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Change Your Allocation, Not Your Beliefs

Summary

In a time of market turbulence, many investors are re-evaluating their fundamental understanding of how the stock market works and searching for high alpha strategies.

However, algo trader Janny Kul attempted to replicate the results of 130 published articles on above-market returns and found that every single one failed to produce results.

Instead of changing their investment beliefs, investors should use recent market events to better understand their risk tolerance and change their asset allocation accordingly.

Alternatively, investors can invest in ETFs and investment products that provide downside protection while preserving most upside gains.

Stick to your knitting

In today's turbulent market environment with both macroeconomic factors and technical factors sending chills down the collective spine of the investment community, many investors are doubling down on their search for high alpha strategies.

However, we must all remember that alpha is very, very hard to find. And it is likely that investors will harm their portfolio performance by jumping to conclusions about new sources of alpha. Instead, investors are much better off revisiting their risk tolerance.

How hard is it to find alpha?

In a recent post on Reddit, algo trader Janny Kul attempted to replicate the results of 130+ research studies on trading and found that every single one failed to produce economic returns.

Similarly, academics Harvey and Liu attempted to replicate factor work and discovered that almost all factors are bunk. What Harvey and Liu say is instructive:

We document over 400 factors published in top journals. Surely, many of them are false. We explore the incentives that lead to factor mining and explore reasons why many of the factors are simply lucky findings. The backtested results published in academic outlets are routinely cited to support commercial products. As a consequence, investors develop exaggerated expectations based on inflated backtested results and are then disappointed by the live trading experience.

Let's be very clear: If academic articles that have been peer-reviewed by PhDs rarely stand up to scrutiny, it makes no sense to change your understanding of how markets work based on an informal article about a new tactical asset allocation strategy.

What makes sense and what doesn't

If the choppy, low return performance of the S&P 500 since January, 2018 has impacted your risk tolerance, you may want to change your asset allocation. That makes sense.

But if the choppy, low return performance of the S&P 500 has you looking for new trading strategies, that makes much less sense. The short-term performance of the stock market might cause you to reassess your tolerance to risk, but it does not cause new alpha generating strategies to appear.

Search for portfolios that match your return/risk portfolio

In short, if your understanding of risk has changed, change your asset allocation. Don't change your beliefs about investing.

The standard way to change risk allocation is to change the ratio between risky assets (stocks) and less risky assets (bonds).

There is another way to do it: look for investments that directly match your return/risk profile. Here are two examples:

  • MPlus Defined Preservation Funds. These funds provide most of the positive returns of an ETF over a period of time while exposing the investor to only a fraction of the negative returns. This captures the risk profile of many investors. For example, if the ETF returns 60% over a three year period the return to the investor may only be 40% but in return, the maximum possible loss is 10%. This is a tradeoff that many investors would be willing to take: if the market melts up, they participate in most, but not all, of the gain; however, if the market melts down the vast majority of the investor's capital is protected. Here is how one of the MPlus Defined Preservation Funds has performed recently:

(Source: Bloomberg)

Sophisticated investors can choose to replicate the performance of MPlus and Innovator using options.

Investing in these products makes much more sense than, say, rotating sectors or increasing allocation to high dividend paying stocks based on historical performance during bear markets. These changes are just marketing timing based on weak empirical data.

Recommendations

Investors scurrying to change their tactical asset allocation in response to market fluctuations are likely to only make money for their brokers. Instead, investors who are re-examining their risk profile as a result of recent market action should instead directly change their allocation to risky assets in their portfolio. An alternative is to use specialized products and ETFs that seek to directly deliver a particular return/risk profile.

(Acknowledgment: Thanks to Scott J. Clark of ASYMmetrics ETFs LLC for his input.)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.