Tactical Asset Allocation: Andrei Simonov

Tactical Asset Allocation
session 5
Andrei Simonov
1
Tactical Asset Allocation 12/07/2021
Agenda
 What is tactical asset allocation?
 Mean-variance perspective on TAA and SAA
 Predictability
– January dummy
– Business cycle variables
– Explaining risk premia: US, World, Sweden.
– Currency risk premia
– Caveats: data snooping, statistical issues.
2
What is TAA?
 Exists since early-to-mid- 80-ies.
 By now $100-200 bln are under management by TAA
managers
 A TAA managers’s investment objective is to obtain
better-than-expected return with (possibly) lower-than-
benchmark volatility by forecasting the returns of two or
more asset classes and varying asset class exposure in
systematic manner (Phillips, Rogers & Capaldi, 1996)
 Can TAA funds be interpreted as stand-alone asset
class?
3
Conditioning Information and Portfolio
Analysis
Er Add conditioning
information and weights
change through time.
Frontier shifts.
Vol
4
Optimal portfolio for risk-averse investor
 T
max w E (R )  w Vw
T
s. t. w T 1  1
2
  11 ..  1N 
 
Here w  ( w1 , w2 ,...),1  (1,1,1,...,1), V   .. .. .. 
T T
 ..  
 N 1 NN 
 T
min L  w T E (R )  w Vw   1  w T 1
2
 E (R )  Vw  1  0 V 1  E ( R )  1
 w . Summing up :
 1 w 1  0
T

1T V 1 E (R ) 
 T 1
 T 1 
1 V 1 1 V 1
V 11 V 1  1T V 1 E (R ) 
w  T 1 
*
 E (R )  1 T 1 
1 V  1   1 V 1 
Global min var
portfolio
5
Equilibrium and TAA
 Let us assume that there exists long-term
expected returns vector e. However, due to
predictability of asset returns, eE(R)
V 11
w  T 1 
* 
V 1 e1T  1eT V 1
1

V 1 1T  1T V 1
1
 
1 V  1    1 V  1   1 V 1
T 1 T 1
       
Global min var StrategicBet TacticalBet
portfolio
 0 E  rn   en  ( E  r1   e1 )
 
1T  1T   E  r1   e1  ( E  rj   e j ) 0 

 E  r1   e1  ( E  rn   en ) 0 
6
How to do it?
 We need a model that explains the
connection between today’s variables and
tomorrow returns.
 Candidates: economic business cycle
variables and Jan. Effect.
7
Example: Incredible January Effect
 Excess returns associated with small firms
w.r.t. Large-cap stocks
 Ritter: Tax effect. Is it so?
 Incredibly Shrinking January Effect
(William J. Bernstein ).
8
Example: dividend yield
Fama-French (1988). 1927-1986

Holding Coeff. t(coeff) R2
period
M 0.21 1.40 0.00
Q 1.07 2.10 0.01
1 2.47 1.27 0.01
2 7.38 2.04 0.09
3 9.94 2.21 0.13
4 12.86 2.43 0.19
• May not be sustained out of sample
9
Risk and return over the business cycle
m ,t  Et  Rm   rt   m vart  Rm  ????
G-7 output, 1973Q2 to 1996Q2

output level
potential line
end. recess beg. expan end. expan beg. recess

Average 15.23% 10.36% 6.96% 2.86%
returns
Return 12.59% 10.63% 16.85% 26.98%
volatility
10
Evaluation of Recent
Recession
 In July 2000, the Yield Curve inverted forecasting
recession to begin in June 2001.
 Official NBER Peak is March 2001 (Yield Curve within
one quarter accurate).
 In March 2001, the Yield Curve returned to normal
forecasting the end of the recession in November 2001.
 On July 17, 2003 the NBER announced the official end of
the recession was November 2001.
11
Exhibit 1
Next couple of slides are due to Cam Harvey

Lead Lag Analysis in Months
Business Cycle 5-Year Yield Spread

NBER NBER Length Length of
Peak Trough of Cycle Inversion Lead Normal Lead Inversion
Dec-69 Nov-70 11 Oct-68 14 Feb-70 9 16
Nov-73 Mar-75 16 Jun-73 5 Jan-75 2 19
Jan-80 Jul-80 6 Nov-78 14 May-80 2 18
Jul-81 Nov-82 16 Oct-80 9 Oct-81 13 12
Jul-90 Mar-91 8 May-89 14 Feb-90 13 9
Average last four 11 11 7 15
Recent Recession
Mar-01 Nov-01 8 Jul-00 8 Mar-01 8 8
12
Exhibit 2
Forecast evaluation
Term
Structure Average Forecast Actual
Inversion Lead to Beginning Recession
Date Recession of Recession Begins Error
Jul-2000 11 Jun-2001 Mar-2001 3
Term Forecast
Structure Average End of
Normal Date Lead Recession Actual End Error
Mar-2001 8 Nov-2001 Nov-2001 0
13
Yield Curve Inverts Before Last Six Recessions
(5-year Treasury note minus 3-month Treasury bill yield-secondary)
Source: Campbell R. Harvey.
Annual
GDP growth
% Real annual GDP growth
or Yield Curve %
8
2
Yield curve
0
Recent
flattening
-2 Recession
Recession Yield curve accurate
Correct Recession Correct in recent recession
-4 Correct 2 Recessions
Correct Data though April 11, 2006
-6
14
Yield Curve Inverts Before Last Six Recessions
(5-year Treasury note minus 3-month Treasury bill yield – constant maturity)
Annual
GDP growth
% Real annual GDP growth
or Yield Curve %
8 Source: Campbell R. Harvey.
2
Yield curve
0
Recent
flattening
-2 Recession
Recession Yield curve accurate
Correct Recession Correct in recent recession
-4 Correct 2 Recessions
Correct Data though April 11, 2006
-6
15
Recent Annualized One-Quarter GDP Growth
(10-year and 5-year Yield Curves-secondary market)
Annualized
1-quarter
GDP growth Yield curve
10-year
8 % Real annualized one-quarter GDP growth
4
6 3
4 2
2 1
0 0
-2 5-year Both curves -1

invert 2000Q3 Data though April 11, 2006
-4 -2
16
Recent Annualized One-Quarter GDP Growth
(10-year and 5-year Yield Curves-constant maturity)
Annualized
1-quarter
GDP growth Yield curve
10-year
8 % Real annualized one-quarter GDP growth
4
6 3
4 2
2 1
0 0
-2 5-year Both curves -1

invert 2000Q3 Data though April 2006
-4 -2
17
What shall we expect now?
US yield curves, 2006
5.4
5.2
4.8
4.6
4.4
1/3/2006
4.2 4/3/2006
7/3/2006
8/29/2006
4
1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr
18
May 2007: Practically flat
5.1
4.9
4.8
1mo
4.7 3mo
6mo
4.6
1yr
2yr
4.5
3yr
4.4 5yr
7yr
4.3 10yr
20yr
4.2 30yr
1/05/2007
3/05/2007
7/05/2007
9/05/2007
11/05/2007
r yr
15/05/2007 y 30
r yr 10
17/05/2007 o 5
o 2y
6m
21/05/2007 1m
19
August 2007
6
1
mo
5 3
mo
0
7
2 00 07
/ 0 07
08 /2
1/ / 08 /20 007 7
3 /08 /2 00 7 r
7 / 08 /2 00 7 yr 30 y
9 /0 8 /2 00 7 m
o
r yr 1 0
8 1 mo 2 y
13 5 /0 8/2 200 07 5
1 7/0 8 / 20 0 7 6
1 1 /0 8/ 20 07
2 3/0 8/ 20
2 7/0 8 /
2 9 /0 20
2
Current Situation: Economic growth
• The economy expanded at an annual pace of 4.1%, the most in
more than a year, according to the median estimate of 81
economists surveyed by Bloomberg News. The Commerce
Department last month calculated the growth rate at 3.4%.
• But the outlook for the second half of 2007 has soured in
recent weeks as the subprime mortgage crisis has restricted
access to credit. The Federal Reserve this month said risks to
growth had ``increased appreciably'' and economists at
JPMorgan and Lehman are among those that have reduced
forecasts.
• There are growing signs of a housing slowdown; new home
sales down, housing prices down, and homeowners with ARMs
facing much higher interest rates.
21
Current Situation
Inflation perceptions. The long-term rate is a combination of

expected inflation, expected real interest rates and an
inflation risk factor. Long-term inflation expectations have
decreased mainly due to the glut of cheap labor resulting
from globalization.
22
Current Situation
Strong buying of long-term bonds by foreigners. For the past

few years, strong buying by Asian central banks have
pushed up the Treasury bond prices. However, there is a
debate as to whether this has had a large impact on bond
prices. In addition, this buying has flattened out recently. A
recent Fed study estimated that the foreign buying pushed
yields down by 150bp. Subprime crisis does not end
buying of T-debt by foreigners. Demand for 5yr TB last
week was very high.
23
Current Situation
Hedge funds. There has been a recent increase in demand for

U.S. bonds from the Caribbean area indicating hedge fund
activity. With long-rates above short rates, many managers
do “carry trades” (borrow short-term and buy long-term
bonds hoping the relation between rates remains stable).
As the term structure flattens, many of these managers
increase their leverage which means more buying pressure
on the long-term bonds.
24
Current Situation
Demographic forces. As the population ages, more money is

allocated into fixed income and long-term bond yields may
decrease.
Inflation risk. The long-rate rates contain expected inflation,

expected real rates and an inflation risk factor. It is widely
perceived that inflation risk (an unexpected episode of
inflation turbulence) has decreased.
25
Annual Real Economic Growth After
Yield Curve Inversions
4.50%
4.00%
3.50%
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
Up to one year after Other quarters
inversions
26
Stock Returns and U.S. Yield Curve
Average Monthly Returns in %
3
2.5
1.5
0.5
-0.5
BE
DE
NL
CH
ES
SG
SE
US
FR
AU
CA
DK
HK
NO
UK
JP
IT
O
AT
W
Data through
November 2000 Inversion Normal
27
Average Monthly Stock Returns After
Yield Curve Inversions
1.40
1.20
1.00
0.80
Equally weighted
0.60
Value weighted
0.40
0.20
0.00
After first month of Normal
inversion
Based on 19 countries.
28
Trader’s calendar (from thestreet.com)
Time Indicator Source Previous Previous
Actual Forecast
(EST) (click for definition) (click for press release) (revised) (original)
Monday, May 21
No releases.
Tuesday, May 22
9 a.m. ICSC-UBS Weekly Chain Store Sales Snapshot International Council of Shopping
-1.5% n.a. +0.8% +0.8%
for the week ended May 19 Centers and UBS
9 a.m. Johnson Redbook Retail Sales Index for the week
Redbook Research +2.0% n.a. +2.2% +2.5%*
ended May 19, vs. April
Wednesday, May 23
9 a.m. Mortgage Applications Survey for the week ended
-- n.a. -- 675.5
May 18 -- Market Composite Index Mortgage Bankers Association
Purchase Index -- n.a. -- 432.3
9 a.m. Consumer Comfort Index for the week ended
ABC News and Washington Post -- n.a. -- -7
May 20
Thursday, May 24
8:30
a.m. Initial Jobless Claims for the week ended May 19 Labor Department -- +305,000 -- +293,000
Four-week average -- n.a. -- +306,000
8:30 Durable goods orders for April -- +0.9% -- +3.7%
a.m. Ex-transportation Census Bureau
-- n.a. -- +1.5%
10 a.m. New home sales for April Census Bureau -- .860M -- .858M
2:30 Treasury auction announcement The Treasury announces the size of its next monthly two-year note
p.m. Bureau of the Public Debt
auction, next Tuesday.
Friday, May 25
10 a.m. Existing Home Sales for April National Association of Realtors -- 6.10M -- 6.12M
10:30 Weekly Leading Index for the week ended May
Economic Cycle Research Institute -- n.a. -- +6.1%
a.m. 18 29
What variables matter?
Methodology:
1. Exploratory: regressing
returns at t on
informational variables at
t-1
2. ”Correct one”: first
finding economic risk
premia (a la APT) and
then regressing it on
informational variables at
t-1
30
Do informational variables have
predictive ability?
 Info variables:
– January dummy
– Past excess return on Equally
weighted CRSP index
– Spread between 1 and 3 mo T-
bills
– Dividend yield
– Spread between Baa and Aaa
corporate bonds
– 1-mo T-bill rate
31
 Here how it
looks like...
32
Performance & Business Cycle
Average Annual Returns During U.S. Business Cycle Phases
30
20
10
-10
-20
-30
Expansion geometric mean

Data through June 2002 Recession geometric mean
33
Performance & Business Cycle (2)
Average Annual Volatility During U.S. Business Cycle Phases
60
50
40
30
20
10
0
l
a lia stria ium ada ark land nce an y ong and taly pan nds and ay ga pain den and UK US orld US FE
tr u lg n m n a K e I Ja rla eal orw rtu S we erl
l
W ex EA
-
us A Be Ca en Fi Fr erm ng Ir e o S it z
A D G o th w Z N P ld
H e
N Ne Sw or
W
Expansion std.dev. Recession std.dev.
Data through June 2002 34
Performance & Business Cycle (3)
Correlations During U.S. Business Cycle Phases
1
0.8
0.6
0.4
0.2
-0.2
l
a lia stria ium ada ark land nce an y ong and taly pan nds and ay ga pain den land UK US orld US FE
tr u lg n m n a l
K e I Ja rla eal orw rtu S we er -
us A Be Ca en Fi Fr erm ng Ir e o z W ex EA
A D G o th w Z N P S it ld
H e
N Ne Sw or
W
Expansion correlation with US Recession correlation with US
3. Performance & Business Cycle (4)
Covariances During U.S. Business Cycle Phases
45
40
35
30
25
20
15
10
5
0
l
a lia tria ium ada ark land nce any ong and taly pan nds and ay ga pain den an d UK US orld US FE
r s
t u lg n m n a l I Ja erla eal or ort S we zerl
w u -
us A Be Ca en Fi Fr erm ng Ir
K e W ex EA
h Z N P S it
A D G o
H et e w Sw o rld
N N W
Expansion covariance with US Recession covariance with US
How important are global factors?
 Based on Ferson-Harvey RFS95
 Question here is: what is more important, local or global
factors for predictability of asset returns.
 Global Informational variables: : ”old friends”: 1 mo t-bill, div.
Yield on MSCI World index, spread between 10yr and 3 mo T-
bills, Eurodollar/US treasury spread, lagged market return,
January dummy.
 Local informational variables: Country x div. Yield, 30-day t-
bill rate, term spread, lagged MSCI country x market return.
K L
E  Rit Z t 1   0  Z t 1     ij  Z t 1   j  Z t 1    0l Z t 1,l 
j 1 l 1
K
 L  L 
     ijl Z t 1,l    jm Z t 1,m 
j 1  l 1  m 1 
37
So, what
matters?
 ”Global only”
model is already
good enough
 Adding local
factors increases
explanatory power
of the model
38
Changes in b vs changes in risk premium
Var  E  '  Z    E(  ' )Var  E  Z   E(  ) 
E( ' )Var  E  Z   E( )
 Only 2-4% of variation is due to beta’s.
39
Sweden (Robertsson, 2000):
Sweden
bond bill mat def fx irs ey mb irw R2
Market Index –2.05 –1.02 –0.42 3.19 1.26 1.24 0.35 0.01 –6.50 6.1
-1.09 -0.64 -0.62 -2.27 -0.5 -0.58 -0.29 -0.03 -11.5 [0.00]
Small Stocks –2.91 –0.75 1.19 0.65 –0.05 –0.02 –0.67 0.08 –13.6 16.8
-1.27 -0.5 -0.65 -2.17 -0.58 -0.61 -0.34 -0.05 -10 [0.00]
Bond Index –1.18 0.37 0.02 0.7 0.14 0.32 0.1 –0.01 4.19 13.1
-0.32 -0.18 -0.13 -0.56 -0.14 -0.14 -0.08 -0.01 -2.41 [0.00]
40
What about currency risk premium?
 Currency specificiyy: zero-sum game

 Dumas-Solnik: currency risk premia
exists. It is time-varying and predictable
41
Caveats:
 Data snooping
– Foster, Smith and Whaley (98): by choosing to
max R2 via choice of instruments one can get
significance when there is none.
– Not clear how to use as list of instruments already
exists...
 In-sample vs. Out-of-sample validation
42
Caveats(2)
 Statistical biases: autocorrelation,
heteroscedastisity (via Monte-Carlo
simulations).
 Non-normality, excess skewness and kurtosis
43
How to deal with statistical issues?
 Bootstrap methodology:
– Form empirical distribution of returns
– Generate time series of returns (length T).
– Perform the regression of interest
– See how many times there exists significance
on level a.
44
U.S. Risk Premium
Survey Background
 Graham/Harvey: Survey CFOs every quarter
 Q2 2000 through Q4 2003 (15 quarters)
 Current survey attracts about 400 respondents
 Why CFOs?
– We know from previous surveys and interviews that the
CFOs use the risk premium for their capital budgeting
– Hence, they have thought hard about risk premium
– Should not be biased the way that analyst forecasts might
be
45
U.S. Risk Premium
One-Year Premium
 One-year risk premium variable. Currently, about 7%
A. One-year risk premium

8
5
Mean premium
0
Jun., Sept., Dec., Mar., Jun., Sept., Dec., Mar., Jun., Sept., Dec., Mar., Jun., Sept., Dec., 46
Tactical Asset Allocation
00 00 00 01 01 01 01 02 02 02 02 03 03 03 03 12/07/2021
U.S. Risk Premium
Ten-Year Premium
 Ten-year risk premium is stable. Currently, about 3.7%
B. Ten-year risk premium
5
Mean premium
0
Jun., Sept., Dec., Mar., Jun., Sept., Dec., Mar., Jun., Sept., Dec., Mar., Jun., Sept., Dec.,
00 00 00 01 01 01 01 02 02 02 02 03 03 03 03
47
U.S. Risk Premium
Momentum in Expectations for 1-year
Premium
8
7
Mean one-year premium
3 y = 0.1912x + 3.8912
2
R = 0.5242
2
0
-15 -10 -5 0 5 10 15
Excess S&P 500 return in previous two months
48
U.S. Risk Premium
Extreme Returns Cause Disagreement
A. Disagreement over the one-year premium and past returns
2
y = 0.0194x + 0.0247x + 3.3696
2
6 R = 0.5892
Disagreement over the one-year premium
2 y = -0.0614x + 3.9079
R2 = 0.1684
1
0
-15 -10 -5 0 5 10
Past one-month excess S&P 500 return 49
U.S. Risk Premium
Positive Relation Between Disagreement
and Expected 10-year Returns
B. Ten-year premium and disagreement
8
7
Mean ten-year premium
6
5
4
3
2
1 y = 0.9777x + 1.5936
R2 = 0.3165
0
1.5 1.7 1.9 2.1 2.3 2.5 2.7 2.9
Disagreement of ten-year premium forecasts 50
U.S. Risk Premium
Example Confidence Intervals: September 16,
2002 95%
Standard Confidence
Mean deviation Interval Median Min Max Total
Over the next 10 years, I expect the average
annual S&P 500 return will be: There is a 1-in-
10 chance it will be less than: 3.65 2.35 3.40 - 3.89 4 -3 10 351

annual S&P 500 return will be: Expected return: 7.81 2.19 7.58 - 8.03 8 0 15 373

10 chance it will be greater than: 11.5 3.33 11.15 - 11.84 11 4 20 355
Over the next year, I expect the average

10 chance it will be less than: -2.98 6.86 -3.7 - -2.26 0 -20 10 348

annual S&P 500 return will be: Expected return: 4.95 2.78 4.66 - 5.24 5 0 12 345

10 chance it will be greater than: 9.96 4.56 9.47 - 10.44 10 0 20 343
Notes: 10-year bond yield 3.9%; 1-year bill yield 1.6%. Confidence interval based on standard deviation of the mean. 51
Conclusion:
 TAA can be an important tool in asset
allocation methodology.
 It is based on time variation of real
economic risk premia.
 Selection of predictors is important.
 We are still in ”top-down” paradigm.
 Devil is in the details= implementation
matters.
52

Tactical Asset Allocation: Andrei Simonov

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Tactical Asset Allocation

Fama-French (1988). 1927-1986

• May not be sustained out of sample

G-7 output, 1973Q2 to 1996Q2

end. recess beg. expan end. expan beg. recess

Next couple of slides are due to Cam Harvey

Business Cycle 5-Year Yield Spread

Jul-2000 11 Jun-2001 Mar-2001 3

Mar-2001 8 Nov-2001 Nov-2001 0

-2 5-year Both curves -1

-2 5-year Both curves -1

Inflation perceptions. The long-term rate is a combination of

Strong buying of long-term bonds by foreigners. For the past

Hedge funds. There has been a recent increase in demand for

Demographic forces. As the population ages, more money is

Inflation risk. The long-rate rates contain expected inflation,

Expansion geometric mean

 Only 2-4% of variation is due to beta’s.

 Currency specificiyy: zero-sum game

A. One-year risk premium

B. Ten-year risk premium

Over the next 10 years, I expect the average

Over the next 10 years, I expect the average

Over the next year, I expect the average

Over the next year, I expect the average

Over the next year, I expect the average

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