Last year was a whirlwind for markets. Most investors started the year optimists: markets were in the midst of a rally, the global economy was expanding, and the prior decade's trade disputes were heading towards resolution. But we all know what happened next – the fastest market crash in history, with equity markets tumbling over 30% in a matter of weeks. Interestingly however, the recovery was almost as fast, and by the end of the year the S&P 500 was pushing all-time highs once more.
However, some are now concerned that equity markets look overvalued, credit spreads look too tight, and low yields mean government bonds offer scant protection, as a result they are wondering whether now is the time to solidify their gains, move their portfolios out of the markets, and store their savings in cash. Prima facie, this is a sound investment thesis, it rests on the first law of commerce: buy low and sell high. If the market is offering an attractive price for your assets, then sell up and store your money in cash, you can buy back in once valuations look more reasonable.
A number of investment managers offer products which employ this principle as the primary investment device. Often referred to as market timing strategies, the investment thesis is simple: rotate client money out of markets which have reached their peak, and into markets which are due for a rally. An example would be rotating between Chinese equities and cash:
- Buy Chinese equities at the start of 2017.
- Sell before they fall in 2018.
- Rebuy the market at its nadir at the beginning of 2019.
- Hold it all the way to the next peak in January 2020, selling sell before the Covid-19 crash.
- And then ride the 2020 recovery, selling before markets dipped at the start of 2021.
Past performance is not a guide to future performance
Following the above strategy would have resulted in investment growth of almost 350% in under 4 years. Market timing strategies are able to deliver exceptional returns, all you need to know is which direction the market is going to move next. That said, anyone would make money if they knew how the market was going to move next, that is why these strategies often have impressive backtests, but struggle to deliver live track records with the same stellar returns. All too frequently investors pull their money out of the market too early and miss a great deal of growth, or buy back in too late, having missed the vast majority of the appreciation. The problem is that, in the short term, markets are volatile, unpredictable and frequently dislocated from fundamentals. This makes consistent, accurate prophecy of short term market movements very difficult.
Rather than just attempting to time the market, we believe that the best way to create value is by constructing a diversified portfolio which maintains long term exposure to a wide array of lowly correlated asset classes. This smooths volatility while maintaining strong performance and attractive risk adjusted returns. Academic research also supports the sentiment that the most effective way for investors to weather drawdowns is through diversification, not market rotation.
The question remains, how to decide which assets are included in the portfolio, and in what proportion? We advocate using robust, academically recognised investment techniques. The academic literature tells us that, in the long run, the returns of an asset are determined by a combination of the asset's current valuation, the macro and style factors exposures of the asset, the present economic environment, and the tendency for mean reversion. Using these inputs it is possible to model long term asset class returns and then construct an optimal portfolio considering asset class correlations.
Although the composition of a portfolio should be stable, it should not be static. As valuations fluctuate, asset class momentum changes or the external economic conditions evolve, the return characteristics of each asset class will change. These changes should be reflected in a portfolio's long term asset allocation. Shorter term, or 'tactical', positions can and should be used to add value. However, when short-term positions are initiated they should have a sound economic rational and not solely focus on following the crowd.
Market timing makes for a compelling investment narrative. It can certainly be useful as one input into tactical asset allocation decisions, but a sustainable driver of long term returns it is not. Investors who want to move beyond myopia, neutralise the market noise, and generate sustainable returns should focus on creating globally diversified, long term, fundamentals driven, investment portfolios.
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