Mitigating Risk Through Tactical Allocation
ATAC Inflation Rotation Fund
Author: Ticker Magazine
Last Update: Jun 22, 11:27 AM EDT
|Stocks and bonds often move in the opposite direction, but the inflection points are not always clear and well defined. ATAC Inflation Rotation Fund has developed a process that uses the signaling power of utility stocks and the U.S. Treasury market to predict upcoming volatility. With a steady focus on absolute return, Edward Dempsey explains how the fund opportunistically switches between asset classes.
ďWe are always guided by the fact that success isnít about the money we make on the upside, but about not losing on the downside. Most of our return is generated through the correct allocation and by the decision when to invest in stocks and when to avoid them.Ē
Q: What is the genesis and history of the fund?
The fund evolved from a separate account strategy that we developed in 2010. After the events of 2000 and 2008, certain sectors of the market were affected with large losses. We wanted to recognize the conditions under which those losses might occur. That led us to our work on the utility sector and Treasuries that we published afterwards.
In 2010 we developed a separate account, designed to play offense and defense and to thrive in any environment, regardless of the stock market direction. In late 2012 that strategy evolved into a mutual fund, where investors could opportunistically be either in stocks or in bonds, not stocks and bonds. Thatís very different from the typical 60/40 portfolio that maintains a static or dynamic exposure to both stocks and bonds. Unlike other mutual funds, we opportunistically switch between stocks and bonds, being 100% in only one of those asset classes at a time.
Q: What core beliefs drive your investment philosophy?
We believe that large losses are devastating to a portfolio. We are always guided by the fact that success isnít about the money we make on the upside, but about not losing on the downside. Most of our return is generated through the correct allocation and by the decision when to invest in stocks and when to avoid them.
We also recognize that momentum is very powerful. It is documented that what goes up, tends to keep going up and vice versa. If there is downward momentum, we want to step aside. When there is upward momentum, we want to fully participate in that trend.
This is a systematic, rules-based strategy. By definition, you need a strong conviction to create a rule. Thatís one of the benefits of this strategy in comparison with a more fundamental approach, which isnít necessarily guided by strong beliefs. Structure and discipline are also important, actually more important than the strategy itself, because you need the discipline to stay with the strategy to benefit from it.
Q: How does the philosophy translate into an investment process?
Our process starts with our research team, which is the intellectual capital of the strategy. We have developed white papers on the utility and U.S. Treasury sectors, which have the ability to predict when the upcoming volatility might change. These white papers show that in the top 1% of all VIX spikes, the utility sectors were already leading the market 83% of the time. That means that there was a de-risking underway. It doesnít mean that every time utilities lead there is a VIX spike, but it means that the utility sector is already there. Long-duration Treasuries show a similar type of signaling power.
In our white papers we use a four-week rolling average. When forward volatility tends to rise, there is an underreaction in markets or gradual diffusion of information, where one part of the market moves and the rest of the market wakes up to it. Thatís key, because those sectors are signaling change in the shape of the yield curve. Utilities and Treasuries are the two main indicators in our white papers, while the rest is proprietary.
This is a weekly strategy, which means that we have 52 decision points in a year. It doesnít mean that we necessarily trade every week, but each week we have to answer two questions regarding the portfolio. The first one is about the direction of volatility for the coming week and whether we should be in equities. If yes, the second question is where in equities we should be.
If utilities are strong or if long-duration Treasuries are stronger than intermediate-duration Treasuries, we would expect volatility to rise. In that case, we would step away from equities. In times when stocks and bonds correlate and are going down together, we have the ability to go to short-duration Treasuries, which are cash-like securities. If Treasuries and utilities are weak, that suggests that forward volatility would fall and thatís a positive signal for equities.
In general, when stocks hit periods of extended volatility, Treasuries do well. Treasuries are probably the only negatively correlated asset class to stocks in stress environment, other than gold and the yen. So, we would position that portfolio 100% into Treasuries, typically long-duration Treasuries via ETFs. That makes us very different from other tactical or alternative funds.
Q: When investing in equities, how do you select stocks?
When we invest in equities, we run three opportunity sets - emerging markets, Russell 2000 Index or the S&P Index. We rank the momentum of emerging markets and small caps to the S&P. If neither of them have better momentum but the utilities risk trigger is positive for equities, we will default to the S&P. If either emerging markets or small-cap Russell 2000 have better momentum, then we will be 100% in emerging markets or Russell 2000.
This is an aggressively positioned approach and we add a twist to it. There was a misconception that the 200-day moving average improves returns. In another white paper, called Leverage for the Long Run, we show with a simple back test that returns are actually subpar when selling below the 200-day moving average. When the market breaks below 200-day, it improves volatility, lowers standard deviation, and deleveraging is going on.
When momentum goes up, leverage helps to magnify and amplify returns. So we run 30% leverage in the equity portfolio to take advantage of and to maximize the momentum effect. Basically, we want to be in the trending momentum asset class and we can amplify returns with leverage. We want to capture that momentum using large liquid index ETFs.
We donít see a lot of value in security selection. The majority of our return is driven by selecting the asset class and the subsector. Overall, we want to stay in the right place when the conditions are favorable.
We donít run a risk parity portfolio. We want to constantly be on the right side of the probabilities and each of these scenarios will present itself in a different way. For instance, why are stocks going in a certain way versus bonds? Typically, a recessionary environment is not good for stocks, but is good for bonds. An inflationary environment can be good for stocks and not good for bonds.
Our focus is delivering absolute return and low correlation. One of the hallmarks of this approach is the low correlation to both stocks and bonds due to the frequency of the switches between these two asset classes.
Q: When do you make the rotational shifts between asset classes?
We have found that the signals have relatively short life and do not stay out in the market for long. In order to capitalize on the signals, we have to be tactical and to move quickly. Weíve outlined in the white papers that the signal works best on a four-week rolling average and we use five days of trading data. It is a weekly strategy with 52 decision points on the calendar.
When in equities, we use momentum to our benefit; if there is no momentum we default to the S&P and lever that by 30% to maximize the advantages of momentum. We execute through index ETFs for low cost and the rapidness of the switching.
Q: Do you rely on historical databases to make your asset allocation decisions?
Yes, in our white papers the data in the testing covers nine decades or almost every economic cycle. We are passing through the era of quantitative easing, which produced negative interest rates around the world. We demonstrated that over time, as that yield curve changes and changes are anticipated, money in the market constantly shifts to take risk or to de-risk. Historically, there is a good track record of conditions of volatility, which leads the stock market weakness.