tactical asset allocation in bull/bear markets

1DeMarche Associates, Inc.

Tactical Asset Allocation in Bull/Bear Markets

Timothy J. Marchesi, CFAPresident, CEO & Co-CIO

DeMarche Associates, Inc.


Agenda

• Importance of Asset Allocation

• Tactical vs. Conventional Approach

• Economic & Market Environment

• Supercycles

• Dynamic Investment Strategies


Importance of Asset Allocation• Studies estimate that asset allocation decision

accounts for 91.5% of the variation between returns of different funds 1

• Asset mix optimization models mathematically seek maximum expected rate of return for a given level of risk (or minimization of risk for a given expected return) 2

1 Financial Analysts Journal, May/June 1991 – Brinson, Singer & Beebower2 Global Asset Allocation Techniques for Optimizing Portfolio Management, 1994 – Lummer & Riepe


Review of Conventional Approach• Inputs based upon history• Typical models assume “average” future outcomes• Often ignore starting /ending market levels

Quarterly One-Year Returns1926-2009

Source: S&P 500 Index Some returns are greater than 50% and less than -50%

Large Capitalization StocksDistribution of Returns

0

5

10

15

20

25

30

35

40

Number of Occurrences

-50 -45 -40 -35 -30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50

Percent Return


Review of Conventional Approach

• Typical models assume “average” future outcomes (sample chart below)

Today 2015 2020 2025 2030

12%

10%

8%

6%

4%

2%

Small Cap EquitiesLarge Cap Equities

Emerging Equities

Hedge FdsBonds


One-Year Returns Are VolatileModels incorporate standard deviation to manage risk


Model Optimization:The Efficient Frontier


What is Tactical?

Webster’s: • “Small-scale action to serving a larger purpose”

In Investment Management:• Method of modifying asset allocation based upon

valuation estimates and judgments of the future return of markets or sectors


Time Horizon for Investment Objectives

ShortTerm

Long Term

Investment HorizonInvestment Horizon

Market Timing

Tactical Asset

Allocation

Strategic Asset

Allocation

Secular Asset

Allocation

One Year Or Less

Current Market Phase Cycle

Several Market Phase Cycles

Multiple Market Supercycles

Asset Allocation Study has both a strategic perspective and a long-term secular perspective


DeMarche Market Phases A typical market cycle has four distinct phases:

*Annualized cumulative returns of S&P 500 Index. Study based upon monthly data from 1/31/63-9/30/11. The annualized cumulative return for the full study period was +9.5%.

Source: DeMarche Research

Phase IV – Bear Market

Phase III – Late Bull/Early Bear

Phase II – Bull Market

Phase I – Early Bull

TotalReturn*

CorporateEarnings

StockPricesTactical Market Phase

Phase IV – Bear Market

Phase III – Late Bull/Early Bear

Phase II – Bull Market

62.0%

20.8%

0.5%

-27.0%

Phase I – Early Bull

TotalReturn*

CorporateEarnings

StockPricesTactical Market Phase


Markets Change Markets change over long periods of time

• As markets change, relative value between asset classes changes

• DeMarche research has acknowledged and identified these long wave markets as “Supercycles”

• Multiple bull and bear markets exist within each “Supercycle”


Supercycle YearsBank Panics/Recessions

Market Cycles(Bull/Bear Cycles)

A. High Growth 1900 – 1929 8 8

B. Moderate Growth 1929 – 1942 3 5

C. High Growth 1942 – 1966 5 8

D. Moderate Growth 1966 – 1980 3 6

E. High Growth 1980 – 2000 2 5

F. Moderate Growth 2000 - Present 2 3

DeMarche Supercycle Study


Supercycle Beginning End DJIA Price Return*

A 1900 1929 +882%

B 1929 1942 -75

C 1942 1966 +701

D 1966 1980 +2

E 1980 2000 +1,444

F 2000 Present* -5

DeMarche Supercycle Study

*As of 3/31/2011. Cumulative returns are shown for each cycle (non-annualized).


Supercycles Environment

A 1900 – 1929 High population growth

B 1929 – 1942 High unemployment

C 1942 – 1966 Baby boom / income growth

D 1966 – 1980 Inflation

E 1980 – 2000 Expansion of consumer credit

F 2000 – ? Demographics & debt

The Consumer in Supercycles


New Normal Macroeconomic Environment

• Demographics “Boomers” retire or shift emphasis from consumption

to saving

• Consumers gradually improve their finances Paying down debt / increase savings


New Normal Macroeconomic Environment (cont’d)

• Unemployment • Wage growth remains slow• Less help from asset gains (wealth effect)• Higher taxes


Strategic Implications ofCurrent Supercycles

• Stock returns likely to underperform mean• Bond returns likely to underperform mean• Policies need other strategies to improve expected

risk/return outcomes


Asset Allocation – Expected ReturnsNext 5 Year “Strategic” Period versus Long-Term “Secular” Time Horizon

Source: DeMarche Associates. See notes on next slide.


Asset Allocation – Expected Returns (cont.)• Notes for chart on prior page:• Represents geometric return estimates for the 5 years

beginning January 2012, compared to long-term average geometric returns over multiple Supercycles (no specific beginning point). 5-year horizon utilizes an assumption of a moderate economic growth environment within the current Supercycle, as defined by DeMarche.

• U.S. Fixed Income has poor E.R. over the strategic period. Such assets presently have very low current income yield and are at risk of principal value losses as interest rates rise.

• Other asset classes are shown for comparison.


Dynamic Investment Strategies

• Hedge Funds • Global Tactical Asset Allocation (GTAA) Funds• Lifecycle or Target Date Fund (TDFs)• Intro to some assets used by dynamic strategies

Commodities High Yield Bonds Emerging Market Bonds


Brief Intro to Hedge Funds and GTAA Strategies

• Different HF Fund of Funds approaches for clients Conservative – emphasis on diversification, lower

volatility Strategic – more use of directional market bets,

leverage• GTAA is long-only, relative valuation-based• Fees higher with HF• Limited transparency with HF• GTAA correlation is high (vs. stocks/bonds)• Wide variance across manager/strategies


Sample Range of GTAA Fund ApproachesClassic More Complex Comprehensive

Asset Classes Used

Cash X X X

Domestic Equity X X X

International Equity X X

Emerging Markets Equity X X

Domestic Bonds X X X

International Bonds X X

Emerging Markets Bonds X X

High Yield Bonds X

Inflation Protected (TIPS) X X

Convertibles X

Commodities X X

Real Estate (REITs) X

Listed Private Equity X

Currency X X

Typical Investments

Mutual Funds X X X

Closed-End Funds X X

Exchange-Traded (ETFs) X X X

Individual Securities X X X

Derivatives X X


What is a Target-Date Fund?

• Description of TDF (or Lifecycle Fund): Diversified investment option Target a specific retirement year (2020, 2030, etc.) Professionally managed

– Stock allocation reduced as retirement year nears– Disciplined rebalancing of underlying funds

May use less-traditional investments


Example of TDF Asset Allocation

Source: PIMCO, compiled by MarketGlide.

Fewer equities as participant retire date nears


TDF Glidepaths Programs reduce equities over time; some have tactical range

Active Average vs Passive Average

0

20

40

60

80

100

2055 2050 2045 2040 2035 2030 2025 2020 2015 2010 2005 2000 1995

Perc

en

tag

e E

qu

ity

All

oc

ati

on

PassiveManagerAverage

ActiveManagerAverage

IndustryMax

IndustryMin

Glidepath


Total return from commodities comes from combination of: rolling futures contracts (roll yield), yield from the cash collateral, and the spot price gain or loss. Derivatives use is widespread (active or passive).

Brief Intro: Commodities• Energy, Metals, Agriculture, Livestock• Weights differ among several indexes

S&P has 65-75% Energy: others cap at 33%• Portfolio diversifier

Hedge against unexpected inflation Slight negative correlation to stocks & bonds in past

• Liquidity varies; fund choices very distinct• Key concerns: China, oil, gold


Brief Intro: High Yield & Emerging Market Bonds• Both have low correlations to U.S. Bonds• U.S. High Yield Bonds

Quality ratings of “BB” or lower (below investment grade) Average maturities 3-10 years High level of current income payments Default risk rises in recessionary periods Higher volatility and potential losses than other fixed income

• Emerging Market Bonds are investment grade Obligations of foreign government or corporation Average maturities 3-10 years Higher fees (management, transaction, custodial) Political, liquidity, and other risks differ from U.S. bonds Currency risk (some issued in U.S. dollars)


Recommendations

• Adjust asset allocation more frequently• Incorporate Supercycles• Emphasize liquidity• Diversify• Increase allocation to dynamic strategies


Questions?

Thank you!

tactical asset allocation in bull/bear markets

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