I have always been curious since I was very young and have wanted to learn new and interesting things. This has ever been true, whether it is about learning languages and about cultures, about how the mind works, or about the markets and the global economy.
As it relates to investing, the last two decades have taught me that there are actually few absolute truths and lots of relative truths. What do I mean by this?
Here’s an example: Value investing works. I believe this is a true statement. But many would agree that it doesn’t work 100% of the time. This is not an absolute truth, for example, like the law of gravity or the fact that the body cannot survive for very long without water. But value as an investment strategy has shown to “work” relative to indexing over long periods of time. If it only worked occasionally or if the returns were the same or lower than indexing, there would not be an argument that it “works.” It would be random noise or maybe a factor that is not persistent over time.
For a strategy to “work” for me, there also needs to be an explainable economic rationale behind it. Gold investors would not likely invest in Apple if the two prices simply moved together for some time. But if Apple started making phones with gold plating and the demand was also high, this could logically also drive some of the price of Gold.
Sure, there are some fun indicators that have decent track records, but many have no economic rationale behind them? The Superbowl Indicator is one of my favorites.
In my experience with investing, here are some strategies I believe “work.” They have been backed by lots of research and there is an economic rationale for each:
- Quality
- Minimum Volatility
- Momentum
- Trends
- Value (and Mean Reversion)
- Diversification
- Factor investing
None of these work all of the time, but they have been demonstrated to work relative to not doing anything other than indexing. By the way, if these things work only part of the time, that also means indexing itself works some of the time. Since fees matter and index fees are minimal, it also makes sense that index investing would work some of the time.
If most are in agreement that all of these work some of the time, the real questions then is “how do I make this knowledge actionable to improve my portfolio or my client’s portfolio?” For many of us, we fall back on diversification. We know it works, most of the time. Let’s just put everything in the stew and it will taste good, right? Of course, we try to get more scientific and methodical than that, but there are some that would advocate almost equal-weighting everything that works and just rebalance. Diversification has nearly always been easier said than done. Especially when things like “Value” are in a long drought when it comes to relative performance. Do you abandon it until it comes back or do you add more now, believing (or is it hoping?) that mean reversion will work and you will be rewarded for it?
“Cruise control doesn’t work on a windy road and autopilot doesn’t work with zero visibility and high winds.”
I believe that one doesn’t need to abandon things that we know work, but at the same time it may make sense to tilt towards things that we know are working better now (factor momentum) or towards things for which we have solid base of reasoning that they will work better. For example, during the Financial Crisis of 2008, I worked on a team that managed various investment models. Municipal bonds, even the high quality ones, were crushed. We reasoned that the selloff was overdone and that there was no fundamental reason for many high quality bonds to have that much price depreciation. We decided to buy muni bonds, even inside of qualified accounts. Some custodians called us, thinking this was a mistake. Many advisors also questioned us. It was our intention to buy them, though. There was zero tax benefit, but some of the bonds were yielding 10+% and had minimal credit exposure. It was in our collective minds, a no-brainer. Things would normalize. Prices and liquidity would come back and investors would be rewarded. This, along with reducing exposure to home builders and REITs, helped our client’s portfolios during the crisis.
Because I believe that strategies that incorporate momentum, minimum volatility, trends, and mean reversion work, I also believe that tactical or dynamic strategies that are built off of these factors, if executed properly, also work. Do I believe that these will work 100% of the time? Of course, not. But this also leads me to believe that “buy and hold” strategies also don’t work all the time. Cruise control doesn’t work on a windy road and autopilot doesn’t work with zero visibility and high winds.
Adaptive Beta is a systematic, quantitative way of using momentum, volatility, trend, and various lenses – fundamental, risk, economic, and technical – to reduce exposure when risk is high, keep it tied to the market when it is normal, and increase it when risk is low. This relates back to the first post here, “Offense Sells Tickets, Defense Wins Championships” and the Chicago Bulls of the 90’s. We want to actually take more risk when the markets are calm and take some exposure off when markets are not rewarding the risk we are taking.
How do we do this? We do this by looking at things like price, day-to-day volatility, economic stress, or earnings growth and valuations. Just as many of us go through seasons of spring, summer, fall, and winter, the markets and the economy go through cycles as well. They are less predictable than the calendar year and can have lots of cross-currents or eddies (trade wars, accounting scandals, fiscal and monetary policies, investor herding, social unrest, pandemics), but the cycles are still there. Trends are different with different asset classes just like the waves crash differently on different parts of the coast line. When trend and momentum have red flags, exposure to the markets is reduced significantly. We are not only looking at price trend and momentum, however. Things like volatility, economic stress, and earnings growth have trends and momentum, too. When market trends and momentum are strong and clear, we increase exposure to the market, including the use of some leverage. When they are neither strong nor weak, we seek index exposure.
The beauty of Adaptive Beta is that it is not a one-size fits all solution. Parameters can be adjusted and diversifiers can be added when risk is high. For example, long treasury bonds have tended to perform well when equities are falling. We don’t believe this will be 100% of the time, especially if monetary policy ever becomes overly tight or we have rampant inflation. But there is some perceived safety in government-backed long bonds and precedent, even if the yield is not attractive. Not surprisingly, during periods of market distress, Adaptive Beta portfolios with long bond exposure performed well in testing versus those with none.
Some investors may focus on risk reduction while others may wish to minimize tracking error. Some may even focus on return enhancement. Each can be accomplished with Adaptive Beta.
To learn more about the Straightway Financial Adaptive Beta strategies or let us know what you think, click here to drop us a line.
Jim Worden, CFA, CMT, CAIA Founder | CEO | CIO
Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale of purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
The S&P 500 or Standard & Poor’s 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies.
Leverage is an investment strategy using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment. Leverage also increases the amount of risk of the investment.
