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April 01, 2010 at 04:00 AM
With every bear market the discussion as to whether “buy and hold” works invariably resurfaces. It will be analyzed in journals, opined over in the mainstream media, and spun into the sales pitch du jour for active management. Then we enter the next bull run and investors simply don’t pay attention anymore. Or perhaps they assume that end-date bias is the culprit, so why don’t we just pick a different end date and be done with it? Well, that only works if you aren’t within a few years of retiring or your stomach is made of iron.
Part of that discussion will also focus on asset allocation:
o Strategic asset allocation: the determination of your overall mix between distinct asset classes.
o Dynamic asset allocation: the maintenance of those target allocations through rebalancing according to a set schedule, or upon a set divergence from the targets.
o Tactical asset allocation: the slight contrarian massaging of target allocations based on recent extreme performance in which one would increase their target allocation to, say, U.S. stocks after they had declined by 40%. They would decrease their target allocations to high-yield bonds if they had been the runaway best performer for the past year, too.
Dynamic and tactical asset allocation don’t really need re-thinking as much as strategic asset allocation. The end goal of strategic asset allocation is to find distinct asset classes that tend to behave differently with respect to one another. Normally this holds true when markets are humming along, but you get those black-swan events (2008 anyone?) which have driven correlations of asset classes to one just when you needed diversification to work most for you and for your clients.
Tied to the Business Cycle
Here’s the problem. Traditional asset classes are all tied to the business cycle. In fact, many alternative asset classes are tied to the business cycle as well. Why? Because if GDP is falling, businesses are not making as much money and they are failing. With lower employment comes less spending. With lower spending, lending money for people to start and maintain businesses seems unattractive, so interest rates are lowered to the point people start borrowing again, but that means returns from fixed income are low. While this is obviously a blunt 30,000-foot perspective, you can see the ramifications for absolute returns.
Wouldn’t it be great if you could find an asset class that wasn’t tied to the business cycles of the world? Well, today’s your lucky day because there are numerous commodity trading advisors, also known as CTAs, who run market-neutral strategies that couldn’t care less if GDP, equity markets, or fixed-income markets are rising, capitulating, or on vacation.
Defining Market Neutral
What’s in a name? Well, in this case, all you need to know. Okay, perhaps you need to know more, such as that market neutral strategies have earned a bad rap through their association with hedge funds. But forget what you think you know about market neutral strategies (and hedge funds for that matter, since it’s the bad ones that got all the press), and let’s start with a tabula rasa.
A market neutral strategy is any investment strategy whose success is independent of systematic risk, the general ebb and flow of the markets. In fact, you could go one step further in saying that market neutral strategies really only care about non-systematic factors. This might seem counter-intuitive to Modern Portfolio Theory (MPT) which tells us that the only free lunch in investing is the reduction of non-systematic risk by adequate diversification within a market. But remember, a market neutral strategy operates independently of the market, so we’re not seeking Beta (exposure to the market).
Let’s take a look at a specific example of a market neutral strategy. Let’s use Research in Motion and Apple Inc. as an example. Suppose we think that Apple is going to do better than RIM in the future. You could take a long position in AAPL and take an equal weight short position in RIM. Since you have X number of dollars in a long position but an equal number of dollars in a short position, you have no net market exposure.
