020

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 7 9/10/2020

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 8 9/10/2020

Example: dividend yield • May not be sustained out of sample Tactical Asset Allocation 9 9/10/2020

Risk and return over the business cycle Tactical Asset Allocation 10 9/10/2020

Evaluation of Recent Recession 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. On July 17, 2003 the NBER announced the official end of the recession was November 2001. Tactical Asset Allocation 11 9/10/2020

Exhibit 1 Next couple of slides are due to Cam Harvey Tactical Asset Allocation 12 9/10/2020

Exhibit 2 Tactical Asset Allocation 13 9/10/2020

Yield Curve Inverts Before Last Six Recessions (5 -year Treasury note minus 3 -month Treasury bill yield-secondary) Annual GDP growth or Yield Curve % Source: Campbell R. Harvey. % Real annual GDP growth Yield curve Recession Correct 2 Recessions Correct Tactical Asset Allocation Recession Correct Recent flattening Yield curve accurate in recent recession Data though April 11, 2006 14 9/10/2020

Yield Curve Inverts Before Last Six Recessions (5 -year Treasury note minus 3 -month Treasury bill yield – constant maturity) Annual GDP growth or Yield Curve % % Real annual GDP growth Source: Campbell R. Harvey. Yield curve Recession Correct 2 Recessions Correct Tactical Asset Allocation Recession Correct Recent flattening Yield curve accurate in recent recession Data though April 11, 2006 15 9/10/2020

Recent Annualized One-Quarter GDP Growth (10 -year and 5 -year Yield Curves-secondary market) Annualized 1 -quarter GDP growth 10 -year Yield curve % Real annualized one-quarter GDP growth 5 -year Tactical Asset Allocation Both curves invert 2000 Q 3 Data though April 11, 2006 16 9/10/2020

Recent Annualized One-Quarter GDP Growth (10 -year and 5 -year Yield Curves-constant maturity) Annualized 1 -quarter GDP growth 10 -year Yield curve % Real annualized one-quarter GDP growth 5 -year Tactical Asset Allocation Both curves invert 2000 Q 3 Data though April 2006 17 9/10/2020

What shall we expect now? Tactical Asset Allocation 18 9/10/2020

May 2007: Practically flat 5. 1 5 4. 9 1 mo 4. 8 4. 7 4. 6 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 4. 5 10 yr 20 yr 4. 4 30 yr 39 033 2 9 043 2 9 053 2 9 063 2 9 093 2 9 10 2 39 113 2 9 123 2 9 133 2 9 163 2 9 173 2 9 18 2 39 193 2 9 203 2 9 23 2 4. 3 Tactical Asset Allocation 19 9/10/2020

3 3 239 9 2539 9 6239 9 3730 9 3030 9 3130 9 320 9 3330 9 3430 9 3730 9 8330 9 3931 9 3031 9 3131 9 3431 9 3531 9 361 9 3731 9 8332 9 3132 9 322 9 August 2007 31 mo 6 mo 1 yr 2 yr 3 yr 5 yr 6 5 4 Tactical Asset Allocation 3 2 1 0 20 9/10/2020

Current 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. Tactical Asset Allocation 21 9/10/2020

Current 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. Tactical Asset Allocation 22 9/10/2020

Current Situation 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 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 150 bp. Subprime crisis does not end buying of T-debt by foreigners. Demand for 5 yr TB last week was very high. Tactical Asset Allocation 23 9/10/2020

Current Situation 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. Tactical Asset Allocation 24 9/10/2020

Current Situation Demographic forces. As the population ages, more money is allocated into fixed income and long-term bond yields may decrease. Inflation risk. The long-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. Tactical Asset Allocation 25 9/10/2020

Annual Real Economic Growth After Yield Curve Inversions Tactical Asset Allocation 26 9/10/2020

Stock Returns and U. S. Yield Curve Average Monthly Returns in % Data through November 2000 Tactical Asset Allocation 27 9/10/2020

Average Monthly Stock Returns After Yield Curve Inversions Equally weighted Value weighted Based on 19 countries. Tactical Asset Allocation 28 9/10/2020

Trader’s calendar (from thestreet. com) Time Indicator (EST) (click for definition) Source (click for press release) Forecast Previous (revised) Previous (original) n. a. +0. 8% n. a. +2. 2% +2. 5%* n. a. -- 675. 5 -- n. a. -- 432. 3 -- n. a. -- -7 -- +305, 000 -- +293, 000 --- n. a. +0. 9% --- +306, 000 +3. 7% -- n. a. -- +1. 5% Census Bureau -- . 860 M -- . 858 M Bureau of the Public Debt The Treasury announces the size of its next monthly two-year note auction, next Tuesday. National Association of Realtors -- 6. 10 M -- 6. 12 M Economic Cycle Research Institute -- n. a. -- +6. 1% Actual Monday, May 21 No releases. Tuesday, May 22 9 a. m. ICSC-UBS Weekly Chain Store Sales Snapshot for International Council of Shopping Centers -1. 5% the week ended May 19 and UBS 9 a. m. Johnson Redbook Retail Sales Index for the week Redbook Research +2. 0% ended May 19, vs. April Wednesday, May 23 9 a. m. Mortgage Applications Survey for the week ended -May 18 -- Market Composite Index Mortgage Bankers Association Purchase Index 9 a. m. Consumer Comfort Index for the week ended May 20 Thursday, May 24 8: 30 a. m. Initial Jobless Claims for the week ended May 19 Four-week average 8: 30 a. m. Durable goods orders for April Ex-transportation 10 a. m. New home sales for April 2: 30 p. m. Treasury auction announcement Friday, May 25 10 a. m. Existing Home Sales for April 10: 30 Weekly Leading Index for the week ended May 18 a. m. Tactical Asset Allocation ABC News and Washington Post Labor Department Census Bureau 29 9/10/2020

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 30 9/10/2020

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 31 9/10/2020

l Tactical Asset Allocation Here how it looks like. . . 32 9/10/2020

Performance & Business Cycle Data through June 2002 Tactical Asset Allocation 33 9/10/2020

Performance & Business Cycle (2) Data through June 2002 Tactical Asset Allocation 34 9/10/2020

Performance & Business Cycle (3) Data through June 2002 Tactical Asset Allocation 35 9/10/2020

3. Performance & Business Cycle (4) Data through June 2002 Tactical Asset Allocation 36 9/10/2020

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 37 9/10/2020

So, what matters? ”Global only” model is already good enough l Adding local factors increases explanatory power of the model l Tactical Asset Allocation 38 9/10/2020

Changes in b vs changes in risk premium l Only 2 -4% of variation is due to beta’s. Tactical Asset Allocation 39 9/10/2020

Sweden (Robertsson, 2000): Tactical Asset Allocation 40 9/10/2020

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 41 9/10/2020

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 42 9/10/2020

Caveats(2) Statistical biases: autocorrelation, heteroscedastisity (via Monte-Carlo simulations). l Non-normality, excess skewness and kurtosis l Tactical Asset Allocation 43 9/10/2020

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 44 9/10/2020

U. S. Risk Premium Survey Background l Graham/Harvey: Survey CFOs every quarter l l l Q 2 2000 through Q 4 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 Tactical Asset Allocation 45 9/10/2020

U. S. Risk Premium One-Year Premium l One-year risk premium variable. Currently, about 7% Tactical Asset Allocation 46 9/10/2020

U. S. Risk Premium Ten-Year Premium l Ten-year risk premium is stable. Currently, about 3. 7% Tactical Asset Allocation 47 9/10/2020

U. S. Risk Premium Momentum in Expectations for 1 -year Premium Tactical Asset Allocation 48 9/10/2020

U. S. Risk Premium Extreme Returns Cause Disagreement Tactical Asset Allocation 49 9/10/2020

U. S. Risk Premium Positive Relation Between Disagreement and Expected 10 -year Returns Tactical Asset Allocation 50 9/10/2020

U. S. Risk Premium Example Confidence Intervals: September 16, 2002 Tactical Asset Allocation 51 9/10/2020

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 52 9/10/2020