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Tactical Asset Allocation session 5

Tactical Asset Allocation session 5. Andrei Simonov. 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

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Tactical Asset Allocation session 5

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  1. Tactical Asset Allocation session 5 Andrei Simonov Tactical Asset Allocation

  2. 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. Tactical Asset Allocation

  3. 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? Tactical Asset Allocation

  4. Conditioning Information and Portfolio Analysis Er Add conditioning information and weights change through time. Frontier shifts. Vol Tactical Asset Allocation

  5. Optimal portfolio for risk-averse investor Tactical Asset Allocation

  6. 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) Tactical Asset Allocation

  7. 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. Tactical Asset Allocation

  8. 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 ). Tactical Asset Allocation

  9. Example: dividend yield • May not be sustained out of sample Tactical Asset Allocation

  10. Risk and return over the business cycle Tactical Asset Allocation

  11. 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. Tactical Asset Allocation

  12. Exhibit 1 Next couple of slides are due to Cam Harvey Tactical Asset Allocation

  13. Exhibit 2 Tactical Asset Allocation

  14. 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 or Yield Curve % % Real annual GDP growth Yield curve Recent flattening Recession Correct Recession Correct Yield curve accurate in recent recession Recession Correct 2 Recessions Correct Data though April 11, 2006 Tactical Asset Allocation

  15. Yield Curve Inverts Before Last Six Recessions(5-year Treasury note minus 3-month Treasury bill yield – constant maturity) Annual GDP growth or Yield Curve % % Real annual GDP growth Source: Campbell R. Harvey. Yield curve Recent flattening Recession Correct Recession Correct Yield curve accurate in recent recession Recession Correct 2 Recessions Correct Data though April 11, 2006 Tactical Asset Allocation

  16. Recent Annualized One-Quarter GDP Growth (10-year and 5-year Yield Curves-secondary market) Annualized 1-quarter GDP growth Yield curve 10-year % Real annualized one-quarter GDP growth 5-year Both curves invert 2000Q3 Data though April 11, 2006 Tactical Asset Allocation

  17. Recent Annualized One-Quarter GDP Growth (10-year and 5-year Yield Curves-constant maturity) Annualized 1-quarter GDP growth Yield curve 10-year % Real annualized one-quarter GDP growth 5-year Both curves invert 2000Q3 Data though April 2006 Tactical Asset Allocation

  18. What shall we expect now? Tactical Asset Allocation

  19. May 2007: Practically flat Tactical Asset Allocation

  20. August 2007 Tactical Asset Allocation

  21. 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. Tactical Asset Allocation

  22. 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. Tactical Asset Allocation

  23. 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. Tactical Asset Allocation

  24. 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. Tactical Asset Allocation

  25. 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. Tactical Asset Allocation

  26. Annual Real Economic Growth After Yield Curve Inversions Tactical Asset Allocation

  27. Stock Returns and U.S. Yield Curve Average Monthly Returns in % Data through November 2000 Tactical Asset Allocation

  28. Average Monthly Stock Returns After Yield Curve Inversions Equally weighted Value weighted Based on 19 countries. Tactical Asset Allocation

  29. Trader’s calendar (from thestreet.com) Tactical Asset Allocation

  30. What variables matter? Methodology: • Exploratory: regressing returns at t on informational variables at t-1 • ”Correct one”: first finding economic risk premia (a la APT) and then regressing it on informational variables at t-1 Tactical Asset Allocation

  31. 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 Yes!!! Tactical Asset Allocation

  32. Here how it looks like... Tactical Asset Allocation

  33. Performance & Business Cycle Data through June 2002 Tactical Asset Allocation

  34. Performance & Business Cycle (2) Data through June 2002 Tactical Asset Allocation

  35. Performance & Business Cycle (3) Data through June 2002 Tactical Asset Allocation

  36. 3. Performance & Business Cycle (4) Data through June 2002 Tactical Asset Allocation

  37. 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. Tactical Asset Allocation

  38. So, what matters? • ”Global only” model is already good enough • Adding local factors increases explanatory power of the model Tactical Asset Allocation

  39. Changes in b vs changes in risk premium • Only 2-4% of variation is due to beta’s. Tactical Asset Allocation

  40. Sweden (Robertsson, 2000): Tactical Asset Allocation

  41. What about currency risk premium? • Currency specificiyy: zero-sum game • Dumas-Solnik: currency risk premia exists. It is time-varying and predictable Tactical Asset Allocation

  42. 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 Tactical Asset Allocation

  43. Caveats(2) • Statistical biases: autocorrelation, heteroscedastisity (via Monte-Carlo simulations). • Non-normality, excess skewness and kurtosis Tactical Asset Allocation

  44. 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. Tactical Asset Allocation

  45. U.S. Risk PremiumSurvey 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 Tactical Asset Allocation

  46. U.S. Risk PremiumOne-Year Premium • One-year risk premium variable. Currently, about 7% Tactical Asset Allocation

  47. U.S. Risk PremiumTen-Year Premium • Ten-year risk premium is stable. Currently, about 3.7% Tactical Asset Allocation

  48. U.S. Risk PremiumMomentum in Expectations for 1-year Premium Tactical Asset Allocation

  49. U.S. Risk PremiumExtreme Returns Cause Disagreement Tactical Asset Allocation

  50. U.S. Risk PremiumPositive Relation Between Disagreement and Expected 10-year Returns Tactical Asset Allocation

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