Unexpected Returns Version 1a


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  • Today we are covering the most impact full ideas I have discovered since taking a closer look at asset allocation following the mkt downturns in the fall of ’08 and this past spring. We are going to look at 1)theory and strategy, 2)fat tails and fractals, 3) a secular market perspective and then I’ll show you the opportunities available to improve and protect a typical moderate aggressive strategic allocation portfolio of 70% equities and 30% debt.
  • 3 The first rationale theory tied to the bell curve and market efficiency originated in 1900 in a paper called Theory of Speculation by Louis Bachelier. The paper analyzed changes in French bonds and was not considered to be a monumental work but it did receive “honorable mention” by the University of Paris. Little did Bachelier know that his theory on uncertainty would be picked up 52 yrs later by Harry Markowitz in his paper on Security Selection and Modern Portfolio Theory. Later Bachelier’s theory on probability, chance, and “fair game” would be resurrected in 1956 by MIT student Paul A. Samuelson in his thesis on option pricing. Sharpe then developed the Equilibrium Theory and CAPM. Then came Eugene Fama with his theories on the random walk of securities and the inclusion of information into security prices. Later came Fischer Black and Merton Scholes with their landmark theory on pricing options. Much of this work with the exception of Black & Scholes, has culminated in popular models and applications such as strategic asset allocation where as we know the primary risk and return focus is std dev and relative returns. From the book Unexpected Returns, Ed Easterling does a masterful job of describing SAA as a sailing approach to investing which does well during secular bull markets.
  • 3 The main industry dialogue is the controversy surrounding CAPM, MPT and Strategic Asset Allocation derived from the harsh reality that the theory and strategy have been turned on it’s head as a consequence of market meltdowns and what some are identifying as a secular bear in equities that started in 2000. For example, our moderate plus clients with an expected time horizon of 10 years have experienced lower returns and much higher risk compared to their more conservative peers.
  • 3 For advisors, the primary discourse today lies in the dilemma caused by an increase in correlations across asset classes during the equity market meltdowns of ’08 and ‘09. While it is true that alternatives do act like good diversifiers and reduce standard deviation over long holding periods, the reality is they proved to be of no help in the fall of ’08 when all asset classes moved down in tandem. As you can see the largest int’l bond, precious metals, bond and commodities funds had enormous spikes in their 12 month correlations. We’ll see later how Sallie Krawcheck head of BOA/Merrill’s advisors succinctly frames the new asset allocation paradigm which get’s to the heart of the correlation and drawdown issue.
  • 3 While it may be commonly thought that treasuries would be a safe haven when equities experience drawdowns of 10% or more, these stats prove otherwise. The reality is that using a 12 mo equity/treasury correlation trigger of zero and 0.20 or below for 36 mo correlations then since ’26 you would have been wrong 38% and 42% of the time respectively for draw downs of 10% or more.
  • 3 Watson Wyatt recently re-defined risk management. They now believe risk mgmt must identify risks beyond normal distributions and 2 std deviations.
  • More on the current state of asset allocation…here’s Ren Cheng, the developer and former CIO of the Fidelity Freedom funds cracking open MPT, the bell curve and emphasizing that fat tails now need to be considered more often than previously… Lynette DeWitt, research director of subadvisory markets and lifecycle funds for Financial Research Corporation (FRC) comments here on the fate of target-date funds…
  • 3 David Blitzer from S&P comments here on the disconnect of the normal distribution bell curve and investment results during the financial crisis. Next we are going to look at theories derived from observation or what David Blitzer defines as “reality.”
  • 3 After the carnage of the market meltdown, I decided to take a hard look at strategic asset allocation. I discovered that there is a wealth of “irrational” theories out there that are at the heart of some very successful market timing, trend following and hedge strategies. One of the oldest is the Elliott Wave Principle which was developed by Ralph N. Elliott in the late 30s who discovered through observation while studying the Dow that equity prices move in a repetitious pattern with “comprehensive exactitude.” Later on Benoit Mandelbrot who began studying income changes while working at IBM came across price data on cotton and observed that changes in cotton prices follow an imitation pattern much like the patterns found in nature. He also discovered that security price changes that fall outside of the traditional 2 std dev bell curve can be quite large and can have a devasting impact on a portfolio. Eventually Mandelbrot developed Fractal Geometry and the term Fat Tails was coined. Behavioral Economics was first developed in the 70s with 2 theories developed from observations that investors react more to price and direction irrespective of fundamentals and investors consider losses to be more painful than gains of equal nominal amounts. Then in ’78, Robert Prechter, a market technician using the Elliott Wave Principle, started making equity market calls that led to a super cycle bull market call just before the ’82 secular bull began. Prechter has since theorized that changes in equity prices proceed changes in social moods with his theory of Socionomics. All these theories can be found in use in one form or another among the following strategies of market timing/technical analysis, trend following, tactical asset allocation and hedging. All these strategies which aim to protect or mitigate drawdowns and loss of principal fall into what Easterling defines as a rowing approach to investing which are appropriate during secular bear markets.
  • These 4 books have had the most influence on my investment perspective with respect to fat tail risk. The first one written by former MIT professor Charles Kindleberger provides detail on what happens when a mania, panic, and crash occurs all of which mirrors the run-up in equities thru 2000 and then thru ’07 and it’s subsequent downturn. The second one was written by U. of Maryland professor, Carmen Reinhart and Harvard professor, Ken Rogoff. It does what Kindleberger’s does but in addition to narrative it also supplies the numbers surrounding financial crisis’. The third one written by Yale professor Benoit Mandelbrot centers on the fundamental risks associated with Modern Portfolio Theory and the use of the bell curve in financial modeling and engineering. The last one relates to the problems associated with humans when it comes to protecting ourselves against what Taleb defines as a black swan or an unforeseen event. The sales rank is indicated to highlight how widely read the subject of financial risk has become among readers.
  • Here is what professor Kindleberger discovered…
  • While much of the narrative on financial crises found in the Reinhart & Rogoff book is similar to what professor Kindleberger details in his book…Reinhart & Rogoff back-up their narratives with cold hard data across both developed and emerging economies. Here are 3 main points to recognize.
  • Professor Mandelbrot discovered… His main point is… “ We have been mis-measuring risk.” “ The odds of financial ruin in a free, global-market economy have been grossly underestimated.” “ The deepest and most realistic finance book ever published.” Nassim Nicholas Taleb on B. Mandelbrot’s The Misbehavior of Markets
  • RN Elliott discovered a 5 wave followed by 3 wave fractal with 11 alternative patterns in observing changes in the Dow. Considered to be the granddaddy of technical analysis, the most recent completion of a triple zig zag from the March lows is said to be the completion of wave 2 up. Wave 3 down according to the EWI people will be of historic proportions.
  • Taleb defines Black Swans in his widely regarded book on risk… He outlines how humans suffer from…
  • I find that these definitions on secular market cycles are as good as any.
  • In July ’09, I started to explore whether others believed we were in a Secular Bear Market. Here are some notable views. More than anything else I believe it is profound to see that all of these market participants have a technical and secular viewpoint. Note: Elliott Wave International accurately predicted the start of a secular bear 10 years ago.
  • Using a moderate aggressive allocation example of 70% equities and 30% debt, we’ll now look at how we can utilize some simple allocation approaches to guard against primary and secular bear mkts and to add alpha during bull mkts.
  • There’s plenty of existing research on how to enhance strategic asset allocation performance…however I’ve identified what I think are the best papers and factors to enhance performance. The 1 st set of papers are focused on improving performance by avoiding losses. The 1 st paper identifies the 10 month moving avg of the S&P 500 as the premier trend following factor to identify a change in a primary market cycle. We already know about the VIX however the other CBOE index that is used as a contrarian factor for measuring market extremes is the Put/Call Ratio. This factor is used typically as a secondary factor for making market timing decisions. The 2 nd set of papers focus on adding alpha. The 1 st paper identifies the real fed funds rate as a factor that can be used to overweight small/mid caps. This factor is attributable to the “Don’t Fight The Fed” rationale that was coined by Marty Zweig many years ago when he wrote his best selling book Winning on Wall Street. The book Style Investing written by the former CIO of Merrill Lynch outlines a growth value approach to equity investing. In addition to the book on style investing I discovered a paper which details how earnings growth mirrors equity returns and supports the use of “Growth At A Reasonable Price” or what is called GARP. The last paper supports using GDP for making country allocation decisions.
  • To measure the effectiveness of these factors in a portfolio I compared tactical allocations within a 70% equity 30% debt strategy against a strategic allocation of 70/30. For all the factors, the tactical allocations to equities was capped at 70%. What I found most appealing was the loss avoidance factors increased returns but also reduced risk and increased sharpe while the alpha factors enhanced return with small increases in risk.
  • While dynamic asset allocation is commonly confused with tactical, for our purposes I will consider an example of our current strategic approach with small and tactical adjustments.
  • Specifically, the dynamic example shifts 15% from equities to debt when all 3 loss avoidance factors are triggered. Outlined in chapter 10 of Unexpected Returns, Professor Easterling details how the need to become defensive during market downturns and describes the asset allocation approach during this period as a rowing approach.
  • Here’s a more granular view in which the allocation becomes defensive when the 3 rowing factors are triggered and then becomes more opportunistic when the one sailing factor, the real fed funds rate, turns negative. So when the rowing triggers are off and the real fed funds rate turns negative the small/mid cap allocation is increased from 10% to 20%. The rationale behind a lower strategic allocation to small/mid cap is to improve risk adjusted returns…historically the modest increase in return with small/mid caps is not supported by the increase in standard deviation…large caps simply have better risk adjusted returns.
  • Utilizing both rowing and sailing factors…below is the variation among a dynamic, strategic and 100% equities allocation over a period which includes a secular bull mkt thru July 2000 and a subsequent bear since. With a focus on ending wealth value and mitigating loss…you’ll notice the benefit of the dynamic portfolio over pure strategic and an all equity portfolio is substantial. Additionally you’ll notice significant improvements in the return and sharpe.
  • The dynamic portfolio outperformed strategic in this bull period by over 117 bps.
  • And as expected dynamic outperforms strategic in the bear period by 178 bps.
  • Here are the rolling return comparisons…
  • The key to maintaining a high Morningstar rating is primarily protecting to the downside and secondarily capturing the upside.
  • Sallie Krawcheck head of the BOA/Merrill retail brokerage sales force sets the bar for how her advisors and clients will now approach asset allocation…I thought it was interesting that she identified both standard deviation, the primary risk of strategic asset allocation and draw downs, the primary risk associated with dynamic and tactical asset allocation as part of the asset allocation equation.
  • Here we have the heads of distribution at the 4 largest broker-dealers recently spelling out what their advisors want. Followed by Strategic Insight’s summary of what product innovation means.
  • Unexpected Returns Version 1a

    1. 1. Unexpected Returns <ul><li>Theory & Strategy </li></ul><ul><li>Fat Tails & Fractals </li></ul><ul><li>Secular Stock Market Cycles </li></ul><ul><li>Opportunities </li></ul>
    2. 2. Theory & Strategy <ul><li>“ Rationale” Theories </li></ul><ul><ul><li>L. Bachelier, Theory of Speculation, 1900 </li></ul></ul><ul><ul><li>H. Markowitz, Security Selection and Modern Portfolio Theory, ’52 (Nobel ’90) </li></ul></ul><ul><ul><li>P.A. Samuelson, Fair Game Theory, ’56 </li></ul></ul><ul><ul><li>W.F. Sharpe, Equilibrium Theory and CAPM, ’64 (Nobel ’90) </li></ul></ul><ul><ul><li>E. F. Fama, Random Walk Theory, ‘65 </li></ul></ul><ul><ul><li>E. F. Fama, Efficient Market Theory, ‘69 </li></ul></ul><ul><ul><li>F. Black, M. Scholes, Option Pricing, ’73 (Nobel ’97) </li></ul></ul><ul><li>Strategies </li></ul><ul><ul><li>Strategic Asset Allocation (SAA) </li></ul></ul><ul><ul><ul><li>Risk Measurement: Std Deviation </li></ul></ul></ul><ul><ul><ul><li>Return Emphasis: Relative Returns </li></ul></ul></ul><ul><ul><li>“ Sailing” - Crestmont Research, Unexpected Returns, Chapter 10 , ‘07 </li></ul></ul>
    3. 3. CAPM/MPT/Strategic AA…Turned On It’s Head <ul><li>10 Yr Period Ending Aug ’09 </li></ul>
    4. 4. Strategic AA Confusion <ul><li>Jan ’73 – Dec ‘08 </li></ul><ul><ul><li>International Debt, Gold, Domestic Debt, and Commodities are the best diversifiers over long periods… </li></ul></ul><ul><li>Sept, Oct, Nov ‘08 </li></ul><ul><ul><li>However they failed to provide diversification benefits in the fall of ‘08… </li></ul></ul>
    5. 5. The Volatility of Equity/Treasury Correlations <ul><li>Jan ’ 26 – Aug ‘09 </li></ul>
    6. 6. Risk Management Redefined <ul><li>Watson Wyatt- </li></ul><ul><li>“ The events of the last two years have demonstrated that risk management cannot stop at the 95 th percentile. We need to find a way to include very unlikely, but potentially high impact, events.” </li></ul><ul><li>“ We believe the recent crisis has shown that risk management based solely on volatility is not sufficient.” </li></ul><ul><ul><li>Source: “ Extreme Risks ” – Watson Wyatt, Nov‘09 </li></ul></ul>
    7. 7. Modern Portfolio Theory, Fat Tails & Strategic AA Financial Research Corp Conference, Nov ‘09 <ul><li>R. Cheng, Former CIO, Founder, Fidelity Freedom Funds- </li></ul><ul><ul><li>&quot;One fundamental mistake our industry is committing is that we love the clean, nice theory too much.“ </li></ul></ul><ul><ul><li>&quot;Something with less chance of happening than 50 times the age of the universe happened three days in a row, or maybe there is a better explanation?&quot; Cheng said. &quot;Your theory sucks.“ </li></ul></ul><ul><ul><li>&quot;We should see a higher frequency of what we used to call extreme events -- it's here to stay.&quot; </li></ul></ul><ul><li>L. DeWitt, Director – Research, Subadvisory Mkts & Lifecycle Fds, FRC- </li></ul><ul><ul><li>“ Based on our recent experience with target-date fund product marketing, performance and the volatile market, I project that target-date funds will not make it through another bear market.” </li></ul></ul><ul><ul><li>“ And... target-date funds may prove to be not the golden egg, but turn into the rotten egg instead for asset managers to be the catalyst for change that restructures the distribution of mutual funds through retirement plans.” </li></ul></ul>
    8. 8. Modern Portfolio Theory & Fat Tails <ul><li>David Blitzer, Chief Economist, S&P- </li></ul><ul><li>“ In that particular trade-off between solving the problem and assuring that the answer can be applied to reality, solving won out. We would have been better off if the answer were only approximately right but was truly applicable, instead of more accurate but not very useful.” </li></ul><ul><li>“ The normal distribution doesn’t work for markets—the volatility experienced in the last year should not have occurred were the market obeying a normal distribution.” </li></ul><ul><ul><li>Source: “ Another Victim of the Financial Crisis…” - Journal of Indexes, Nov/Dec ‘09 </li></ul></ul>
    9. 9. Theory & Strategy <ul><li>“ Irrational” Theories </li></ul><ul><ul><li>R.N. Elliott, The Elliott Wave Principle, ’38 </li></ul></ul><ul><ul><li>B. Mandelbrot, Fractal Geometry & Fat Tails, ’51 onward </li></ul></ul><ul><ul><li>D. Kahneman & A. Tversky, Cognitive Bias Theory, & Herding, ’72 (Nobel ’02) </li></ul></ul><ul><ul><li>R. Prechter, Elliott Wave Theorist, ‘78 </li></ul></ul><ul><ul><li>D. Kahneman & A. Tversky, Prospect Theory, & Loss Avoidance, ’79 (Nobel ’02) </li></ul></ul><ul><ul><li>R. Prechter, Socionomics, ‘99 </li></ul></ul><ul><li>Strategies </li></ul><ul><ul><li>Market Timing/Technical Analysis </li></ul></ul><ul><ul><li>Trend Following </li></ul></ul><ul><ul><li>Tactical Asset Allocation & Hedging </li></ul></ul><ul><ul><ul><li>Risk Measurement: Portfolio Value & Drawdowns </li></ul></ul></ul><ul><ul><ul><li>Return Emphasis: Absolute Returns </li></ul></ul></ul><ul><ul><li>“ Rowing” - Crestmont Research, Unexpected Returns, Chapter 10 , ‘07 </li></ul></ul>
    10. 10. Risk <ul><li>Manias, Panics, and Crashes: A History of Financial Crises , ’78, ‘05 C. Kindleberger </li></ul><ul><li>Amazon.com Sales Rank: #2,811 </li></ul><ul><li>This Time Is Different: Eight Centuries of Financial Folly , ’09, C. Reinhart, K. Rogoff Amazon.com Sales Rank: #204 </li></ul><ul><li>The Misbehavior of Markets , ’04, B. Mandelbrot </li></ul><ul><li>Amazon.com Sales Rank: #5,378 </li></ul><ul><li>The Black Swan , ’07, N. Taleb </li></ul><ul><li>Amazon.com Sales Rank: #251  </li></ul>
    11. 11. <ul><li>Manias- </li></ul><ul><ul><li>Mob psychology, herding; “the trend is my friend” </li></ul></ul><ul><ul><li>Supply of credit explodes; substitutes of traditional money are developed </li></ul></ul><ul><ul><li>Euphoria in asset prices (commodities, real estate, equities) and spending </li></ul></ul><ul><ul><li>Greed grows more rapidly than wealth </li></ul></ul><ul><ul><li>Investors speculate and seek short-term gains </li></ul></ul><ul><ul><li>Capital is leveraged for investment </li></ul></ul><ul><ul><li>Economists see a new era in which traditional business cycles become obsolete </li></ul></ul><ul><ul><li>Bubbles form, prices become un-attached to fundamentals </li></ul></ul><ul><li>Panics- </li></ul><ul><ul><li>Start with a displacement and shock to the macroeconomic system </li></ul></ul><ul><ul><li>Sudden fright without cause </li></ul></ul><ul><ul><li>Demand suddenly stops, buyers become sellers, with an awareness that it’s time to become liquid </li></ul></ul><ul><ul><li>Revulsion </li></ul></ul><ul><li>Crashes- </li></ul><ul><ul><li>Discovery of fraud and swindles </li></ul></ul><ul><ul><li>Regardless of where it starts, prices end below where they started </li></ul></ul><ul><ul><li>A lender of last resort steps forward </li></ul></ul><ul><li>Lesson- </li></ul><ul><ul><li>The last 400 years has been full of financial crises and so will the next 400 years </li></ul></ul>Kindleberger
    12. 12. <ul><li>Financial Crisis- </li></ul><ul><ul><li>Again and again, countries (both developed and emerging), banks, individuals, and firms take on excessive debt in good times without enough awareness of the risks that will follow when the inevitable recession hits. </li></ul></ul><ul><li>This Time Is Different Syndrome- </li></ul><ul><ul><li>The firmly held belief that financial crises are things that happen to other people in other countries at other times; crises do not happen to us, here and now. We are doing things better, we are smarter, we have learned from past mistakes. The old rules of valuation do not apply. </li></ul></ul><ul><li>“ Second Great Contraction”- </li></ul><ul><ul><li>Dispelled any prior notion that among academics, market participants, or policy makers that acute financial crises are either a thing of the past or have been relegated to the “volatile” emerging markets. </li></ul></ul><ul><ul><li>Both in the run-up to the recent crisis and in its aftermath, the United States has driven straight down the quantitative tracks of a typical deep financial crisis. </li></ul></ul>Reinhart & Rogoff
    13. 13. <ul><li>“ Modern” Financial Theory is founded on shaky theories- </li></ul><ul><ul><li>Price changes are statistically independent (“efficient”) </li></ul></ul><ul><ul><li>Prices are normally distributed (bell) </li></ul></ul><ul><ul><li>Investors are rational </li></ul></ul><ul><ul><li>All investors are alike </li></ul></ul><ul><ul><li>Price change is continuous </li></ul></ul><ul><ul><li>Price changes follow a Brownian motion (“random walk”) </li></ul></ul><ul><li>Mandelbrot sees (from studying prices)- </li></ul><ul><ul><li>Prices have fractal relationships with each other and have a “long memory” </li></ul></ul><ul><ul><li>The bell curve fits reality very poorly; markets are far wilder and scarier </li></ul></ul><ul><ul><li>Tails follow a “power law” typically found in nature </li></ul></ul><ul><li>5 Rules of Market Behavior- </li></ul><ul><ul><li>Markets are risky </li></ul></ul><ul><ul><li>Trouble runs in streaks </li></ul></ul><ul><ul><li>Markets have a personality </li></ul></ul><ul><ul><li>Markets mislead </li></ul></ul><ul><ul><li>Market time is relative </li></ul></ul>Mandelbrot
    14. 14. The Elliott Wave A Grand Fractal
    15. 15. <ul><li>Black Swans- </li></ul><ul><ul><li>Completely unpredictable </li></ul></ul><ul><ul><li>Low probability, high consequence </li></ul></ul><ul><ul><li>Underestimated </li></ul></ul><ul><ul><li>Unconnected to a series of patterns or causes </li></ul></ul><ul><li>Confirmation Bias- </li></ul><ul><li>Selective use of data to fit one's opinion, belief or &quot;feeling&quot; about something. A &quot;natural tendency to look only for corroboration.&quot; </li></ul><ul><li>The Platonic Fallacy- </li></ul><ul><ul><li>People ignore “black swans” because we are more comfortable seeing the world as something structured, ordinary, and comprehensible. </li></ul></ul><ul><ul><ul><li>Leads to three distortions: </li></ul></ul></ul><ul><ul><ul><ul><li>Narrative fallacy : creating a story post-hoc so that an event will seem to have an identifiable cause </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Ludic fallacy : believing that the unstructured randomness found in life resembles the structured randomness found in games </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Statistical regress fallacy : believing that the structure of probability can be delivered from a set of data </li></ul></ul></ul></ul>Taleb
    16. 16. Secular Stock Market Cycles <ul><li>Usually lasts 5 to 25 years and consists of a series of sequential primary trends </li></ul><ul><li>Secular bull- </li></ul><ul><ul><li>Shorter less punishing primary bear markets which rarely (if ever) wipe out the gains of the previous primary bull markets. </li></ul></ul><ul><ul><li>Succeeding primary bull markets which make up for the real losses of any previous bear markets. </li></ul></ul><ul><li>Secular bear- </li></ul><ul><ul><li>Shorter primary bull markets which are sometimes shorter than the primary bear markets </li></ul></ul><ul><ul><li>… and rarely compensate for the real losses of the primary bear markets occurring during the extended market cycle/trend </li></ul></ul><ul><li>Source: Wikipedia </li></ul>
    17. 17. Are we in a Secular Bear Market? July ’09 <ul><li>“ We ’ re halfway through a secular bear market in equities … it means you can ’ t really be a buy and hold investor. ” </li></ul><ul><li>·          David Rosenberg, Chief Economist, Gluskin Sheff & Associates, former Chief Economist. Merrill Lynch, on CNBC ’ s Squawk Box, July 7, ‘ 09 </li></ul><ul><li>“ After considering all the technical arguments, I remain of the opinion that the bear market is still in force, and that the current advance is a correction against the primary trend. ” </li></ul><ul><li>·          Richard Russell, The Dow Theory Letters, April, ‘ 09 </li></ul><ul><li>  </li></ul><ul><li>“ The bull market that we all have come to know is now over. ” </li></ul><ul><li>·          Bill Gross, PIMCO, Jan ‘ 09 </li></ul><ul><li>  </li></ul><ul><li>“ I believe we're in a secular bear market. ” </li></ul><ul><li>·          Rob Arnott, founder and chairman of Research Affiliates, Oct ‘ 08 </li></ul><ul><li>“ We are still in the super bear of 2000. ” </li></ul><ul><li>·          Jeremy Grantham, chairman of money manager GMO, July ‘ 08 </li></ul><ul><li>“… a secular bear is self-evident. It's difficult to imagine how the market could be characterized any other way when, despite recent bull market highs, the S&P 500 has lagged Treasury bills for a decade. ” </li></ul><ul><li>·          John P. Hussman, Ph.D., Manager, Hussman Strategic Growth, Feb, ‘ 08 </li></ul><ul><li>“… stocks have entered a secular bear market, a long period of flat or declining stocks. ” </li></ul><ul><li>·          Ned Davis Research, Nov ‘ 01 </li></ul><ul><li>  </li></ul><ul><li>“ What matters above all is that the stock market is transitioning from the biggest bull market ever into the biggest bear market ever. ” </li></ul><ul><li>·          Elliott Wave Financial Forecast, July ‘ 99 </li></ul><ul><li>  </li></ul><ul><li>Others secular bear market believers - Jim Rogers, Robert Shiller, George Soros </li></ul><ul><li>  </li></ul><ul><li>  </li></ul><ul><li>  </li></ul>
    18. 18. Opportunities
    19. 19. Opportunities
    20. 20. Opportunities
    21. 21. Dynamic Asset Allocation Defined <ul><li>The term 'Dynamic Asset Allocation' (DAA) can also refer to an investment strategy that seeks to produce high total returns irrespective of the performance of market indices using the tools of Tactical asset allocation/Global tactical asset allocation (TAA/GTAA) around a strategic benchmark. Indeed, many investment firms and commentators use the terms TAA, DAA, and GTAA interchangeably. </li></ul><ul><li>Source: Wikipedia </li></ul>
    22. 22. Opportunities
    23. 23. Opportunities Combine Strategic/Sailing with Tactical/Rowing Rowing Sailing No Trigger Trigger No Trigger Trigger Large 40% 37.5% Large 40% 30% Small/Mid 10% 0% Small/Mid 10% 20% International 20% 17.5% International 20% 20% Equities 70% 55% Equities 70% 70% Debt 30% 45% Debt 30% 30%
    24. 24. Opportunities Combine Strategic/Sailing with Tactical/Rowing
    25. 25. Opportunities Combine Strategic/Sailing with Tactical/Rowing
    26. 26. Opportunities Combine Strategic/Sailing with Tactical/Rowing
    27. 27. Opportunities Combine Strategic/Sailing with Tactical/Rowing
    28. 28. Morningstar Ratings & The Utility Theory <ul><li>“ A rating system that provides a heavier penalty for risk.” </li></ul><ul><ul><li>“ Investors have a certain level of utility or satisfaction for each level of monthly return” </li></ul></ul><ul><ul><li>Utility function </li></ul></ul><ul><ul><ul><li>Decreasing marginal utility as returns increase </li></ul></ul></ul><ul><ul><ul><li>Emphasis on downside variation since “investors don’t like to lose money” </li></ul></ul></ul><ul><ul><li>“ A fund’s excess returns over and above the return on the risk-free asset.” </li></ul></ul><ul><ul><ul><li>Risk-Free Asset = T-Bill </li></ul></ul></ul><ul><li>Fund % Rankings </li></ul><ul><ul><li>Utility Theory = Wealth at the beginning-of-period vs end-of-period </li></ul></ul><ul><ul><ul><li>Morningstar Risk Adjusted Return = Annualized value of the “certainty equivalent” geometric excess return </li></ul></ul></ul><ul><ul><ul><ul><li>“ Certainty Equivalent” Geometric Excess Return = Guaranteed riskless return that provides the same utility to the investor as the variable excess returns </li></ul></ul></ul></ul>
    29. 29. S. Krawcheck Asset Allocation & Risk <ul><li>Barron’s, Oct ‘09 </li></ul><ul><li>&quot;There is only one free lunch in investing, and this is asset allocation&quot; </li></ul><ul><li>“ Risk is not just about standard deviation, it's about how much money you can lose.&quot; </li></ul>
    30. 30. Strategic Insight Forum Observations from Our Nov Conference <ul><li>“ The View From Distributors-” </li></ul><ul><li>&quot; All four distributors* have seen advisors question the traditional model of ‘ buy-and-hold. ’ This means an increasing emphasis on dynamic or tactical allocation, including shifting assets into cash and/or greater use of global allocation funds. ” </li></ul><ul><li>“ Challenges of Product Innovation- ” </li></ul><ul><li>“ The long-term, “ buy and hold ” model needs some tweaking – notably by mixing it a greater awareness of short-term market dynamics, risk management and diversification. ” </li></ul><ul><li>“ Products need to be designed with more of an eye to outcomes, not processes. ” </li></ul><ul><li>* Merrill L, Morgan S, Smith B, Edward J </li></ul><ul><ul><li>Source: “ Windows Into The Mutual Fund Industry ” – Strategic Insight, Dec‘09 </li></ul></ul>
    31. 31. Lessons Learned <ul><li>The last 400 years has been full of financial crises and so will the next 400 years. </li></ul><ul><li>Again and again, countries (both developed and emerging), banks, individuals, and firms take on excessive debt in good times without enough awareness of the risks that will follow when the inevitable recession hits. </li></ul><ul><li>The bell curve fits reality very poorly; markets are far wilder and scarier. </li></ul><ul><li>Losses have a greater impact on performance than gains and can occur in near turn succession and/or over secular periods. </li></ul><ul><li>Fat tails and secular bear mkts turn strategic aa programs upside down </li></ul><ul><ul><li>If we are in a secular bear that started in '00 or '07 then more losses and lower lows in equities may be in front of us. </li></ul></ul><ul><ul><li>The next mkt downturn may put strategic aa funds (plus target dates) out of business. </li></ul></ul><ul><li>Opportunities exist to improve on strategic aa portfolios. </li></ul><ul><li>To maintain high Morningstar Ratings a portfolio must primarily protect on the downside. </li></ul><ul><li>Advisors and their clients are looking for portfolios that protect on the downside. </li></ul>
    32. 32. Unexpected Returns <ul><li>“ Consequences are more important than probabilities.” </li></ul><ul><ul><li>Peter Bernstein, Founder, Journal of Portfolio Management </li></ul></ul>