Managers are not good timers - more evidence

There are two ways to add value as a multi-asset class mutual fund, the traditional alpha of picking investments and beta timing through asset class allocation changes. A beta timing choice, for example, is picking whether to hold stocks over bonds. An alpha choice is picking the right stocks. The quality of  a manager is based on his skill characteristics. Some can be classified with the first type, beta choices, as showing characteristic timing while alpha generation will show-up as characteristic selectivity.

Timing skills are hard to measure. In a perfect world, having position information is important, but not always available. There is the strategic choice of assets and also the tactical changes in these allocations. The timing skill is the ability to re-weight asset classes against the strategic allocation. Some argue that measures of trading skill are based downward if changes are made between measurement observations. If you trade tactically inside of a month and skill is measured monthly, the value of timing may be lower than reality. Similarly, other will say skill is biased upward because long-term strategies like the use of options can add value but is not truly related to timing skill. 

There is much room for discussion in this area, but the latest work suggests that timing skill does not exist for most multi-asset class mutual funds. The paper "Multi-asset class mutual funds: Can they time the market? Evidence from the US, UK and Canada" looks at timing skills through a number of approaches to measurement and finds that skill is rare. It may exist, but not with most and not with mutual funds. It does not matter what part of the world. Timing of asset allocations is hard.

The backfire effect - One more reason for systematic investing

Every discretionary trader faces a challenge when he trades with any conviction. The interesting question is what happens when the trader is presented with new facts. The whole idea of trading with conviction is showing confidence in an idea that will allow you to risk sizable money. A correct conviction is what generates above average returns. However, conviction can go overboard if you are not willing to hear about new facts or alternative arguments. The best traders are ones that can change their minds when presented with new fact. Unfortunately, psychologies have found something called the backfire effect. 

The premise most work under is that when beliefs are challenged with facts, your opinions will be altered. In reality, when deep convictions are challenged by contradictory evidence, our beliefs actually get stronger. Most protect what is in their collection of beliefs. Over time, you become less skeptical of your beliefs. Perhaps Yogi Berra said it right, "Don't confuse me with the facts."

We know this effect to be true from our experience. Many don't want advice supported with facts. Researchers have found that this bias may be stronger the more knowledgeable someone is about a subject. Experts are less sensitive with changing your views. Trying to correct someone with evidence does not work. If you give both side of an argument, the opposing facts, even when true, are dismissed. This tells us much lot about human nature and also why there is failure with investing. Investors will hang onto their losers because alternative facts may only cause intransigence. You will hang onto those ideas until the pain of lose overwhelms. 

So what can you do to avoid this problem? Obviously, a stop loss will help. There is a point where you will cut your loses regardless of your views. You impose stopping behavior upon yourself. Of course, you have to execute when the stop is reached and not change your mind.

The broader issue is learning to follow a disciplined approach open to new facts. One of the great advantages with systematic trading is that as new information is received and updated, it will not be dismissed or discounted. It will be used in the exact way it was programmed. There is no backfire effect because there is no dismissing of new facts. Another good reason for systematic trading. 

30% of traders have not lived through cycle

We often see the same statistics week after week, but every once in awhile you will see something that will make you sit-up and take notice. This is one that caused a jolt. 30% of traders have never seen a full economic cycle. This is like saying 30% of the army has never been shot at. 

This lack of experience creates a very unstable environment. Regardless of how much you have read, there is nothing like living through the down part of a cycle. Saying this is not a pride issue, but one of experience. Market move and you have to experience that sick feeling when they are going lower and there is no good reason and there is no place to hide. Even worse is when there is a good reason but there is nothing you can do about it except work as hard as you can to take advantage of the sell-off. You have to be prepared, do you your homework, and then be ready when other may lose focus.  

Market sell-offs in a down cycle are sharp and fast. Higher volatility is expected. Down cycles are not the same as the slow trends when markets rally. Decisions have to be made fast. This is another reason for why disciplined and systematic is helpful. It can serve as an alternative to experiences not lived. 

Differences in managed futures traders - not all trend-followers

All CTA managers are not created equal. There is more to this strategy space than just trend-following although trend-followers represent the majority of the assets under management. A recent study earlier this year by SocGen looked at the correlation across a number of managed futures strategies and found there is strong variation in their return behavior over a fifteen year test period. The managers that specialize in a specific asset class will have lower correlation with other managers only because it is less diversified than most trend-followers. For those managers that may have a diversified portfolio, quantitative macro is the least correlated with trend-followers.

The volatility of these CTA strategies will also be markedly different. Trend-followers will be the second most volatile strategy next to commodities. Of course, commodities are more volatile than financial markets given the high underlying volatility, and as a strategy focused on one asset class, it will be less diversified. The best returning category is the diversified technical group which can have both trend and counter-trend components. The second highest return strategy is trend-following. 

A broad set of different strategies are available in managed futures and may offer as much or more diversification as managers within another hedge fund strategy.