Bull Or Bear, Focus On Asset Allocations

August 19, 2014

However investors respond to where the market is heading, they need to stay invested.



This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Andrew Gogerty, vice president of investment strategies for Boston-based Newfound Research LLC.

As a quantitative firm, we generally refrain from waxing philosophical about economic conditions and policy. We subscribe to the theory that markets are chaotic—while trends emerge and persist, predicting those trends is nearly impossible.

We don’t particularly care that Dr. Frankenstein’s monster was an 8-foot tall, grotesque beast. By all clinical and scientific definitions, it was alive, and frankly, so is this market—at least for now.

So whether we should or should not have reanimated the market is a topic best left to economic historians. Instead, the question that needs to be addressed is, What now?

Generally, our view is to stay invested, and I’ll get to the reasons why and how we’ve added the PowerShares Multi-Strategy Alternative Portfolio (LALT) to our U.S. Equity Dynamic Long/Short strategy, but first let’s look at what’s happening now in the market.

In exploring that question, we find the true ugliness of the monster we have created:

  • The “recession babies”—21- to 35-year-olds—are so scarred by the last several years that they have the “most conservative portfolio profile of any age bracket under 65,” according to a recent report published by Bloomberg News.
  • In trying to control our monster, we’ve suppressed the yield curve. The yield on 10-year Treasurys—a terrific predictor of the forward 10-year annualized return for a constant maturity 10-year bond index, now sits at only 2.39 percent.

Combined, we have a frightening picture: A generation that should have the most aggressive profile has instead loaded up its portfolio with risk-mitigating asset classes with expected returns that barely stay ahead of inflation.

A Thoughtful Response

We believe by combining a quantitative approach with tactical flexibility, we can create an objective portfolio whereby we cast aside emotional biases and reintroduce return-generating asset classes into portfolios—all with the comfort that these solutions can adequately “de-risk” in times of crisis.

Among the most interesting developments this year was the violent strength and reversion of value equities in the second quarter. The large gap in relative strength of growth versus value equities—a trend that started in early 2013—collapsed in that quarter in dramatic fashion.

Going forward, we are now positioned for a return of strength in growth equities relative to value securities.

In the nontraditional income space, we see broad momentum tail winds across all asset classes. That said, our models currently tilt toward the bank loan, high-yield, preferred equities and mortgage REITs on a risk-adjusted basis. However, our models have continued the reduction in global dividend equities that began in the first quarter.

Keep Cash At Bay

Risk, as defined within our firm, hasn’t presented a material opportunity to raise cash in our portfolios this year. Our investment models continue to identify broad asset class momentum around the globe using our dynamic, volatility-adjusted momentum philosophy.

Within U.S. equities, we continue to see broad strength across sectors, and vertically from large- to small-cap. Our models have kept our domestic and global sector strategies fully invested throughout the year. Our models are telling us that the 5-10 percent drawdowns seen in the U.S. market at certain times earlier this year are a healthy consolidation in our opinion, rather than the emergence of a new momentum trend.

A Liquid Alternative Addition

We recently added the PowerShares Multi-Strategy Alternative Portfolio (LALT) to our U.S. Equity Dynamic Long/Short strategy. This ETF tracks a Morgan Stanley multistrategy index and aims to capture nontraditional risk premia across equities, interest rates, currencies and volatility markets.

The fund allows us to incorporate previously unavailable, institutional asset-class strategies into our managed account portfolio, and complements the existing alternative long and short exposures.

This exposure, combined with a number of Quantshares ETFs that our U.S. Equity Dynamic Long/Short strategy uses delivers a diversified return stream that can complement existing core holdings using long and long/short U.S. equity exposures.

Among the QuantShares ETFs in the strategy are:

Reminder On ETF Liquidity

I’d be remiss if I didn’t stress that many of the ETFs mentioned above, particularly the QuantShares funds, have a combination of low assets and low average daily trading volume (ADV) of the actual ETF shares.

But remember that while the volume of traded ETF shares may be low, it’s the liquidity and volume of the underlying stocks that determines how closely the ETF will track its net asset value, and provide market makers the opportunity to offer tighter spreads to market participants.

More specifically, stocks in these portfolios are from the broad U.S. market where the liquidity is deep and broad. For example, the anti-beta ETF BTAL has approximately 85 percent of its assets invested in large- and midcap stocks. That type of exposure along with the creation/redemption process gave us confidence that these ETFs can support material growth in assets.

The bottom line is this: Take a holistic view of ETF liquidity by examining the underlying holdings, not simply the number of shares of the ETF that are traded every day.

A good rule of thumb is that you can normally trade up to 10 percent of the ADV of the underlying holdings of an ETF before you see market impact issues. That level is oftentimes far larger than the ADV of the ETF shares.


Newfound Research LLC is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in August 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research LLC, call us at 617-531-9773, visit us at www.thinknewfound.com or email us at [email protected]. For a list of relevant disclosures, click here.



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