Revenue Content

Saturday, January 31, 2015

Bloomberg Business

A Strategy For Building Resilience In The New Global Context

Jan 22, 2015, 10:09:34 PM

Global leaders gathered in Davos-Klosters, Switzerland last week for the 45th Annual Meeting of the World Economic Forum (WEF), amid a torrent of news that made the theme of the conference, "The New Global Context," very much of the moment: the Swiss Franc has been decoupled from the Euro; the European Central Bank is championing $1.3 trillion in quantitative easing; the IMF has downgraded its global growth forecasts for this year and next; and terrorism remains top-of-mind after events in Paris and a new hostage situation involving ISIS.

The notion of a new global context was echoed in the conclusions of Global Risks 2015, the 10th annual global risk report published ahead of the Davos meeting by WEF, in partnership with Zurich Insurance Group and other leading institutions.

Shift in views of global risks' likelihood and impact

The report highlights the emergence of a new global context against the backdrop of increasingly interconnected global risks that are set to test the resilience of businesses and societies in the years to come.

In previous iterations of the report, global decision-makers surveyed have typically identified economic risks as those most likely to occur over the next 10 years. However, Global Risks 2015 shows that three of the top four risks, in terms of likelihood, are geopolitical in nature.

Interstate conflict is reckoned to be the risk most likely to materialize, with failure of national governance, and state collapse or crisis, ranking third and fourth, respectively. In terms of the impact specific risks might have, interstate conflict is ranked fourth, behind weapons of mass destruction and newly emerging environmental and societal issues such as water crises and rapid and massive spread of infectious disease.  

"There is growing recognition that the world and the risk landscape is more fragile and fragmented," said Axel Lehmann, Chief Risk Officer, Zurich Insurance Group, while discussing the report at Davos. "Economic risks and geopolitical risks are still very prevalent in the short term, but in the long-term view, societal and environmental risks are at the forefront. Societal issues, in particular profound social instability, are like the spider in the net—the big unknown that is influenced by every risk type."

Lehmann identified rapid urbanization as a societal issue, with the associated risks becoming global in scale. In 1950, one-third of the world's population lived in cities. In 2025, two-thirds of the population will live in cities, and 80 percent of GNPs will be produced in cities. "Huge investment in urban infrastructure is required," he said, citing the figure of $70 trillion needed by 2030.

"In Africa alone, $80 billion per annum is necessary until 2020, and only half is funded. Fifteen of the 20 global megacities are built along coastal areas, exposed to natural catastrophes. More people will be moving to cities in search of jobs and places to live—and they might be unavailable. Urbanization entails a whole range of key risks that need both stronger city-level institutions delivering practical solutions, and flexible, innovative, multi-stakeholder governance to deliver sustainable growth."

The price of geopolitical risk and the need for resilience

Gauging the impact of the geopolitical risks that are now deemed most likely to occur over the next 10 years can be an elusive goal.

In a lively discussion at Davos, Natalia Ann Jaresko, Ukraine's Minister of Finance, said that the financial markets often misprice geopolitical risk. "History has shown that the markets weren't ready for the systemic effects of the 2008 financial crisis, and they contributed to the size of the crisis because they underpriced the risk that the system was going to collapse in the way it did," said Jaresko. "The Eurozone collapse was misjudged and overpriced in time—overpriced because expectations were not being achieved in the end, and because today the Eurozone is basically where it was before, despite all of the overpriced risks."

Jaresko cited three reasons for her belief: Investors react to their own market appetite, not necessarily to the specifics of what's happening; geopolitical risk is not an objective risk that can be priced; and investors move en masse in or out of markets and in the pricing, and, right or wrong, not many are willing to buck the system.

Martin Senn, Chief Executive Officer, Zurich Insurance Group, agreed with Jaresko. "Geopolitical risk cannot be effectively priced," he said. "The real question is not whether the financial markets are mispricing geopolitical risks, but whether we have a full understanding of those risks and whether we are taking the necessary steps to build resilience as these risks are more and more interconnected and transportable. What the global risk report makes clear is that the very nature of geopolitical risks is changing. It's not just interstate conflict and terrorism that are impacting economic policy—it is natural resources, cyber issues, popular sentiment in elections. For example, this year, 45 percent of the G20 electorate is going through elections, creating significant uncertainty."

Not just about financial markets

Senn stressed that it is not just a matter of how geopolitical risks affect financial markets, but businesses, as well. "How is your business positioned with regards to supply chain exposure and the impact on the balance sheet of your organization? Risk drives return, so there are a lot of businesses that can view geopolitical risk as an opportunity if managed effectively, and not just as a downside exposure. That is why it is essential to have a full understanding of the exposures to geopolitical risks, and to take the necessary steps to build up the respective resilience."

Effective risk management in the new global context is a two-pronged effort that involves prevention and resilience. Resilience is critical because it is impossible to avoid risk events in a globally interconnected age. Resilient companies do not just manage risk within their organization—they proactively manage risk throughout their networks of suppliers, contractors and franchisees. By building strong internal and external relationships, and engendering trust and a desire to collaborate and share information, all stakeholders can communicate with each other to rapidly adapt to change.

Nurturing this trust requires leaders who can relate with suppliers, investors, business partners and others, pull them together, facilitate the sharing of information and provide direction and guidance. "Transparency, and stakeholders being able to speak up more easily with today's technology, make it even more important to build sustainable trust and reputation based on the company's values," said Senn.  

Trust and collaboration are vital

The theme of profound social instability highlights an important dilemma that has been smoldering since the financial crisis, but surfaces prominently in Global Risks 2015: Global risks transcend borders and spheres of influence, and require stakeholders to work together. Yet these global risks also threaten to undermine the trust and collaboration needed to adapt to the challenges of a new global context.

For example, said Lehmann, "concerns about rising technological risks, most notably cyber attacks, remind us that geopolitical tensions are taking place in a very different environment than before. Information flows instantly around the globe, and emerging technologies such as drones enable new players and new types of warfare to enter the stage."

The evidence manifests Lehmann's point. Geopolitical conflicts are increasingly being played out online. These interstate conflicts can affect the private as much as the public sector (witnessed by the recent U.S.-UK agreement to simulate a cyber attack on their financial sectors). The growing importance of cyber-security in geopolitical disputes means that national interests often outweigh the public good in the debate about developing the global governance needed to mitigate cyber risks.

Against this backdrop, businesses need to think through how surety insurance can help protect capital and earnings by covering the risks of investing in different parts of the world. At the same time, a holistic, board-led approach that acknowledges the interconnectedness of risks supported by strong strategic planning, a healthy cash balance and a focus on lean cost structures can help create the resilience necessary to weather risks, be they a cyber attack, financial crisis or geopolitical hazard that threatens business continuity. By localizing and developing multiple suppliers, and incorporating flexibility into product and service design, you can create resilience to supply chain disruptions.

"A proactive approach to embedding such resilience into your company is critical to its future prosperity," said Lehmann. "Resilience doesn't create itself, and it requires a lot of thought and action to achieve it across an organization. But with the right insights and strategy, it is possible to create a truly resilient organization that can withstand the constant challenges of an interconnected risk landscape in the new global context."


Panhandle Pete

Wednesday, January 21, 2015

Adaptive Asset Allocation: Which Is Better - Quarterly, Monthly, Or Weekly Trading?


Adaptive Asset Allocation: Which Is Better - Quarterly, Monthly, Or Weekly Trading?

Yesterday, 01:26 AM ET | by Toma Hentea

Summary

  • The performance of adaptive asset allocation is sensitive to the look back period, as well as to the frequency of market monitoring.
  • The best performance is obtained by monthly monitoring, which significantly outperforms quarterly or weekly monitoring.
  • For the SPY+TLT pair over the 2004-2014 time interval, the highest CAGRs are as follows: 14.70% for monthly monitoring, 12.93% for quarterly monitoring, and 11.74% for weekly monitoring.
  • The best look back periods are 2 to 7 months, 10 to 20 weeks, and 1 quarter.
  • The relative performance of the adaptive allocation strategy is consistent for ETFs and related mutual funds. We obtained similar effects on (SPY, TLT), (VTI, AGG), (FSTMX, FTBFX), and (VTSMX, VBMFX).

In a couple of recent articles, we demonstrated that a very simple and well-diversified portfolio may be made up of two instruments - one representing the total stock market, and the other representing the total bond market. These portfolios are quite robust, and achieve decent returns using simple strategies such as rebalancing and momentum-based adaptive allocation. At the suggestion of some readers, we investigate the sensitivity of the adaptive allocation strategy to the frequency of market monitoring and the duration of the look back period.

As in our previous articles, we considered the following four portfolios: one built with the SPDR S&P 500 Trust ETF (SPY) and the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT), the second with iShares and Vanguard ETFs, the third with Vanguard mutual funds, and the fourth with Fidelity mutual funds.

  • ETFs portfolio: iShares 20+ Year Treasury Bond ETF and SPDR S&P 500 Trust ETF.
  • ETFs portfolio: iShares Core US Aggregate Bond Market ETF (NYSEARCA:AGG) and Vanguard Total Stock Market ETF (NYSEARCA:VTI).
  • Mutual funds portfolio: Vanguard Total Bond Market Index Fund (MUTF:VBMFX) and Vanguard Total Stock Market Index Fund (MUTF:VTSMX).
  • Mutual funds portfolio: Fidelity Total Bond Market Index Fund (MUTF:FTBFX) and Fidelity Spartan Total Stock Market Index Fund (MUTF:FSTMX).

For purposes of comparison, we simulate these portfolios from December 2003 to December 2014, a total of eleven years. The time period of the study was selected based on the availability of historical data of the investment instruments; AGG was created in September 2003.

The data for the study were downloaded from Yahoo Finance, using the Historical Prices menu for the eight tickers: SPY, TLT, AGG, VTI, VBMFX, VTSTX, FTBFX, FSTMX. We use the weekly and monthly price data from September 2003 to December 2014, adjusted for stock splits and dividend payments.

The article has two parts. In the first part, we discuss the effect of the frequency of market monitoring. The second part presents the effect of varying the look back period.

Part I: Quarterly, Monthly, and Weekly Market Monitoring

The first study was done on the SPY+TLT. We compare the results obtained by monitoring the market quarterly, monthly, or weekly in the following manner. Quarterly monitoring is done at market closing on the last trading day of each quarter. Monthly monitoring is done at market closing on the last trading day of each month. Weekly monitoring is done at market closing on the last trading day of each week.

The portfolio is at all times invested 100% in either SPY or TLT. All the funds are invested in the instrument with the highest return over the current look back period. The following look back periods were utilized in our simulations: 1 to 4 quarters for quarterly monitoring; 2 to 20 months for monthly monitoring; 5 to 50 weeks for weekly monitoring.

The data below show the best investment results over 11 years, from January 2004 to December 2014. The first line is for quarterly monitoring with a 1-quarter look back period; the second is for monthly monitoring with a 3-month look back period; the third for weekly monitoring with a 13-week look back period. It is apparent that monthly monitoring delivers significantly better results than weekly or quarterly monitoring.

Table 1. SPY+TLT quarterly, monthly, and weekly monitoring of portfolios January 2004-December 2014

Total Return%

CAGR%

Max DD%

Number of trades

Quarterly

281.1

12.93

-19.59

22

Monthly

347.0

14.70

-17.13

29

Weekly

141.1

11,74

-17.37

60

Part II: The Effect of the Look Back Period

The effect of the look back period is presented separately for quarterly, monthly, and weekly monitoring.

For quarterly monitoring, the look back period was varied from 1 quarter to 4 quarters. The results obtained for the SPY+TLT portfolio are shown in Table 2. It is apparent that a look back of one quarter is significantly better than any other period.

Table 2. SPY+TLT quarterly, look back periods from 1 to 4 quarters January 2004-December 2014

Look back [quarters]

Total Return%

CAGR%

Max DD%

Number of trades

1

281.1

12.93

-19.59

22

2

77.2

5.20

-29.80

17

3

77.6

5.21

-31.54

14

4

56.4

4.15

-36.75

12

For monthly monitoring, the look back period was varied from 2 months to 20 months.

The first two figures show the scatter of the compound annual growth rate (CAGR). A few observations can be made from analyzing these results:

  • The SPY+TLT portfolio is the most sensitive to a change in the look back period. A look back period between 2 and 4 delivers the highest returns.
  • VTI+AGG, as well as the mutual fund portfolios are little sensitive to changes in the look back period. Still, a look back period in the 2-6 month range delivers higher returns.

(click to enlarge)

Figure 1. CAGR for monthly monitoring with look back periods from 2 to 20 months.

Source: This chart is based on Excel calculations using the adjusted monthly closing share prices of securities.

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Figure 2. CAGR for monthly monitoring with look back periods from 2 to 20 months.

Source: This chart is based on Excel calculations using the adjusted monthly closing share prices of securities.

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Figure 3. Maximum drawdown (DD) for monthly monitoring with look back periods from 2 to 20 months.

Source: This chart is based on Excel calculations using the adjusted monthly closing share prices of securities.

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Figure 4. Maximum drawdown for monthly monitoring with look back periods from 2 to 20 months.

Source: This chart is based on Excel calculations using the adjusted monthly closing share prices of securities.

For weekly monitoring, the look back period was varied from 5 weeks to 50 weeks.

The first two figures show the scatter of the compound annual growth rate . A few observations can be made from analyzing these results:

  • The SPY+TLT portfolio is the most sensitive to a change in the look back period. A look back period between 10 and 21 weeks delivers the highest returns.
  • VTI+AGG, as well as the mutual fund portfolios are not very sensitive to changes in the look back period.

(click to enlarge)

Figure 5. CAGR for weekly monitoring with look back periods from 5 to 50 weeks.

Source: This chart is based on Excel calculations using the adjusted weekly closing share prices of securities.

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Figure 6. CAGR for weekly monitoring with look back periods from 5 to 50 weeks.

Source: This chart is based on Excel calculations using the adjusted weekly closing share prices of securities.

(click to enlarge)

Figure 7. Maximum drawdown for weekly monitoring with look back periods from 5 to 50 weeks.

Source: This chart is based on Excel calculations using the adjusted weekly closing share prices of securities.

(click to enlarge)

Figure 8. Maximum drawdown for weekly monitoring with look back periods from 5 to 50 weeks.

Source: This chart is based on Excel calculations using the adjusted weekly closing share prices of securities.

Conclusions

The performance of adaptive asset allocation is sensitive to the look back period, as well as to the frequency of market monitoring. The best performance is obtained by monthly monitoring, which significantly outperforms quarterly or weekly monitoring.

The optimal look back period varies with the type of assets that make up the portfolio. For the assets considered in this study, the best look back periods are 2 to 7 months, 10 to 20 weeks, and 1 quarter. The author prefers a look back period of 3 months in conjunction with monthly monitoring.

Disclosure: The author is long TLT, SPY. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.