Simple Moving Average (SMA) is one of the oldest and simplest measurements of trend. Arrived at by taking the average of prices over a period of time, it remains a popular tool for timing investments and risk-management. The following series of posts outlines how investors can use SMAs to get superior risk-adjusted returns.
A lagged response will result in higher drawdowns. It could, however, lead to lower transaction costs by papering over short-term mean-reverting moves.
Simple portfolio asset allocations should start with a mix of equities and bonds. Typically, a 60/40 or a 70/30 split between them is suggested as a good starting point. The big questions are:
What are the trade-offs between 60/40 and 70/30?
Should you stick to large-caps or use mid-caps for the equity leg?
Should you rebalance every month or is an annual rebalance enough?
Should you invest the legs separately or opt for an equity-oriented balanced fund?
60/40 vs. 70/30 * Large vs. Mid-caps
60/40, monthly rebalance70/30, monthly rebalance
From a drawdowns point of view, using the large-cap NIFTY 50 index seems to deliver a smoother ride to the investor. However, there is hardly any difference between the drawdown profile of the 60/40 vs. that of the 70/30. From a returns point of view, a 70/30 portfolio has about a point over the 60/40.
So, risk-averse investors should probably go with a large-cap 70/30 mix. And for those who want reach a bit, a mid-cap 70/30 should do the trick.
Monthly vs. Annual Rebalance
The less frequently you rebalance your portfolio, the less you pay out in transaction costs. However, with a lower frequency of rebalances, you run the risk of one piece of your portfolio overshadowing the rest and dictating the overall risk of the portfolio.
70/30, annual rebalance
For a 70/30 portfolio, it appears that an annual rebalance has negligible effect on portfolio returns or drawdowns.
Tax impact – DIY vs. Mutual Fund
If you choose to implement the legs of the portfolio separately, then you create a taxable event every time you rebalance. A mutual fund, on the other hand, has no such drag.
70/30 large-cap, after tax vs. equity-oriented hybrid fund 70/30 mid-cap, after tax vs. equity-oriented hybrid fund
Taxes seem to lop-off about 2% of annualized returns in the DIY portfolio while the mutual fund gets to compound it throughout. In both the large-cap and mid-cap scenarios, an equity-oriented hybrid fund comes out ahead.
If you were set this up as an SIP, then it is possible to avoid selling positions by just buying the asset that has fallen below its target. So taxes predominantly dent lumpsum investment returns.
Conclusion
If you are an SIP investor, then a DIY 70/30 large-cap or mid-cap portfolio (if you are willing to bear a bit more volatility) should do the trick. But lumpsum investors should probably shop around of a decent equity-oriented hybrid fund.
In The Technology Trap: Capital, Labor, and Power in the Age of Automation (Amazon,) Carl Benedikt Frey gives us a brief history of technology’s impact on society and how we can better prepare ourselves for the coming AI revolution.
Historically, new technologies got adopted only when it didn’t threaten the status quo of the elites.
For most of history, the politics of progress were such that the ruling classes had little to gain and much to lose from the introduction of labor-replacing technology. They rightly feared that angry workers might rebel against the government. One reason economic growth was stagnant for millennia is that the world was caught in a technology trap, in which labor-replacing technology was consistently and vigorously resisted for fear of its destabilizing force.
The Technology Trap
Artisans formed guilds and openly lobbied to prevent guild members and outsiders from producing things in new ways. However, as trade increased, competition between trading blocs eroded the power of protectionists. Areas that became more exposed to outside competition invested more in the invention of new technologies.
New technologies can be either labor saving or labor displacing. The problem with the latter is that displaced works see a rapid erosion in their income. So even though technological innovation boosts aggregate incomes over the long term, it is not cost-less at the individual level.
The simple existence of better technology does not inevitably translate into faster economic growth. For that, widespread adoption is required. If you want society to be open to new technologies, you absolutely must have a social safety net and a plan to make sure the displaced workers have the wherewithal to up-skill themselves.
In MSCI Country Index Correlations, we looked at country index correlations through time. Here is a quick update that “flattens” out the rolling correlation of the momentum versions of these indices with the MSCI INDIA MOMENTUM Index.
Three-year Rolling Correlations
MSCI Country Momentum Index 3-year Rolling Correlations
Five-year Rolling Correlations
MSCI Country Momentum Index 5-year Rolling Correlations
Take-away
Momentum is a lose proxy for sentiment and the tides of optimism floats all boats. All equity markets are correlated with each other – some strongly (HONG KONG) and some weakly (CANADA.)
The median correlations across both 3- and 5-year rolling periods are greater than +0.70 between INDIA MOMENTUM and EMERGING MARKETS MOMENTUM.
Cumulative Returns of INDIA and EM MOMENTUM (MSCI)
No market is an island. Sentiment is tail that wags the dog.
Typically, investors expect higher returns from high risk investments compared to low risk ones. However, realized returns are the opposite of what they expect.
High Beta vs. Low Vol
This anomaly, where lower risk systematically results in higher returns, has spawned a number of “betting against beta” strategies. A common approach is to rank a universe of stocks by volatility and create a portfolio off the top-N. However, this approach could lead to a highly volatile portfolio if relative correlations are not considered.
1+1 = 0
Here are two stocks with their volatility plotted against time:
correlated low-vol stocks
If you create a portfolio off these two stocks, what happens to portfolio volatility?
A portfolio made off low-vol stocks can be high vol
In the worst case scenario, where all the volatilities are correlated, portfolio volatility can end up being a sum of all component volatility.
If low-vol stocks can create a high-vol portfolio, can high-vol stocks create a low-vol portfolio? Yes! It all depends on how the volatilities are correlated.
inversely correlated high-vol stocks
In the best case scenario, portfolio volatility can be a very low constant value if the components are inversely correlated.
a low-vol portfolio created off volatile components
It doesn’t matter if individual volatilities are high or low. What matters is the correlation of volatilities.
Portfolio Optimization
A simple ranking of stocks will not help in creating a low-vol portfolio. What we need is a holistic approach that considers the correlation of volatilities and optimizes the entire portfolio.
One way to go about this is to use gradient descent. Start with a random portfolio and go in the direction that minimizes variance (min-var) or expected tail loss (min-ETL)
min-var and min-ETL backtest
With a monthly rebalance, the chances of the portfolio getting trapped in a local-minima are low. And the backtest looks promising.
Investing in Low-Volatility Portfolios
Equity investors can map our Minimum Variance and Minimum ETL Themes to their portfolios to gain exposure to these low-vol strategies.
