1. 4106 Advanced Investment Management Tactical Asset Allocation session 4
Andrei Simonov
Tactical Asset Allocation
11/28/2018

2. 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

3. What is TAA? Exists since early-to-mid- 80-ies.
By now $ 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

4. Optimal portfolio for risk-averse investor
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5. 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
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6. 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

7. 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

8. Example: dividend yield
May not be sustained out of sample
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9. Risk and return over the business cycle
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10. 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
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11. Tactical Asset Allocation
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12. 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

13. 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
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14. Annual Real Economic Growth After Yield Curve Inversions
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15. Stock Returns and U.S. Yield Curve
Average Monthly Returns in %
Data through
November 2000
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16. Average Monthly Stock Returns After Yield Curve Inversions
Equally weighted
Value weighted
Based on 19 countries.
Tactical Asset Allocation
11/28/2018

17. Stock returns and the business cycle: the trader’s calendar http://www
Stock returns and the business cycle: the trader’s calendar 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 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               
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               
Money Magazine and ABC News
-27
-21
Thursday, Jan. 23
Initial Jobless Claims for the week ended Jan               
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

18. 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
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19. 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!!!
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20. Here how it looks like...
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21. Stock returns and the business cycle: Average Returns NBER Expansions and Contractions January 1970-March 1997
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22. Stock returns and the business cycle: Volatility NBER Expansions and Contractions January 1970-March 1997
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23. 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
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24. 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
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25. So, what matters? ”Global only” model is already good enough
Adding local factors increases explanatory power of the model
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26. Changes in b vs changes in risk premium
Only 2-4% of variation is due to beta’s.
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27. Sweden (Robertsson, 2000):
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28. What about currency risk premium?
Currency specificiyy: zero-sum game
Dumas-Solnik: currency risk premia exists. It is time-varying and predictable
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29. 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
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30. Caveats(2)
Statistical biases: autocorrelation, heteroscedastisity (via Monte-Carlo simulations).
Non-normality, excess skewness and kurtosis
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31. 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
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32. Alternative ways of determining risk premia: Surveys
Graham/Harvey: Survey CFOs every quarter
Q through Q (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
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33. U.S. Risk Premium One-Year Premium
One-year risk premium quite variable. Currently, about 3%
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34. U.S. Risk Premium Ten-Year Premium
Ten-year risk premium is stable. Currently, about 4%
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35. U.S. Risk Premium Asymmetry
CFOs believe the downside is much more likely than the upside
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36. 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