4106 Advanced Investment Management Tactical Asset Allocation session 4 Andrei Simonov Tactical Asset Allocation 11/28/2018

Agenda 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 11/28/2018

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? Tactical Asset Allocation 11/28/2018

Optimal portfolio for risk-averse investor Tactical Asset Allocation 11/28/2018

Equilibrium and TAA 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 11/28/2018

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. Tactical Asset Allocation 11/28/2018

Example: 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 ). Tactical Asset Allocation 11/28/2018

Example: dividend yield May not be sustained out of sample Tactical Asset Allocation 11/28/2018

Risk and return over the business cycle Tactical Asset Allocation 11/28/2018

Yield Curve Inverts Before Last Six Recessions (5-year Treasury bond - 3-month Treasury bill) Next couple of slides are due to Cam Harvey Annual GDP growth or Yield Curve % Real annual GDP growth Yield curve Recession Correct Recession Correct Yield curve accurate in recent forecast Recession Correct 2 Recessions Correct Data though 1/12/03 Tactical Asset Allocation 11/28/2018

Tactical Asset Allocation 11/28/2018

Update January 2003 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 11/28/2018

Recent Annualized One-Quarter GDP Growth (10-year and 5-year Yield Curves) % Real annualized one-quarter GDP growth 10-year Both curves invert 2000Q3 5-year Data though 1/12/03 Tactical Asset Allocation 11/28/2018

Annual Real Economic Growth After Yield Curve Inversions Tactical Asset Allocation 11/28/2018

Stock Returns and U.S. Yield Curve Average Monthly Returns in % Data through November 2000 Tactical Asset Allocation 11/28/2018

Average Monthly Stock Returns After Yield Curve Inversions Equally weighted Value weighted Based on 19 countries. Tactical Asset Allocation 11/28/2018

Stock returns and the business cycle: the trader’s calendar http://www 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 1.835M 1.680 1.747M 1.697M Building permits 1.880M 1.710M 1.738M Wednesday, Jan. 22 7 a.m. Mortgage Applications Survey for the week ended Jan. 17 -- Refinancing Index                Mortgage Bankers Association 5433.4 n.a. 5786.4 Purchase Index 355.3 358.0 9 a.m. BTM-UBSW Weekly Chain Store Sales Index for the week ended Jan. 18                Bank of Tokyo-Mitsubishi and UBS Warburg +0.3% Redbook Retail Average for the month through Jan. 18, vs. Dec.                LJR Redbook +1.5% +2.0% +2.0%* 2 p.m. Federal budget for Dec. FY '03                Treasury Department $4.37B $5.0B $26.6B $26.6B (Dec. FY '02) 6:30 p.m. Consumer Comfort Index for the week ended Jan. 18                Money Magazine and ABC News -27 -21 Thursday, Jan. 23 Initial Jobless Claims for the week ended Jan. 18                Labor Department 381,000 363,000 360,000 Four-week average 386,500 388,500 387,500 10 a.m. Leading economic indicators for Dec.                Conference Board +0.1% unchgd. +0.5% +0.7% Tactical Asset Allocation 11/28/2018

What variables matter? Methodology: Exploratory: regressing returns at t on informational variables at t-1 ”Correct one”: first finding economic risk premia (a la APT) and then regressing it on informational variables at t-1 Tactical Asset Allocation 11/28/2018

Do informational variables have 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 Yes!!! Tactical Asset Allocation 11/28/2018

Here how it looks like... Tactical Asset Allocation 11/28/2018

Stock returns and the business cycle: Average Returns NBER Expansions and Contractions January 1970-March 1997 Tactical Asset Allocation 11/28/2018

Stock returns and the business cycle: Volatility NBER Expansions and Contractions January 1970-March 1997 Tactical Asset Allocation 11/28/2018

Stock returns and the business cycle Correlation with MSCI U. S Stock returns and the business cycle Correlation with MSCI U.S. NBER Expansions and Contractions January 1970-March 1997 Tactical Asset Allocation 11/28/2018

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. Tactical Asset Allocation 11/28/2018

So, what matters? ”Global only” model is already good enough Adding local factors increases explanatory power of the model Tactical Asset Allocation 11/28/2018

Changes in b vs changes in risk premium Only 2-4% of variation is due to beta’s. Tactical Asset Allocation 11/28/2018

Sweden (Robertsson, 2000): Tactical Asset Allocation 11/28/2018

What about currency risk premium? Currency specificiyy: zero-sum game Dumas-Solnik: currency risk premia exists. It is time-varying and predictable Tactical Asset Allocation 11/28/2018

Caveats: Data snooping In-sample vs. Out-of-sample validation 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 Tactical Asset Allocation 11/28/2018

Caveats(2) Statistical biases: autocorrelation, heteroscedastisity (via Monte-Carlo simulations). Non-normality, excess skewness and kurtosis Tactical Asset Allocation 11/28/2018

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 a. Tactical Asset Allocation 11/28/2018

Alternative ways of determining risk premia: Surveys Graham/Harvey: Survey CFOs every quarter Q2 2000 through Q3 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 11/28/2018

U.S. Risk Premium One-Year Premium One-year risk premium quite variable. Currently, about 3% Tactical Asset Allocation 11/28/2018

U.S. Risk Premium Ten-Year Premium Ten-year risk premium is stable. Currently, about 4% Tactical Asset Allocation 11/28/2018

U.S. Risk Premium Asymmetry CFOs believe the downside is much more likely than the upside Tactical Asset Allocation 11/28/2018

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. Tactical Asset Allocation 11/28/2018