Sunday, February 22, 2015

Asset allocation, momentum, and bad habits



Can pensions be gluttons for trends? The evidence has been growing that markets have trends and there is a momentum effect, but the same research also shows that at longer-term horizons there is a reversal of any momentum effect. Mean reversion will occur so blindly following trends may be a problem. Investors should follow momentum, but over time the impact is diminished and an investors has to move on. The asset allocation process has to be reviewed on a regular basis. This is one of the reasons why exit strategies for trend-following is critical. 

The behavior of pension funds leads to an interesting question concerning their habits. There is strong evidence that their allocations are pro-cyclical but do pension funds hold to the extreme or follow trends for longer than they should? Do they have the bad habit of holding too long or being gluttons for momentum? Recent research suggests that pension funds could sharpen their skills at making these critical investment decisions. (See, Asset Allocation and Bad Habits.) 

Pension funds may act too slowly to reverse a specific course of action. They adjust their strategic allocation over a long horizon which is based on momentum but the implementation and exit may result in acting too late. Invest based on the past, but realize that over a multi-year period, there will  be a reversal. Like any trader, the exit strategy may drive performance.



One of the simplest solutions is to have managed futures or global macro managers in the portfolio who will act much quicker than the pension fund. They should tactically capture the momentum across assets classes and then exit before a reversal. In a perfect world, the pension fund should focus on long-term allocations, while the manage should look for opportunistic gains based on more recent momentum.

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