Our New Refrain: ‘First Time In a While’

A common theme we are observing in the markets right now is “first time in a while.”

For example, it’s the first time in a while that foreign developed markets are the strongest equity segment geographically. It’s the first time in a while that we’ve had any uptrend in emerging markets – same with U.S. fixed income. Within fixed income, it’s the first time in a while that longer duration is outperforming shorter duration. That’s multiple firsts in the last year or so, all hitting at the same time as we enter February. As readers might expect by now, these market firsts are translating to firsts in a while” for our portfolios as well.

For us, this highlights the adaptability of a systematic investing approach to asset management.

Because our strategies are rules-based, we can perform historical tests to determine how our strategies are likely to perform in various environments, rate cycles, and economic climates. We have built up a tremendous amount of confidence in our strategies because of these tests.

However, our rules-based framework for strategy development also leads to some interesting questions.

One of the great questions we receive is about how we can be confident our strategies will continue to work in the future if the future is unlikely to look like the past. The answer, in our view, has everything to do with adaptability. It is our belief that more adaptable strategies are less reliant on past events and thus more strongly positioned to perform well in the future. The current market environment is a prime example.

Allow us to explain…

Every strategy makes assumptions and creates constraints for itself. For example, a strategy that will only buy and hold the S&P 500 has historically performed ok on an absolute basis. However, if U.S. stocks ever enter a Nikkei (Japan’s S&P 500 equivalent) Index-style decline, then it will likely perform poorly. In other words, a strategy of buying and holding the S&P 500 is only as good as the index it is tied to. The index is completely dependent on the environment in which it operates.

On the other hand, a strategy that can go both long AND short the S&P 500 index has likely underperformed a buy-only strategy over the last few decades. Yet, since it is more adaptable, it should perform better in that Nikkei-style decline we just mentioned. Someone who allocates to this strategy is making a bet that being more adaptable is better, despite the recent performance of the two different strategies (long only vs long/short). Due to the strategy’s adaptability, it is less dependent on the environment for its success. It is important for investors to remember that for every unit of adaptability, one must generally accept at least one unit of potential underperformance versus less adaptable strategies (i.e., indexes).

Now let’s bring the adaptability theme full circle to shed light on the question about how our strategies might perform if the future looks different than the past. Our firm operates strategies with varying levels of tactics and thus adaptability.

The composition of each strategy shifted dramatically over the past 18 months. For example, our portfolios were overweight growth stocks in 2021. Then, thanks to our systematic investing process that use trend following, the portfolios were much more value-oriented in 2022 and early 2023. Similarly, our strategies now have a much higher allocation to foreign developed equities, following almost a decade of generally being underweight. Lastly, bond duration is also much higher today than during the past 12 months, as the trend in longer-term bonds has strengthened.

This adaptability means our strategies are not dependent on whatever factor is driving performance at any point in time. It’s almost as if the past does not exist (and neither does the future)!

How is this accomplished within our framework? The longest timeframe we consider as part of our systematic investing rules is the last 200 trading days. Data prior to the last 200 days is ignored.

Sometimes people are surprised to hear that the longest timeframe accounted for by our systematic investing process is only 200 days (at most). But, our experience and historical stress testing of the data shows that this timeframe is sufficient to support clients reaching their financial goals. confidence that will continue.

That said, we’ll repeat something we said earlier: All strategies make assumptions. We make an assumption that the assets in our portfolios will go up over the long term to help us earn the return we expect. We also make an assumption that the historical behaviors of stocks relative to bonds will continue in the future, which influences the baseline allocations we use when constructing our portfolios. These assumptions put us in line with the vast majority of the portfolio management universe.

The key difference between the rest of the universe and us is that we let price trends tell us what to do in the moment, tactically. It is this adaptability and nimbleness that allows us to rotate exposures relatively quickly. It allows us to be less captive to the past and therefore eliminate our reliance on the future needing to look like the past. We believe this provides a portfolio management infrastructure.