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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 +79672654510 +79672654510 Tactical Asset Allocation

  11. US Term Structure 1970-1995 Andrei Simonov - debt and money markets

  12. Evaluation of 2001 and 2008 Recessions • 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. • In August 2006 , the Yield Curve inverted forecasting recession to begin in July 2007. • Official NBER Peak is December 2007 (Yield Curve within two quarters accurate). • In May 2007, the Yield Curve returned to normal forecasting the end of the recession in January 2008. • On September 20, 2010 the NBER announced the official end of the recession was June 2009. Andrei Simonov - debt and money markets

  13. Recent recessions in retrospect Andrei Simonov - debt and money markets

  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. Tactical Asset Allocation

  19. Current yield curve(May 15th, 11) Tactical Asset Allocation

  20. June Meeting Outcomes Implied probability 0.0% - 0.25% Producer Price index (Apr); Retail Sales (Apr); Business Inventories (Mar); Bernanke Speech 0.75% 0.50%

  21. August Meeting Outcomes Implied probability 0.0% - 0.25% Producer Price index (Apr); Retail Sales (Apr); Business Inventories (Mar); Bernanke Speech 0.75% 0.50%

  22. September Meeting Outcomes Implied probability 0.0% - 0.25% Producer Price index (Apr); Retail Sales (Apr); Business Inventories (Mar); Bernanke Speech 0.75% 0.50%

  23. Duke survey: optimism is up. Pessimistic/OptimisticCFOs Tactical Asset Allocation

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

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

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

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

  28. 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

  29. 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

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

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

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

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

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

  35. 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

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

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

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

  39. 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

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

  41. 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

  42. U.S. Risk PremiumSurvey Background • Graham/Harvey: Survey CFOs every quarter • Q2 2000 through Q4 2008 (52 quarters) • Current survey attracts about 500 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

  43. U.S. Risk PremiumTen-Year Premium Tactical Asset Allocation

  44. Tactical Asset Allocation

  45. Duke CFO magazine Global Business Outlook survey - U.S. - First Quarter, 2010 14. On February 12, 2010 the annual yield on 10-yr treasury bonds was 3.7%. Please complete the following: Mean SD 95% CI Median Minimum Maximum 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: 1.30 8.13 0.61 - 1.99 2 -50 75 535 Over the next 10 years, I expect the average annual S&P 500 return will be: Expected return: 7.62 9.66 6.81 - 8.43 6 -20 100 544 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 greater than: 11.76 11.43 0.79 - 12.72 10 -10 100 537 Over the next year, I expect the average annual S&P 500 return will be: There is a 1-in-10 chance it will be less than: -3.31 11.64 -4.30 - -2.33 0 -50 75 535 Over the next year, I expect the average annual S&P 500 return will be: Expected return: 5.62 8.44 4.91 - 6.33 5 -25 100 544 Over the next year, I expect the average annual S&P 500 return will be: There is a 1-in-10 chance it will be greater than: 11.39 8.81 10.65 - 12.14 10 -10 95 534 Tactical Asset Allocation

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

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

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

  49. 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. Tactical Asset Allocation

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