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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

SPHQ: How Much Quality Is In The ‘High Quality’ ETF?

During bull markets, investors love to chase risky momentum stocks with questionable fundamentals in pursuit of big returns. When volatility increases and markets decline, on the other hand, investors get spooked and start putting more of their money in investments that are perceived as safer and “higher quality.” With the significant drop in the market to start 2016, we can be sure that many investors are looking to shift their portfolios towards higher quality stocks. The challenge is how to define “high-quality” because it is not as straightforward as one might think. ETF investors may view the PowerShares S&P 500 High Quality Portfolio ETF (NYSEARCA: SPHQ ) as an appealing option. After all, the words “high quality” are right there in the name. Over the past six months, SPHQ has seen net inflows of $144 million, nearly triple the cash coming in to the similarly sized SPDR S&P 500 Growth ETF (NYSEARCA: SPYG ). However, investors that truly want to invest in quality stocks need to dig a little deeper. While SPHQ does a better-than-average job of selecting stocks with strong fundamentals, its flawed methodology means investors are getting exposure to some companies with significant weakness in their underlying business. Accounting Earnings Are Unreliable SPHQ tracks the S&P 500 High Quality Rankings Index, which, according to its website , “includes companies rated A- or above based on per-share earnings and dividend payout records for the past 10 years.” As we’ve written about many times before, reported earnings and dividends are not reliable indicators of the underlying quality of a business. High dividend paying stocks can end up being dividend traps, and flawed accounting rules mean that EPS growth has almost no correlation with value creation . Identifying fundamentally sound companies requires more work than just looking at EPS and dividends. SPHQ’s overly simplistic methods allow for some distinctly low quality businesses to find their way into this ETF. Low Quality Businesses In A High Quality ETF The ultimate marker of a high quality business is earning a return on invested capital ( ROIC ) above its weighted average cost of capital ( WACC ). These excess returns drive economic earnings , a far truer measure of profits for equity investors. Figure 1 shows the nine companies in SPHQ that fail this very basic test, having earned negative economic earnings in each of the past five years. Figure 1: SPHQ Stocks With Low-Quality Businesses Click to enlarge Sources: New Constructs, LLC and company filings. General Electric (NYSE: GE ) stands out at the top of Figure 1. The industrial conglomerate has not turned an economic profit since 2006, and its balance sheet is not as strong as it first appears either. $3.5 billion in off-balance sheet debt due to operating leases add to the company’s liabilities. GE has a reputation as a stable business, and the massive sale of GE Capital provides cash to continue serving its 3.2% dividend for many years because the rest of the business is not making money. The firm’s dismal economic earnings prove the underlying business is not nearly as strong as it once was, and the stock’s 8% drop so far this year shows it’s far from safe in a bad market. Utilities make up a good portion of Figure 1, unsurprising for a sector that consistently is near the bottom of our sector ratings . Xcel Energy (NYSE: XEL ) is one of the worst, as it has failed to earn an ROIC above 4% going all the way back to 2002. Even worse, the company has only recorded positive free cash flow once in the past decade. It funds its dividend through taking on more long-term debt, which has ballooned from $7 billion to $17 billion in the past decade. Over $2 billion of that debt is hidden off the balance sheet. Accounting earnings would suggest that XEL is improving, with EPS improving by 6% in the last fiscal year. However, that improvement is almost entirely due to changes in non-operating pension costs, due in part to the company increasing its expected return on plan assets . When we strip out these non-operating items, we see that the company’s true after-tax operating profit ( NOPAT ) declined by 3%. Investors in SPHQ might be surprised to learn that they hold a stake in a company with such a poor track record of destroying shareholder value. Economic Earnings Matter Most In A Tough Market When markets get shaky, it’s not the companies with EPS growth that weather the storm, it’s those that deliver solid economic earnings. Just look at the crash of 2008 . The only stocks that delivered solid returns to investors while the market crashed were those that earned a high ROIC. That is the pattern investors should follow for long-term success in the market. SPHQ is better than a lot of other ETFs out there, and over 75% of its holdings earn out Neutral-or-better rating. Still, its “high-quality” moniker, combined with the lack of diligence involved in selecting its holdings, may mislead some investors. Surviving a market crash is hard. You can’t just trust an ETF’s label and hope your investments will be safe. It takes real diligence and discipline to reveal the true quality of a company’s earnings and measure the strength of its underlying business. We will be the first to tell you that good fundamental research is rare, time-consuming, and expensive. As a result, by the time many investors realize they need fundamental research, it’s too late. Their portfolios have been crushed. We think the recent decline in liquidity is going to lead the market to recognize the true, long-term fundamentals of lots of stocks, a trend that began in 2015 and led to significant outperformance by our Most Dangerous Stocks newsletter as well as many of our Danger Zone picks in 2015. Less liquidity means more natural price discovery, something many experts have warned has been missing for too long. Those same experts have noted that when natural price discovery came back, it could do so with a vengeance. Markets could be volatile for a while. Be prepared. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.

Is It Ever A Bad Time To Invest?

When the markets seem scary, it’s tempting to wait for a “better” time to invest. History suggests this may be a mistake. Many investors feel nervous about making a commitment to equities, particularly following robust periods of market performance. There are always economic clouds on the horizon, and no one wants to envision their investments taking an immediate loss. But trying to “time the market” by waiting for a more opportune time to invest may be a mistake, as time horizon has often been a significant factor in long-term market results. We would all time the market if we could do it successfully. Who wouldn’t want to avoid major market declines or fully participate in a bull market? The problem is that market timing requires one to make decisions that even professionals find difficult, if not impossible. This is not to say that considering the overall direction of the markets and making tactical tilts aren’t without merit. Trying to time one’s overall exposure to the equity market, however, brings with it a new set of risks, and may ultimately derail an investor’s long-term goals and objectives. The Pitfalls of Timing Individual investors are notoriously bad at picking the right times to invest. Fund flows show that investors tend to move in and out of the market at precisely the wrong time – in essence, buying high and selling low. In 2008 and 2009, for example, during the depths of the bear market, investors pulled significant assets out of equity funds. Several years later, they moved back into equity funds just as many equity indexes were approaching or had surpassed old highs (see Figure 1). Figure 1: Market Timing Travails Source: Strategic Insight Simfund MF, FactSet. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. In fact, the patterns of overall equity market returns are one of the reasons that market timing is so difficult. Market increases have often come in spurts, and missing some of the market’s best days could have a significant impact on returns, as those days have historically accounted for a surprising portion of the market’s overall annual returns (see Figure 2). Figure 2: Impact of Missing Equity Market’s Best Days S&P 500 10 Years Ending October 21, 2015 Source: FactSet. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Over Time, Stocks Have Tended To Go Up Over extended periods of time, the U.S. stock market has tended to rise in value. Consider Figure 3, which shows that the S&P 500 has risen in 75% of all one-year time periods since reliable market data began (in 1926). Over longer periods, the percentage of positive outcomes has also increased as well – for example, there has been no 15- or 20-year period in the S&P 500’s history in which the index has registered a negative return. Figure 4 shows the S&P 500’s performance over rolling 10-year periods (that is, the 10-year periods ending in 1935, 1936, 1937 and so on). In only two instances – ending in the depths of the Great Depression and in the midst of the global financial crisis – did the S&P 500 produce negative returns after a 10-year holding period. We believe this underscores the importance of maintaining a long-term perspective. Figure 3: The Percentage of Positive S&P 500 Outcomes Has Varied by Holding Period Source: FactSet. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Figure 4: Benefits of Long-Term Investing S&P 500 10-Year Rolling Returns Source: FactSet. Data as of October 31, 2015. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Managing Risk Through Diversification Of course, the case for any given asset class only goes so far. Maintaining diversification is another way to help mitigate the downside risk of an overall portfolio. Investors have often relied on a mix of stocks and investment-grade bonds for this reason. In the current low-yield environment, however, we favor diversification across a broader asset allocation framework that reaches beyond traditional equities and fixed-income to enhance diversification against broad market risk. Investors today also have access to a broader array of investment options that can provide diversification benefits. For example, once the province of institutions and wealthy individuals, alternative investment strategies are now increasingly available in vehicles without investor qualification restrictions. So-called “liquid alternative” funds are retail mutual funds that pursue alternative investment strategies. Adding alternatives strategies to a portfolio of traditional equity and bond investments can help lower correlations to equity and fixed-income markets. Given the significantly expanded range of alternative strategies available today to a broad audience, adding the potential diversification benefits of non-traditional approaches has become a simpler exercise. Climbing The Wall Of Worry Over time, the stock market has managed to navigate periods of economic crisis and geopolitical uncertainty and has overcome significant market pullbacks. Although the global economy continues to expand at a moderate pace, helped by the stimulative efforts of central banks, the proverbial wall of worry stands high today. The Federal Reserve’s potential tightening cycle, China’s slowing growth trajectory, weak commodity markets and elevated valuations are just a handful of concerns that have investors pondering a move to the sidelines. The angst investors feel in the current environment is understandable, and behavioral tendencies can be difficult to resist. Working with a financial advisor can provide investors with a long-term perspective and help them make decisions based on goals, objectives and risk tolerance rather than emotion. This material is provided for informational purposes only. Nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. The views expressed herein are generally those of Neuberger Berman’s Investment Strategy Group (ISG), which analyzes market and economic indicators to develop asset allocation strategies. ISG consists of a team of investment professionals who consult regularly with portfolio managers and investment officers across the firm. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. Certain products and services may not be available in all jurisdictions or to all client types. Indexes are unmanaged and are not available for direct investment. Unless otherwise indicated, returns shown reflect reinvestment of any dividends and distributions. Neuberger Berman LLC is a Registered Investment Advisor and Broker-Dealer. Member FINRA/SIPC. The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC.