Tag Archives: eem

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

First Fed Hike Puts These ETFs In Focus

Months of speculation and nail-biting hearsay about the timeline of the first rate hike in almost a decade finally ended yesterday thankfully, with neither shocks, nor surprises. The Fed pulled the trigger at long last, raising benchmark interest rates by a modest 25 bps to 0.25-0.50% for the first time since 2006, making it official that the U.S. economy is out of the woods; though still has miles to go. The step also sets the U.S. apart from other developed economies and had a great impact on the global currency market. The Fed believes that the possibility of further improvement in the labor market as well as in inflation is ripe at the current level. Muted inflation mainly due to stubbornly low oil prices has been an issue for long for the Fed. But in the 12 months through November, the core consumer price index grew 2% (matching the Fed’s target), the highest reading since May 2014 , followed by the 1.9% advancement in October. Unemployment rate fell to 5%, a more than seven-year low level. Average hourly earnings are rising of late. What’s more noteworthy was that the Fed did not move an inch from the ‘ gradual ‘ rate hike trajectory. Also, the central bank indicated that while the job market criteria is apparently accomplished, the Fed’s future focus would be on the inflation reading, which is yet to pick up at a sustained pace. Global growth worry is another factor, which is holding the Fed back from acting fast on tightening. Fed’s Projection The Fed lowered its 2015 projection for personal consumer expenditure inflation to 0.3-0.5% from 0.3-1.0% and 0.6-1.0% guided in September and June, respectively. The projections were also slashed for 2016 and 2017 from 1.5-2.4% to 1.2-2.1% and from 1.7-2.2% to 1.7-2.0%, respectively. The expectations for 2016 and 2017 real GDP growth have been ticked down to 2.0-2.7% from 2.1-2.8% guided in September (Fed’s June prediction for 2016 was 2.3-3.0%) and to 1.8-2.5% from 1.9-2.6%, respectively. However, the real GDP growth expectation for 2015 has been changed to 2.0-2.2% from 1.9-2.5% projected in September. As already discussed, unemployment was the true healer with its 2015 expectation being 5%, almost in line with the 4.9-5.2% expected in September. The coming two years will also see the same uptrend as estimates for 2016 were lowered from 4.5-5.0% to 4.3-4.9% while the same for 2017 remained unchanged at 4.5-5.0%. The notable changes were in the projection for the benchmark interest rate for 2015, 2016 and 2017. Fed’s funds rate for the longer run may be maintained at 3.0-4.0% but projection for 2015, 2016 and 2017 were changed from negative 0.1- positive 0.9% to 0.1-0.4%, from negative 0.1- positive 2.9% to 0.9-2.1% and from 1.0-3.9% to 1.9-3.4%, respectively. Market Impact However, the historic move did not mess up the market, as the investing world was prepared well ahead of the meeting. In fact, the Fed gave the global market enough time to digest the news when the central bank brought the December rate hike possibility back on to the table in October end. With no drama in the December meeting, the market is now focusing more on a sluggish rate hike, not just the hike itself. As a result, probability of a dovish rate hike trail ahead cheered equity investors almost across the globe. Even the highly vulnerable areas like emerging markets also tacked on gains during the Fed meeting. This produced a handful of surprise winners and losers post meeting. However, bonds obeyed the rule book and started diving as soon as the Fed enacted the lift-off. The two-year benchmark Treasury yield jumped 4 bps to 1.02% on December 16 – a five and a half year high. However, the yield on the 10-year Treasury note rose just 2 bps to 2.30% and yield on the long-term 30-year bonds saw a 2 bp nudge to 3.02%. All bond ETFs were in the red. Given this, we have highlighted ETF winners and losers from the Fed move: The PowerShares DB US Dollar Bullish Fund (NYSEARCA: UUP ) – Natural winner The U.S. dollar is a common winner following the lift-off. The U.S. dollar ETF UUP gained 0.04% after hours. The iShares MSCI Emerging Markets (NYSEARCA: EEM ) – Surprise Winner Emerging markets normally fall out of favor in a rising rate environment as investors dump these high-yielding, but risky, investing tools for higher yields at home. However, possibility of a gradual hike boosted the emerging market ETF EEM by about 2% on December 16. The fund added 0.2% after hours. The SPDR S&P Regional Banking ETF (NYSEARCA: KRE ) – Natural Winner The regional bank sector was pleased by the Fed decision and the resultant rise in yields, as it tends to benefit from the steepening of the yield curve. As a result, regional bank ETF KRE was up about 1% and added 0.1% after hours. The Market Vectors Gold Miners ETF (NYSEARCA: GDX ) – Surprise Winner but Potential Loser As soon as the greenback gains, commodity prices fall. Gold, one of the key precious metals, might have gained from the slower hike bet, but is likely to lose ahead. The SPDR Gold Trust (NYSEARCA: GLD ) tracking the gold bullion added over 1.2% while the largest big-cap gold mining ETF GDX added about 4% on the same day. The latter saw more gains as it often trades as a leveraged play on gold. But both lost over 0.3% and 0.6% in extended hours. The iShares Mortgage Real Estate Capped ETF (NYSEARCA: REM ) – Surprise Winner but Potential Loser Mortgage REITs perform better in a low interest rate environment. However, though high-yield REM added 3.2% yesterday, it might see a slump ahead. Original Post

Differentiating Between Emerging Markets For Better Returns

Summary Emerging markets are often grouped together, but it’s better not to. Changes in monetary policies may be upon us and some countries should do better than others. Countries with sizable deficits are more likely to experience problems and should be avoided. The year 2015 has been a forgettable one so far for many emerging markets. For instance, the iShares MSCI Emerging Markets ET F (NYSEARCA: EEM ), which is the leading ETF for emerging markets is down by 11 percent this year when it comes to liquidity. By comparison, stock markets in countries such as the U.S. and Japan are at record levels. Some people may therefore feel that emerging markets are more of a bargain and have more upside still left in them. A long position in emerging markets is an option worth exploring from this standpoint. On the other hand, some may argue that the worst is not over for emerging markets and there is still some downside left. Avoiding long positions or even initiating short positions in emerging markets is the way to go if one agrees with this viewpoint. A third option is to break down emerging markets into smaller groups and pick the one that is most likely to do well in the future. The group that is most likely to underperform is to be avoided or even shorted as an alternative or as an addition to long positions in emerging markets. How to differentiate between emerging markets While they may be grouped together under a single name, the fact remains that emerging markets are more often than not very different from one another. Some countries have little if anything in common with other emerging markets despite all of them being referred to as emerging markets. It may therefore be a good idea to think of emerging markets not as a single group, but rather as several distinct groups. There are many ways one could divide emerging markets into separate groups. For instance, some may be democratic countries, while others are more autocratic. Some rely heavily on the export of raw commodities, while others depend on the export of manufactured goods. There are lots of options if one wants to break down emerging markets into smaller groups. However, one way that should be given extra consideration is to divide countries based on whether they run a surplus or a deficit. More specifically, does a country run a current account surplus or a current account deficit and why should it matter? Why it matters whether countries have a current account surplus or deficit Countries with significant current account deficits tend to borrow heavily relative to the size of their economy, usually from foreign sources of capital. For many years, this wasn’t such a big issue due to the prevalence of very low interest rates in the U.S. This forced many to look at alternative places with higher yields. Many emerging markets offered such a destination. However, the Federal Reserve is widely expected to begin raising interest rates, which will make it more expensive to borrow. Monetary conditions have actually already tightened even though the policy of zero interest rates is technically not yet over. Capital outflows have picked up in a number of emerging markets as foreign capital is anticipating the next move by the Fed. In this environment where borrowing is increasingly problematic, countries with a current account surplus should be more resilient to higher interest rates than those with chronic deficits. The latter will have to make more adjustments to the existing structure of their economy than the former and this may cause a divergence in how countries perform going forward. Deficit countries do have a number of options when it comes to dealing with higher interest rates. For instance, they could try to reduce their imports and the need for hard currency to pay for these imports. Large reserves can also provide relief. Even so, surplus countries should have a much easier time as their transition period should be shorter and less complicated than those that have to fix or at least try to reduce their deficits. A major advantage for the former in comparison to the latter. Emerging markets ranked by surplus or deficit The table below lists 15 of the most prominent emerging markets, starting from those with the largest current account surplus to those with the biggest deficit. These countries combined make up 96.33 percent of EEM. Based on these numbers, Taiwan should have the least amount of trouble dealing with the Fed raising interest rates. South Africa is the one that looks the most vulnerable as of right now. Mexico may have a bigger deficit, but it’s also a bigger economy. Country GDP Current account surplus/deficit (USD) Taiwan 489B 19.67B South Korea 1410B 10.61B Russia 1861B 5.4B Thailand 374B 1.56B Malaysia 327B 1.21B Philippines 285B 0.95B China 10360B 0.63B Turkey 800B 0.09B Poland 548B -0.96B Chile 258B -2.59B Indonesia 889B -4.01B Brazil 2346B -4.17B India 2067B -6.2B South Africa 350B -8.68B Mexico 1283B -8.86B How to position yourself with regard to emerging markets One drawback of an ETF such as EEM is that it can get dragged down by a few bad apples. Some countries may do very well within the basket, but their performance can get negated by other countries that are doing poorly. A possible solution to this issue would be to take out the bad apples and leave only the good ones. If someone agrees with the thesis that emerging markets with big deficits will have a harder time with higher interest rates, then it’s best to avoid these countries and stick with the ones that run sizable surpluses. The latter are much less likely to experience any setbacks resulting from changes in global monetary policies. As such, they’re more likely to outperform resulting in better returns.