It Was the Worst of Times: Diversification During a Century of Drawdowns

AQR, September 26th 2018

Abstract

Big equity drawdowns happen time and again and tend to drag down typical investor portfolios with them. Unfortunately, attempting to tactically avoid the next equity sell-off is likely to disappoint investors. This article uses nearly 100 years of data to evaluate the effectiveness of diversifying investments during the worst of times for most portfolios. We analyze the potential benefits and costs of shifting away from equities, including into investments that are diversifying (i.e., lowly correlated) and investments that are defensive (i.e., expected to outperform in bad times). With regard to the latter, we observe an intuitive trade-off: investments with better hedging characteristics tend to do worse on average. Investors should evaluate this trade-off in deciding how—and how much—to diversify their exposure to equity drawdowns.

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Noah Schwartz CFP
The Perils of Owning Individual Stocks

Larry Swedroe, Director of Research BAM Alliance, ETF.com, June 2017

Abstract

Individual stock ownership offers both the hope of great returns (finding the next Google, for instance) and the potential for disastrous results (ending up with the next Lehman).

Because investors are not compensated for taking the risk that their result will be the disastrous one—the market doesn’t compensate investors with higher expected returns for taking risks that are easily diversified away—the rational strategy is not to buy individual stocks.

Unfortunately, the evidence is that the average investor, while being risk averse, doesn’t act that way. In a triumph of hope over wisdom and experience, investors fail to diversify.

Given the obvious benefits of diversification, the question is,  why don’t investors hold highly diversified portfolios? One reason is that it’s likely most investors don’t understand just how risky individual stocks are. To correct that lack of knowledge, we’ll review the literature. I’m confident most investors would be shocked at the data on individual stock returns.

 

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Noah Schwartz CFP
Managed Futures and Asset Allocation

Peng Chen, Ph.D., CFA, Christopher O’Neill, Ph.D., CFA, CFP®, Kevin Zhu, Ph.D., Ibbotson Associates, February 2005

Abstract

We study the role of managed futures in long-term asset allocation portfolios. We begin by determining whether managed futures returns can be replicated through investing in broadly diversified stock and bond indices. Next, we investigate whether adding managed futures funds improves the risk-return tradeoff for long-term asset allocation portfolios. The results suggest that managed futures funds offer distinct risk and return characteristics to investors that are not easily replicated through investing in traditional stocks and bonds. Including managed futures also improves the risk-return tradeoff of the long-term asset allocation portfolios we consider, thus benefiting long-term investors. Our scenario analysis on interest rate environments indicates that managed futures exhibit superior performance during periods in which most traditional asset classes underperform. Overall, the results suggest that the managed futures funds benefit long-term investors, particularly in rising interest rate environments.

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Noah Schwartz CFP
A Review of the Empirical Evidence on the Dimensions of Expected Stock Returns

Wei Dai , DFA Research, August 2015

Abstract

There is a vast literature that documents the empirical evidence on the cross-section of average stock returns, and a large number of variables have been linked to expected returns [e.g., Harvey, Liu, and Zhu (2013) catalogue 315 factors for asset returns]. Since it is impossible to review every existing study, we attempt to cover
topics that are related to identifying differences in the cross-section of expected returns. Campbell (2000) and Davis (2001) provide discussions of the work done in the second half of the 20th century, and this survey focuses more on the work done since then.
We start by updating some of the classic themes, such as CAPM, size, relative price, and momentum, with more recent evidence. We then move on to newer topics that have emerged in recent years, which include profitability, investment, net share issues, volatility, and liquidity. We include a brief discussion of mutual fund performance studies and conclude with some practical implications.

 

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Noah Schwartz CFP
Putting a Value on Value: Quantifying Advisor's Alpha (Vanguard)

Francis M. Kinniry Jr., CFA, Colleen M. Jaconetti, CPA, CFP ®, Michael A. DiJoseph, CFA, Yan Zilbering, and Donald G. Bennyhoff, CFA, Vanguard Research, September 2016

Abstract

This updated research paper delves into the concept of Vanguard Advisor's Alpha®, which outlines how advisors can add value, or alpha, through relationship-based services such as financial planning, discipline, and guidance, rather than market outperformance.

The paper includes seven "quantification modules" summarizing key wealth-management best practices and providing a reasonable framework for describing and further differentiating your value proposition.

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Noah Schwartz CFP
A Century of Evidence on Trend-Following Investing

Brian K. Hurst, Yao Hua Ooi, Lasse H. Pedersen; Journal of Derivatives, November 1, 2017

 

Abstract

This paper seeks to establish whether the strong performance of trend following is a statistical fluke of the last few decades or a more robust phenomenon that exists over a wide range of economic conditions. Using historical data from a number of sources, we construct a time series momentum strategy back to 1880 and find that the strategy was consistently profitable over the next 110 years.

The data also provide context for evaluating a more recent period for the strategy. We consider the effect of increased assets in the strategy as well as the increased correlations across markets since the credit crisis. We also review a number of developments that are potentially favorable for the strategy going forward.

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Noah Schwartz CFP
From Efficient Market Theory to Behavioral Finance

Shiller, Robert J., From Efficient Market Theory to Behavioral Finance (October 2002). Cowles Foundation Discussion Paper No. 1385.

Abstract

The efficient markets theory reached the height of its dominance in academic circles around the 1970s. Faith in this theory was eroded by a succession of discoveries of anomalies, many in the 1980s, and of evidence of excess volatility of returns. Finance literature in this decade and after suggests a more nuanced view of the value of the efficient markets theory, and, starting in the 1990s, a blossoming of research on behavioral finance. Some important developments in the 1990s and recently include feedback theories, models of the interaction of smart money with ordinary investors, and evidence on obstacles to smart money.

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Noah Schwartz CFP
Absolute Momentum: A Simple Rule-Based Strategy and Universal Trend-Following Overlay

Antonacci, Gary, Absolute Momentum: A Simple Rule-Based Strategy and Universal Trend-Following Overlay (April 2013).

Abstract

There is a considerable body of research on relative strength price momentum but much less on absolute momentum, also known as time series momentum. In this paper, we explore the practical side of absolute momentum. We first explore its sole parameter - the formation, or look back, period. We then examine the reward, risk, and correlation characteristics of absolute momentum applied to stocks, bonds, and real assets. We finally apply absolute momentum to a 60/40 stock/bond portfolio and a simple risk parity portfolio. We show that absolute momentum can effectively identify regime change and add significant value as an easy-to-implement, rule-based approach with many potential uses as both a stand-alone program and trend-following overlay.

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Noah Schwartz CFP
Risk Premia Harvesting Through Dual Momentum

Antonacci, Gary, Risk Premia Harvesting Through Dual Momentum (October 1, 2016). Journal of Management & Entrepreneurship, vol.2, no.1 (Mar 2017), 27-55.

Abstract

Momentum is the premier market anomaly. It is nearly universal in its applicability. This paper examines multi-asset momentum with respect to what can make it most effective for momentum investors. We show that both absolute and relative momentum can enhance returns, but that absolute momentum does far more to lessen volatility and drawdown. We see that combining absolute and relative momentum gives the best results.

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Noah Schwartz CFP
Market Efficiency, Long-Term Returns, and Behavioral Finance

Fama, Eugene F., Market Efficiency, Long-Term Returns, and Behavioral Finance (February 1997).

Abstract

Market efficiency survives the challenge from the literature on long-term return anomalies. Consistent with the market efficiency hypothesis that the anomalies are chance results, apparent over-reaction to information is about as common as under-reaction. And post-event continuation of pre-event abnormal returns is about as frequent as post-event reversal. Consistent with the market efficiency prediction that apparent anomalies can also be due to methodology, the anomalies are sensitive to the techniques used to measure them, and many disappear with reasonable changes in technique.

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Noah Schwartz CFP
Momentum

Jegadeesh, Narasimhan and Titman, Sheridan, Momentum (October 23, 2001). University Of Illinois Working Paper. 

Abstract

There is substantial evidence that indicates that stocks that perform the best (worst) over a three- to 12-month period tend to continue to perform well (poorly) over the subsequent three to 12 months. Momentum trading strategies that exploit this phenomenon have been consistently profitable in the United States and in most developed markets. Similarly, stocks with high earnings momentum outperform stocks with low earnings momentum. This article reviews the evidence of price and earnings momentum and the potential explanations for the momentum effect.

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Noah Schwartz CFP
Time Series Momentum

Moskowitz, Tobias J. and Ooi, Yao Hua and Pedersen, Lasse Heje, Time Series Momentum (September 1, 2011). Chicago Booth Research Paper No. 12-21; Fama-Miller Working Paper. 

Abstract

We document significant “time series momentum” in equity index, currency, commodity, and bond futures for each of the 58 liquid instruments we consider. We find persistence in returns for 1 to 12 months that partially reverses over longer horizons, consistent with sentiment theories of initial under-reaction and delayed over-reaction. A diversified portfolio of time series momentum strategies across all asset classes delivers substantial abnormal returns with little exposure to standard asset pricing factors and performs best during extreme markets. Examining the trading activities of speculators and hedgers, we find that speculators profit from time series momentum at the expense of hedgers.

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Noah Schwartz CFP
Fact, Fiction and Momentum Investing

Asness, Clifford S. and Frazzini, Andrea and Israel, Ronen and Moskowitz, Tobias J., Fact, Fiction and Momentum Investing (May 9, 2014). Journal of Portfolio Management, Fall 2014 (40th Anniversary Issue); Fama-Miller Working Paper. 

Abstract

It’s been over 20 years since the academic discovery of momentum investing (Jegadeesh and Titman (1993), Asness (1994)), yet much confusion and debate remains regarding its efficacy and its use as a practical investment tool. In some cases “confusion and debate” is us attempting to be polite, as it is near impossible for informed practitioners and academics to still believe some of the myths uttered about momentum — but that impossibility is often belied by real world statements. In this article, we aim to clear up much of the confusion by documenting what we know about momentum and disproving many of the often-repeated myths. We highlight ten myths about momentum and refute them, using results from widely circulated academic papers and analysis from the simplest and best publicly available data.

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Noah Schwartz CFP
Value and Momentum Everywhere

Asness, Clifford S. and Moskowitz, Tobias J. and Pedersen, Lasse Heje, Value and Momentum Everywhere (June 1, 2012). Chicago Booth Research Paper No. 12-53; Fama-Miller Working Paper.  

Abstract

We study the returns to value and momentum strategies jointly across eight diverse markets and assetclasses. Finding consistent value and momentum premia in every asset class, we further find strong common factor structure among their returns. Value and momentum are more positively correlated across assetclasses than passive exposures to the asset classes themselves. However, value and momentum are negatively correlated both within and across asset classes. Our results indicate the presence of common global risks that we characterize with a three factor model. Global funding liquidity risk is a partial source of these patterns, which are identifiable only when examining value and momentum simultaneously across markets. Our findings present a challenge to existing behavioral, institutional, and rational asset pricing theories that largely focus on U.S. equities.

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Noah Schwartz CFP
A Quantitative Approach to Tactical Asset Allocation

Faber, Meb, A Quantitative Approach to Tactical Asset Allocation (February 1, 2013). The Journal of Wealth Management, Spring 2007 

 

Abstract

In this paper we update our 2006 white paper “A Quantitative Approach to Tactical Asset Allocation” with new data from the 2008-2012 period. How well did the purpose of the original paper – to present a simple quantitative method that improves the risk-adjusted returns across various asset classes – hold up since publication? Overall, we find that the models have performed well in real-time, achieving equity like returns with bond like volatility and drawdowns. We also examine the effects of departures from the original system including adding more asset classes, introducing various portfolio allocations, and implementing alternative cash management strategies.

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Noah Schwartz CFP
Global Portfolio Diversification for Long-Horizon Investors

Harvard Business School Finance Working Paper No. 17-085

Luis M. Viceira, Harvard Business School - Finance Unit; National Bureau of Economic Research (NBER), Zixuan (Kevin) Wang, Harvard Business School, John Zhou Harvard University

Date Written: March 2017

Abstract

This paper conducts a theoretical and empirical investigation of the risks of globally diversified portfolios of stocks and bonds and of optimal intertemporal global portfolio choice for long horizon investors in the presence of permanent cash flow shocks and transitory discount rate shocks to asset values. We show that an upward shift in cross-country one-period return correlations resulting from correlated cash flow shocks increases the risk of global portfolios and reduces investors' willingness to hold risky assets at all horizons. However, a similar upward shift in cross-country one-period return correlations resulting from correlated discount rate shocks has a much more muted effect on long-run portfolio risk and on the willingness to long horizon investors to hold risky assets. Correlated cash flow shocks imply that markets tend to move together at all horizons, thus reducing the scope for global diversification for all investors regardless of their investment horizon. By contrast, correlated discount rate shocks imply that markets tend to move together only transitorily and long-horizon investors can still benefit from global portfolios to diversify long-term cash flow risk. We document a secular increase in the cross-country correlations of stock and government bond returns since the late 1990's. We show that for global equities this increase has been driven primarily by increased cross-country correlations of discount rate shocks, or global capital markets integration, while for bonds it has been driven by both global capital markets integration and increased cross-country correlations of inflation shocks that determine the real cash flows of nominal government bonds. Therefore, despite the significant increase in the short-run correlation of global equity markets, the benefits from global equity portfolio diversification have not declined nearly as much for long-horizon investors as they have for short-horizon investors. By contrast, increased correlation of inflation across markets implies that the benefits of global bond portfolio diversification have declined for long-only bond investors at all horizons. However, it also means that the scope for hedging liabilities using global bonds has increased, benefiting investors with long-dated liabilities. Finally, we show that the well documented negative stock-bond correlation in the U.S. since the late 1990's is a global phenomenon, suggesting that the benefits of stock-bond diversification have increased in all developed markets.

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Noah Schwartz CFP
Common risk factors in the returns on stocks and bonds

Eugene F.Fama Kenneth R.French, Journal of Financial Economics Volume 33, Issue 1, February 1993, Pages 3-56

Abstract

This paper identifies five common risk factors in the returns on stocks and bonds. There are three stock-market factors: an overall market factor and factors related to firm size and book-to-market equity. There are two bond-market factors, related to maturity and default risks. Stock returns have shared variation due to the stock-market factors, and they are linked to bond returns through shared variation in the bond-market factors. Except for low-grade corporates, the bond-market factors capture the common variation in bond returns. Most important, the five factors seem to explain average returns on stocks and bonds.

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Noah Schwartz CFP
Return to Buying Winners and Selling Losers: Implications for Stock Market Efficiency

Jegadeesh and Titman

This paper documents that strategies that buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over three- to twelve-month holding periods. The authors find that the profitability of these strategies are not due to their systematic risk or to delay ed stock price reactions to common factors. However, part of the abnormal returns generated in the first year after portfolio formation dissipates in the following two years. A similar pattern of returns around the earnings announcements of past winners and losers is also documented.

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Noah Schwartz CFP
Reflections on the Efficient Market Hypothesis: 30 Years Later

Malkiel, Burton G. G., "Reflections on the Efficient Market Hypothesis: 30 Years Later." Financial Review, Vol. 40, No. 1, February 2005.

Abstract: The evidence is overwhelming that active equity management is, in the words of Ellis (1998), a "loser's game." Switching from security to security accomplishes nothing but to increase transactions costs and harm performance. Thus, even if markets are less than fully efficient, indexing is likely to produce higher rates of return than active portfolio management. The most successful modern-day investor, Warren Buffett, sums up the advice in this paper with characteristic wisdom: "Most investors, both institutional and individual, will find that the best way to own common stocks ... is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals."

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Noah Schwartz CFP
Asset Allocation: Management Style and Performance Measurement, An Asset class factor model can help make order out of chaos. Journal of Portfolio Management, Winter 1992, pp. 7-19

In a study by Nobel Laureate William F. Sharpe, an asset class factor model can help make order out of chaos, the following conclusions were stated. The graph and description are taken directly from the online version of the article.

"Figure 18 below shows the distribution of the average tracking errors obtained from the style analyses of 636 stock, bond and balanced funds. Each value is the average error term value obtained from a style analysis using returns for one fund covering the period from January 1985 through December 1989. Note that the distribution is roughly normal, with a mean of -0.074 (-7.4 basis points per month). This is roughly consistent with the hypothesis that the average mutual fund cannot "beat the market" before costs, because such funds constitute a large (and presumably representative) part of the market. Annualized, the mean underperformance is approximately 0.89% per year -- an amount that, if anything, may be slightly less than the non-transaction costs incurred by a typical mutual fund."

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Noah Schwartz CFP