Trading Strategies To Beat Traditional Asset Allocation

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Includes: QAI, WDTI, XLF, XLP
by: Efficient Alpha

This is part of our series written exploring the myths in popular investing as exposed in Michael Dever’s new book, “Jackass Investing.” In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling.

By Joseph Hogue, CFA

Asset classes; stocks, bonds, commodities, real estate, and alternative investments have become the fundamental force behind diversification and portfolio management over the last few decades. The author’s recount of how the universe of investments was classified back in the 60s reads like a who’s who of finance. We true nerds out there bow in reverence each time the names of those like Bill Sharpe and Harry Markowitz are uttered. You can imagine my reluctance then at the author’s idea that asset classes are, “a quant artifact of an investing past.”

The story of asset classes, in an extremely simplified nutshell, involves the esteemed professors trying to find a way to examine portfolio returns without having to calculate covariances for every stock in the market. Analyzing the optimal portfolio just wasn’t possible with the computing power available at the time. Asset classes, aggregating all investments with similar characteristics, allowed investors to analyze portfolios in a fraction of the time.

Why it’s easy to use asset classes

The problem is, as is pointed out in the book, there is really little need for this level of simplification in today’s investment analysis. I am usually a few years behind the computing curve, and yet even the computer I use can easily calculate the covariance matrix for possible portfolio combinations. Asset classes today have devolved from a necessity into a stereotype. Stereotypes are meant to help us through unknown situations where assumptions may be needed. By stereotyping investments within asset classes, the investor only needs to analyze the general market for stocks, or that of bonds to make an investment decision. Investors not willing to commit to the time necessary to develop an informed strategy can fall back on the stereotype of asset classes to construct what the author calls a, “poor-folio.” Unfortunately, just as other stereotypes can limit our social relationships, using generalized conventions in investing can severely limit your returns.

The problem with using asset classes is that by diversifying across classes you are not necessarily diversifying across return drivers. Return drivers, the central theme of the book, are those primary factors that influence an investment’s returns. The chart below presents the return drivers for the most commonly used asset classes.

(Click chart to expand)

Click to enlarge

I will disagree with the author in the chart’s detail. The chart leaves out commodities, private equity, and venture capital as asset classes and oversimplifies the difference between domestic and international assets. While equities in general rely on investor sentiment and earnings growth, these drivers may be at extremely different cycles across the globe. Despite this, the book’s point is intact. Investing simply across asset classes does not provide enough diversification across return drivers to optimize a portfolio. Asset classes have become the easy-out for investors and have contributed to the flat performance in portfolios over the last decade. Because the mix of asset classes used to ‘diversify’ portfolios depend on the same or similar return drivers, they have not protected the investor against market volatility and losses. The ‘easy’ way is seldom the best way, especially in finance. While it might be soothing to the armchair investor that a quick diversification across assets is enough to construct a portfolio, it’s a short road to long-term losses.

Action Strategy

I fully understand that the vast majority of the investing public does not have the time necessary to develop and implement a Wall Street-level trading program. For this reason, some generalization is needed in your approach to investing and portfolio management. I have previously advocated a core-satellite approach to investing where the investor keeps the majority of the portfolio in a diversified mix of investments and only rebalances infrequently. The rest of the portfolio is used to implement trading strategies and is actively managed.

Do not construe the point as being anti-asset classes. Asset classes can be a part of your portfolio within one of your trading strategies. For example, because the beta for stocks in the financial services sector (1.58) is much higher than that of the consumer staples sector (0.6), investors can implement a trading strategy depending on market volatility and direction. I have been using the Financials Select SPDR (XLF) against the Consumer Staples Select SPDR (XLP) for a long/short trading strategy depending on how far above or below volatility is above its moving average.

The idea behind trading strategy development is to understand the primary return drivers of an investment and then map out the market in which they will operate. If you think the market will be particularly positive for those drivers then a long position is warranted. If the market may turn against the drivers, then you would want to employ a short strategy.

The easiest way to employ trading strategies in your portfolio is to let someone else do it. Remembering the caveat that the easy way is seldom the best, looking to actively managed exchange traded funds for exposure to sophisticated trading strategies is the best alternative for the investor with limited time. The WisdomTree Managed Futures Strategy Fund (WDTI) is a good start and one about which we talked about in a previous article. The fund seeks to achieve returns regardless of the general market direction by actively managing a combination of commodity, currency, and treasury futures. The managed futures fund is negatively correlated with both the Barclay’s Capital Aggregate Bond Index and the S&P500 Index (NYSEARCA:SPY).

Another good start would be the IQ Hedge Multi-Strategy Tracker (QAI) which attempts to replicate the risk-adjusted returns of hedge funds by following a variety of strategies like: long/short equities, market neutral, and fixed income arbitrage.

Investors willing to put in the necessary time to develop their own strategies should be willing to employ less common trading strategies. Embracing short-selling should be first on your list and is something a previous article showed how the individual investor has the advantage over the institutional players. Though most investors are uncomfortable with the idiosyncrasies of currencies, a carry trade strategy is a great way to profit from trends in interest rates. We’ll explore more strategies in upcoming articles in the series.

Disclosure: I am long XLF.

Additional disclosure: This series has been written on a contracted basis with the book's author. The opinions expressed in the article are those of Efficient Alpha and not necessarily those of the book's author. Efficient Alpha has been contracted to describe strategies and concepts used within the book but not to promote or recommend any strategies, the author, or the author's services.