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Fund Managers Have Some Valid Reasons To Avoid Momentum

Momentum, relative, absolute or dual, is essentially a timing strategy that is used for the purpose of achieving better risk-adjusted returns in the longer-term as compared to passive allocation strategies or even buying and holding. Below is a backtest of a dual momentum strategy with two assets, S&P 500 Total Return and cash, and a 12-month timing period, since 1989. Click to enlarge It is clear that risk-adjusted returns of this dual momentum strategy are superior when compared to those of an equal weight portfolio (50% in S&P 500 Total Return and 50% in cash) or to those of a passive investment in S&P 500. Specifically, the annualized return of the dual momentum strategy (blue line) outperforms a passive investment in S&P 500 total return (yellow line) by 160 basis points and drawdown is lower by a factor of 3. The above results illustrate the potential of timing models, especially when combined with relative momentum. However, this is a trivial example and most investors prefer a certain degree of diversification. In addition, the improved risk-adjusted performance of the above trivial strategy can be attributed to trend-following, which can be achieved by a wide variety of simpler strategies, for example moving average crossovers. Below I list three reasons why investors neglect momentum: Reason #1: Momentum strategies require a transition from passive to active management This transition is not trivial and actually requires that a fund manager is also a trader. Going from passive allocation to timing models requires different systems and operating structure. In an era of constant bashing of active management, some fund managers decide that the transition is risky for their business. Reason #2: With momentum strategies there is possible loss of investment discipline Timing models require trading discipline. The most difficult task of trend-followers is adhering to strategy rules. This is in contrast to passive allocation schemes that offer inherent discipline because they only require rebalancing. Loss of discipline can cause friction in a fund management firm due to different opinions of managers about whether or not to adhere to strategy rules and signals. Those of us who have actually used timing strategies can understand the impact of loss of discipline and the friction in can create. In reality, using timing strategies without a mechanism to enforce discipline slowly leads to random decisions and losses. Most fund managers know the risks involved but researchers do not have actual experience with the dangers involved in transitioning from passive to active management. Managing the savings of people is a job that requires high level of professionalism and respect for the customer. Those who wonder why momentum is neglected should try to answer the following question: If you were given today $1B to manage, would you choose a passive allocation scheme or a timing method? Most fund managers choose the passive allocation scheme because they understand the risks of trading timing models. This decision is not because they do not understand momentum. Actually, momentum is a trivial timing strategy. Reason #3: Momentum suffers from data-snooping bias This is a very serious objection against using momentum and also other technical strategies despite the convincing backtests offered by some researchers even if they include robustness and out-of-sample tests. Note that if a strategy is optimized, robustness tests are unlikely to fail. Also, note that out-of-sample tests make sense only in the case of a single independent hypothesis. As soon as one mixes and matches assets to produce a desired result based on backtested performance on already used data, out-of-sample tests lose their significance. It is known that if one tries many strategies on historical data, a few of them may outperform in out-of-sample testing by luck alone. Let us look at some examples of dual momentum strategies below. The first strategy is for SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) and the iShares 20+ Year Treasury Bond (NYSEARCA: TLT ) and with 12 months timing period. Below are the backtest results: Click to enlarge It may be seen that the dual momentum strategy (blue line) underperforms the equal weight portfolio in SPY and TLT. The annualized return of dual momentum is 300 basis points lower and maximum drawdown is higher by nearly 9%. Next, EEM is added in an effort to provide exposure to emerging markets. However, as soon that is done, data-snooping is introduced. Below are the results: Click to enlarge It may be seen that although the dual momentum strategy outperforms equal weight, there is a correction in equity (blue line) in 2015. The return for 2015 was -8.5%. However, this is not the main problem with this attempt to improve the asset mix in an effort to obtain superior performance. Actually, the outperformance was possible due to conditions in emerging markets (NYSEARCA: EEM ) that may never occur again, or better said, the risks of never occurring again are high. Specifically, in 2005 EEM was up more than 55% and in 2009 the return was close to 72%. However, last year emerging markets crashed. Therefore, a fund manager employing this strategy in 2015 paid the price of data-snooping bias. But why EEM and not QQQ? Below is the backtest for SPY, QQQ and TLT dual momentum with a 12-month timing period: Click to enlarge In this case, the equal weight portfolio generated 360 more basis points of annualized return with just 7% more drawdown and it outperformed dual momentum. One may find many backtests where dual momentum works well and many where it does not. This is actually the point, and the risk involved. If your research shows a specific asset mix where dual momentum worked well, I do not care about any out-of-sample and robustness tests unless you can prove that there was no data-snooping involved. Since providing such proof is highly unlikely, I can understand why most fund managers neglect momentum. Besides, momentum becomes a crowded trade when its signals align with strong uptrends and are influenced by passive investment decisions. In the era of Big Data and machine learning, it is difficult to know which strategy represents a unique, independent hypothesis, or it is the result of data-snooping and p-hacking. Thus, many fund managers hesitate in adopting popular strategies that are based on trivial rules and fully disclosed in books, articles and blogs. They may be wrong but I do not blame them for their decision in adhering to passive allocation. Momentum is part of technical analysis and many traders know that this type of analysis has contributed to a massive wealth-redistribution in recent history. Note: Charts created with Portfolio Visualizer. Original article

Will Semiconductor ETFs See A Brighter 2016?

The semiconductor industry has been on a roller coaster ride in recent times. The space hogged investors’ attention in 2014 only to plunge the very next year. The struggling PC market took all the shine out of this segment. Two independent research firms – Gartner and International Data Corporation – validated the fact. As per Gartner, PC shipments in 2015 totaled 288.7 million units, marking an 8% decline from 2014. Meanwhile, according to IDC, PC shipments witnessed a decline that was “the largest in history ” breezing past the 9.8% drop registered in 2013. In fact, the fourth quarter of 2015 marked the fifth successive quarter of global PC shipment decline, pointing at soft holiday season sales and a shift in consumers’ PC purchase preference, per Gartner. Both firms agreed that the launch of Windows 10 in third-quarter 2015 had an insignificant impact on PC shipments during the all-important holiday season. This was because customers upgraded their existing PCs rather than buying new ones. Also, a strong greenback, higher inventories in the semiconductor and electronics supply chain are also held responsible for this decline, per the research agencies. What’s in Store in 2016? However, most research agencies expect things to improve in 2016. In any case, the wind is in favor of the broader technology sector. As a result, semiconductor, the value-centric traditional tech area should expand modestly this year, primarily in the second half. Value-oriented trading should be in focus this year thanks to a paradigm shift in global economy. Policy tightening in the U.S., an accommodative stance in most developed economies, and lack of clarity about China’s currency movements should keep value investing busy throughout this year. Secondly, IDC predicts that the take-up of Windows 10 by corporates is likely to pick up and consumer purchase will be steady by the second half of 2016. Also, attractive PCs at affordable prices, the need for higher security and improved performances will eventually drive consumers toward an upgrade. The World Semiconductor Trade Statistics (WSTS) predicts the global semiconductor market to grow 1.4% to $341 billion in 2016 and 3.1% to $352 billion in 2017. This explains that moderate optimism is prevailing around the area. All regions are expected to post positive growth in 2017 with the Americas leading the way. Also, this tech sub-sector might shoot up on the requirement of its products in emerging technology applications like tablets and smartphones despite subdued PC shipments. If this was not enough, the semiconductor space is consolidating rapidly with a number of deals announced lately. ETFs to Play The latest discussion definitely tells you to park your money in semiconductor ETFs, especially after a down year like 2015. At present, there are four regular semiconductor ETFs namely Market Vectors Semiconductor ETF (NYSEARCA: SMH ), iShares PHLX Semiconductor ETF (NASDAQ: SOXX ), SPDR S&P Semiconductor ETF (NYSEARCA: XSD ) and PowerShares Dynamic Semiconductors Fund (NYSEARCA: PSI ) . Why to Look Beyond SMH? Of these, only SMH has a Zacks ETF Rank #3 (Hold) while the other three have a Zacks ETF Rank #1 (Strong Buy). Investors should note that SMH has as much as 18.6% exposure in Intel Corp., the biggest weight of the basket. Though Intel has exposure in three other ETFs, the weight is not as much as it is for SMH. As a result, the recent underperformance by the Intel stock post earnings cast out SMH from the ‘Strong Buy’ league. Below, we highlight three other semiconductor ETFs in detail for the interested investors. SOXX in Focus This ETF follows the PHLX SOX Semiconductor Sector Index and offers exposure to 30 U.S. firms. The fund has amassed $409.3 million in its asset base. The product charges a higher fee of 48 bps a year from investors. Intel (NASDAQ: INTC ) takes the fourth spot at 7.8% of total assets. XSD in Focus This fund tracks the S&P Semiconductor Select Industry Index, holding 42 stocks in its portfolio. It is widely spread across a number of securities as none of these allocates more than 3.44% of the assets. The product has a definite tilt toward small cap stocks at 65% while the rest is evenly split between the other two market cap levels. The $196.7-million fund charges 35 bps in fees per year. PSI in Focus This fund tracks the Dynamic Semiconductor Intellidex Index, holding 29 U.S. securities in the basket. Intel makes up for 5.2% share in the basket and not in the top-three holdings. This $50.7-million ETF charges 63 bps in fees. Original Post

On Currencies That Are A Store Of Value, But Maybe Not For Long

Picture Credit: Dennis S. Hurd I get letters from all over the world. Here is a recent one: Respected Sir, Greetings of the day! I read your blog religiously and have gained quite a lot of practical insights in financial field. Your book reviews are very helpful and impartial. I request you to write blog post on dollar pegs in Middle East and under what conditions those dollar pegs would fall. If in case you cannot write about it, kindly point me to some material which can be helpful to me. Thanks for your valuable time. Now occasionally, some people write to me and tell me that I am outside my circle of competence. In this case, I will admit I am at the edge of that circle. But maybe I can say a few useful things. Many countries like pegging their currency to the US dollar because it provides stability for business relationships as businesses in their country trade with the US, or, with other countries that peg their US dollar, or, run a dirty peg of a controlled devaluation. Let me call that informal group of countries the US dollar bloc [USDB]. The problem comes when the country trading in the USDB begins to import a lot more than they export, and in the process, they either liquidate US dollar-denominated assets or create US dollar-denominated liabilities in order to fund the difference. Now, that’s not a problem for the US – we get a pseudo-free pass in exporting claims on the US dollar. The only potential cost is possible future inflation. But, it is a problem for other countries that try to do so, because they can’t manufacture those claims out of thin air as the US Treasury does. Now in the Middle East, it used to be easy for many countries there because of all the crude oil they produced. Crude oil goes out, goods and US dollar claims come in. Now it is reversed, as the price of crude is so low. Might this have an effect on the currencies of the Middle East. Well, first let’s look at some currencies that float that are heavily influenced by crude oil and other commodities: Australia, Canada, and Norway: Click to enlarge Commodity Currencies As oil and commodities have traded off so have these currencies. That means for pegged currencies, the same stress exists. But with a pegged currency, if adjustments happen, they are rather large violent surprises. Remember the old saying, “He lied like a finance minister on the eve of the devaluation,” or Monty Python, “No one expects the Spanish Inquisition!” That’s not saying that any currency peg will break imminently. It will happen later for those countries with large reserves of hard currency assets, especially the dollar. It will happen later for those countries that don’t have to draw on those reserves so rapidly. Thus, my advice is threefold: Watch hard currency reserve levels and project future levels. Listen to the rating agencies as they downgrade the foreign currency sovereign credit ratings of countries. When the ratings get lowered and there is no sign that there will be any change in government policy, watch out. Watch the behavior of wealthy and connected individuals. Are they moving their assets out of the country and into hard currency assets? They always do some of this, but are they doing more of it – is it accelerating? Point 3 is an important one, and is one seemingly driving currency weakness in China at present. US Dollar assets may come in due to an excess of exports over imports, but they are going out as wealthy people look to preserve their wealth. On point 2, the rating agencies are competent, but read their write-ups more than the ratings. They do their truth-telling in the verbiage even when they delay downgrades longer than they ought to. Point 1 is the most objective, but governments will put off adjustments as long as they can – which makes the eventual adjustment larger and more painful for those who are not connected. Sadly, it is the middle class and poor that get hit the worst on these things as the price of imported staple goods rise while the assets of the wealthy are protected. And thus, my basic advice is this: gradually diversify your assets into ones that will not be harmed by a devaluation. This is one where your government will not look out for your well-being, so you have to do it yourself. As a final note, when I wrote this piece on a similar topic , the country in question did a huge devaluation shortly after it was written. Be careful. Disclosure: None.