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Robert Kendall Managing Director

Many times I've discussed and suggested that advisors should always use process over attitude. When I say this, am I just saying to follow the buy and sell signals in the allocations that VPM is generating? The answer is a simple no!

While part of the process is following the suggested buy and sells and reallocations, there's a much further process that is happening behind the scenes.

The training videos on our website in section 4 direct advisors to build a tracking manual. There are four primary reviews that should be performed on an ongoing basis. They are weekly, monthly, quarterly and annually.

The reason for these reviews is to establish a dynamic process over time that fits the philosophies of your firm as well as the different variables that occur during the walk forward process of VPM.  The reason why these reviews are important is that they help to develop context to understand decisions that need to be made around different market cycles, as well as circumstances that happened in different asset classes, as well as the individual symbol considerations.

Some people think when I talk about Process Over Attitude that all I say is do the signals. While that's true, there are times when events occur, both in the markets as well as individual stocks, that require a little bit more thought.

One of the issues that have always been in play, and I have discussed this in the training videos, is when stocks get extended, it is critical to make sure that you review stocks that are in upward runaway patterns as well as downward spirals. They might be causing the positive and negative effects on your portfolios. This does not apply so much to ETF's or mutual funds

In the case of extended stocks, these are stocks that you are concerned that they have gone up too fast. There are a couple actions that you could take that would still involve being in what I would consider process. For one, there is the simple review of a stock that has ratcheted up very quickly due to a proposed buyout. These are always easy. You can just go ahead and take profits as they’re trading near the buyout price. It is not likely to move much above that price if there is a deal in the works. If this stock has spiked and VPM is issuing a new buy, then you should not execute that order. You'd want to deactivate the symbol to avoid this coming into your portfolio because often times the stock has already experienced the returns it would due to the buyout.

But there are other circumstances that need to be reviewed and processes that needs to be put in place, such as extended moves that have exceeded both holding periods and expected returns that VPM demonstrates in its trade profile stats. There are two ways that you can handle this. One would be to track the stock on a daily model and exit it on a sell signal 100%. Another option would be to sell off half of the position and exit the balance of the position when the weekly models issue a sell signal.

Other corporate events such as news, negative or positive, can also be evaluated and tracked at a different level. I think it's critical to understand that when I wrote the articles several weeks ago titled “The Value of Process,” there are events that you, the advisor, should be involved with in the decision process.

The value of utilizing the review process and documenting it is that it will help you to understand some of these actions as you move forward. Any action that is taken should be documented and then reviewed on the quarterly basis to determine the validity of the action. One question that should be asked is “Was the action appropriate? Did it add value or did it take away value?” If you see that these actions are not adding value as you go through the evaluation and updating process, then what you want to do is document which actions are positive and which ones are negative.

Through that evaluation process, you start to develop a dynamic process that operates within the context of your practice and your philosophies and is validated through positive occurrences.

By doing this, you will be documenting actions on different types of events that need to be thought through before executing or even adding new client funds to trades. This is the key. By having a documented reviewed process, it gives you the context to know that the decisions that you're making as you walk forward the VPM process are valid.

When utilizing the indexing, such as mutual funds and ETF's, many of these considerations are not valid as they do not have the dynamics that an individual stock portfolio will have. With most of these strategies, you will initiate and follow the process. Buys and sells should match the current positions when you're bringing in new money. However there may be circumstances within current market dynamics that may cause you to consider certain types of actions. All of these actions should be directed through either the daily or weekly models determining on what you're trying to achieve.

My main goal is to make sure that decisions that you're making in deploying capital or executing trades are based upon logic not emotion. There are many circumstances in which you can use some of the daily models to help you to guide your decisions versus making an emotional one.

In my view, as you are the advisor with fiduciary responsibility, it is important to make sure that all considerations are pondered before implementing and deploying capital. Advisors need to ensure that their fiduciary responsibility has been handled appropriately. With many of the new regulations that are coming into play, these actions most likely will need to be documented which furthers the case for doing written reviews on our suggested increments. It appears more and more that documentation will become key in your practice remaining in compliance.

I will write further articles on some of these concepts to bring an understanding of the benefits of reviewing your portfolios on the daily, weekly, monthly, quarterly and annual basis.

Robert Kendall Managing Director

The market action of the last 10 years has clearly shown the weakness of the primary tool used by the investment advisory industry to manage risk-- passive asset allocation or MPT. While it has its place as one method of risk control for an investor's portfolio, it is not the only method!

Expand your Horizons

Many planners and advisors are using passive asset allocation methods because it's the only strategy they have been exposed to. Others do so because their firms have forced them to use it to manage risk.

They use historical statistics to allocate a portfolio among different asset classes or funds representing those asset classes as the primary method. They then reconsider the allocations based on the investor's circumstances and risk tolerance, make small changes, and rebalance the portfolio to the new percentage allocations. Yet, most of the changes are random in nature and are a reaction to the clients concerns or the advisors fears.

The primary function of the changes is to calm the client and for the advisor to demonstrate that they have done something about their concerns by “window dressing.” This is so they can go back to running their businesses and little to do with the original plan or market conditions.

I believe that financial advisers owe it to their clients to understand alternative methods of risk reduction. They should broaden their horizons and also consider dynamic market timing, dynamic asset allocation, and strategic diversification.

Passive asset allocation or Modern Portfolio Theory (MPT) is risk management based on combining non-correlated asset classes to create a portfolio with risk lower than the average risk of its component parts.

Because it's passive, it cannot respond to evolving market conditions. By definition, it can only deliver mediocre returns (the average return of its component holdings). It takes almost superhuman discipline by requiring proponents to not only hold on to investments that have already taken serious losses, but also to sell portions of the top performers in order to buy more of the losing investments.

Furthermore, it subscribes to the almost un-American ethic that if you work less at your investing, you'll do better.

Fear of the Unknown

The real issue is that most advisors operate in the markets from fear and not from structure or knowledge. So many of the decisions to change a portfolio are reactions to clients concerns or fear of the uncertainly of the market.

Over the last 10 years, financial professionals using passive asset allocation in real life have become somewhat disillusioned. Returns seriously lagged during the bull market. Then adding insult to injury, losses were deeper than expected during the market decline of 2007 to 2009. Previously non-correlated asset classes were suddenly moving in the same direction as prices collapsed.

The financial press responded with front-page stories speculating loudly about the "asset allocation hoax." But there was no hoax, only a failure to understand that there is no Holy Grail approach to investing.

There are other options such as market timing and technical analysis, despite being some the most criticized, they both are valid alternatives.

Many mutual funds and variable annuities, consistent with their obvious conflict of interest on the subject, denounce it. They say you can't time the market. They go through all types of examples so you will buy their funds so they can collect 1 to 2 percent in imbedded fees.

A Change in the Wind

Yet, both market timing and technical analysis seem to be winning over converts by the droves. In a recent comprehensive study of the advisory industry, Financial Research Corp. of Boston found that active management was the fastest growing segment of the financial adviser industry.

The conventional wisdom on the Street is that "studies show market timing doesn't work." Yet in the 1990s, academia produced a stream of papers demonstrating tradable inefficiencies in the market. In addition, the first American Nobel laureate economist, Paul Samuelson, reversed his random-walk-based negativism to market timing, allowing that it might succeed for investors with limited time horizons.

Recently, major studies of the results of large groups of market-timing firms over various time periods have demonstrated that market timers deliver real risk-adjusted returns after fees. In the case of VPM, we have seen 10 years of positive alpha delivered on our equity portfolios and our mutual fund portfolios.

All this is not meant to imply that market timing or technical analysis is perfect Market timing, too, has its considerations. All market timing approaches go through phases of under-performance and over-performance with the market. Some for relatively short periods, some for long periods, and some never return to profitability.

In addition, the translation of the buy decision into action has plagued many timers, as the chosen instrument may not mirror the market being modeled. In volatile or trendless markets, market timing is vulnerable to whipsaws. Studies show that market timing works best the more actively securities are traded. This, plus the 100% in, 100% out trading, can lead to strained relations with fund companies.

Fund company concerns may not be valid, however. They fail to consider netting of opposing trades, cash positions of funds, asset levels, today's lower commission costs, the fact that the addition of days necessary to avoid redemption fees do not address the supposed costs of the eventual trade to other shareholders, and finally, that the fund family industry was built on the back of the very exchange feature that the fund companies now seek to limit.

Still, there is little argument that it can be a daunting task to find sufficient shelf space to trade market timing strategies. Fortunately, the development of the actively tradable fund families such as Rydex, ProFunds, Potomac, as well as exchange-traded funds (ETF) and basket trading have lessened this issue for active managers. I have found that equity based portfolios have the greatest risk control and add more alpha than you can with mutual funds or ETF's.

The Blend of Concepts

Early in the 1990s, a few investment firms began to offer a new risk management strategy--dynamic asset allocation. It mixed much of what is best in passive asset allocation and market timing strategies. The approach is simple: A universe of funds composed of all of the domestic style boxes, international funds, bond funds, and money market funds is assembled.

Based on academic studies that identify one of the best tradable market inefficiencies as the tendency for a rising trend to continue, the funds from the diverse universe are ranked daily, weekly, or monthly, and the best performers are chosen. These funds are held until something else supplants them for the top leadership. Since money market funds are also ranked, they can cushion the blow of a declining market.

This uncomplicated strategy accomplishes a lot. Like passive allocation, it draws on a universe of asset class funds and is diversified into a number of fund positions. But dynamic asset allocation is actively managed and can respond to market conditions. Its focus on the best performing funds helps to prevent it from falling prey to the shortcomings of the passive strategy. It doesn't have to by definition achieve mediocre returns, and it doesn't take money from profitable positions to fund losing ones.

At the same time, dynamic asset allocation avoids the principal downfall of market timing systems; It does not interpose a set of market-related trading rules between the investor and the returns he or she hopes to achieve from a specific investment. Each fund's return/price movement--and only that return--drives the investment, retention, and sell decision. Macro factors cannot get in the way. While it requires much more effort than passive asset allocation, dynamic asset allocation tends to have better risk-adjusted returns.

Implementing a Dynamic Asset Allocation Strategy

This strategy does have some considerations, though. Many of the problematic fund relations issues remain. Also, momentum investing tends to go through trendless, whipsaw periods where small, short-term losses can occur. The practitioner must remember that the strategy simply puts the odds of success on the investor's side. It does not guarantee profits on every trade.

Another technique, strategic diversification, works by combining strategies into a portfolio of strategies. It works much the same way as traditional asset allocation does. Diversifying client investments not only along asset class lines, but also based on the strategic techniques used, further reduces risk. For example, a financial planner can maintain a passive portfolio together with a timed or tactically managed investment and a dynamically allocated investment service.

As with traditional asset allocation, it is important that clients really diversify. In other words, advisers can't combine five similar strategies and expect to reduce risk significantly. That would be like fielding a football team with eleven quarterbacks playing all of the positions. They could be the eleven finest quarterbacks, but as a team trying to fill all the roles, they probably would not be too successful.

Diversification is more than simply owning many different styles and asset classes; they must be different, non-correlated assets. Advisers need to find approaches that work with different asset classes--U.S. equities and their subcategory styles, global investments, bonds, and alternative or defensive investments like precious metals and real estate. They should not shy away from asset classes or strategies that have underperformed in the short run if they have a good long-term record.

To avoid the problems associated with passive asset allocation, active strategies must account for a substantial portion of the strategic portfolio. Active management's value results from the inherent advantage of active over passive strategies--the ability to capitalize on intermediate-term trading opportunities to avoid risk and seek profits. By diversifying among these actively managed strategies, investors will have already captured passive asset allocations singular benefit--lower risk through diversification.

In addition, combining different styles of active management is important. A strategically diversified portfolio should include some tactical (market timing) strategies, as well as the dynamic asset allocation approaches. Different techniques (fundamental, technical, top-down, bottom-up, cyclical, predictive, seasonal, neural net) further the diversification cause. Keep in mind that diversification works to reduce risk only if it is among non-correlated strategies. There is some downside to diversification as over diversification can dilute potential profits or alpha in the portfolio.

Fortunately, advisers are now offering multiple strategies on one investment platform. Non-manager planners can find these offerings on retail platforms in the separate accounts arena for large stock accounts managed by traditional fund providers; they are also available from active advisers utilizing mutual funds and variable annuities. The investment management fees charged to the client, a percentage of assets under management, are split with the referring advisor.

While this is a solution for obtaining diversification for your clients it also is a very expensive option. Most of the out-sourced management cost between 50 and 125 basis points. This represents tens of thousands of dollars in lost revenues for the referring advisor.

The mutual fund and variable annuity product environment is especially appealing. In a stock portfolio, active trading can generate high transaction costs, but active managers working with no-load funds or variable annuity subaccounts have few or no transaction costs (although these costs do exist within the funds or the subaccounts).

On the other hand, separate account managers can better handle the tax costs of their efforts within taxable accounts. Active managers prefer to work in the deferred tax environment provided by IRAs, retirement plans, and variable life and annuity products. Finally, to achieve adequate diversification, investors need to own a number of strategies, so a low minimum account size per strategy may also be an important consideration.

Although they face an increasingly challenging market, investors and their financial advisers have more tools available than before. Employing them all in a single portfolio can achieve a new level of risk reduction. Strategic diversification means today's investor is like a football coach in a close contest. He's not going to use just his defense to win the game. He's going to use every weapon at his disposal--his offensive unit, his defense, his special teams, and all the talents of a well-stocked bench--to bring home a winner.

Waiting for the returns

There have been 14 declines greater than 20 percent since 1929. The big story is in the time it takes to recover from these events. They take much longer than most would think to recover from the declines.

While a passive “Buy and Hold” Approach has worked for many over the years, advisors and clients are learning more every day that they may not have the time needed for the market and their accounts to recover the losses over these time periods. This is especially true when the money that has been saved and invested for years begins to be liquidated to pay for their intended purposes, whether it is for retirement, college savings, or other activities. Once clients’ investments begin to be withdrawn, they may never reach past market peaks again.

 

Over the last six months, the markets have continued to increase in their volatility and many of you wonder how to deal with this issue. There are several things you can do to work within this environment. This article is intended to direct you to actions if needed that are likely to be more structured, rather than actions based on anxiety or emotions. While many of these actions will help in certain windows of market activity of high volatility, only certain elements of the strategy should be applied in normal trending environments.

Overall, these strategies deployed over a long-term are likely to cause a decline in overall returns, rather than enhance them. However, for highly volatile stocks with beta of 2+ or stocks that have exceeded or are in runaway pattern, this strategy can be very helpful locking in profits.

The strategy can be used on a number of levels such as scaling out of the position or exiting a position altogether. It is my suggestion, should you deploy any of these ideas in this article, that you document them and go back to review what the outcome was.

For example, if you want to utilize the strategy to exit a position based on a short term pattern, utilize one of the daily models (use best optimize models for this strategy.) The two basic actions you could take is to exit the position completely or to sell half of the position on a daily exit signal and exit the balance of the trade when the weekly models issues an exit.

You must be aware that this will increase the ticket volume and therefore the cost of running a strategy. This is why I suggest that if you do deploy these ideas, that you deploy them on symbols that have exceeded their expectations both in returns or holding periods or a combination of both. Also, if there is news on a stock that causes the price to move up sharply, you can also deploy a daily model using the exit on half or all of the position, depending on the circumstances surrounding the symbol.

There are many elements that are necessary in utilizing VPM on individual equity strategies due to corporate actions, sharp movements in prices both up and down, stock splits, spinoffs, and other events that can affect the pricing of the stock that you own.

This is why I have suggested over the years that in any actions that you take, record them in your tracking manual. I strongly suggest that you maintain these as they will help you understand your actions and give you the ability to review them and validate these actions as you move forward.

While you could use outside tools to make these decisions, my suggestion is to utilize the VPM process. We have to tools available to identify the same patterns on shorter-term charts that were defined on the longer-term charts. This maintains consistency by using the same strategy to make all of your decisions.

An article that I wrote several months ago discussed how overrides and user intervention result in lower returns over 60% of the time when applied on an ongoing basis. But there are often times in the real world decisions that have to be made for a plethora of reasons when managing money.

There are windows in time that volatility is extreme, especially volatility in individual issues, that will require that these actions to be executed.

Many of you have wondered about the use of stop loss orders or other types of technical issues to control downside risk. This action is intended to protect a stock that you purchased or in the case of a stock that has run away to the upside and has exceeded your expectations from a return standpoint.

This basic strategy is useful more in individual equity strategies than it would be in mutual funds or indexes. Often times, there are symbols that you may purchase that will have very strong rallies and exceed the stats listed on the trade profile. This profile will display what the average holding period is and what the expectation for the returns are within a standard deviation of both holding periods and return expectations. Oftentimes, when stocks exceed these expectations, you get into a window of time that has more uncertainty.

I've never been a fan of stop loss orders. My experience is that often there are especially amateur type ideas where people will just say “I don't want to risk more than 10% from any entry point or a trailing stop from a recent high.” This is a randomly chosen point which has nothing to do with the patterns or the expectations for any particular symbol. There are plenty of valid techniques with which to determine stop loss orders. Yet, in most cases people tend to utilize stops in a more random entry then a structured entry. Most of the times, the random 10% retracement number will cause you to get out of trades long before they have completed. This is especially true when you're monitoring and trading intermediate trends as they unfold over weeks and months.

An example of a failure in this methodology is a stock that's run from 20 to 30. If you place a 10% stop on the last peak at 30 with $26 ¾, the stock drops $3.50 and then reverses and runs to 35, 40 or higher. Meanwhile, if you get stopped out you become a bystander, watching the stock move up while you are on the sidelines.

The biggest issue with this strategy is there usually is no way or structure to reenter the stock for the reversal. So the end result is you make some money but left most of the profits on table. It increases your probability of selling before the rally begins. You will notice that if you look at the trade profile on most stocks, you can come up with an average loss number. This will give you a better idea of what the average loss is on that model and some perspective on what usually occurs when there are losing trades on that particular symbol. 

The table below shows that average loss on an optimized symbol over the total database of 18333 symbols is 8.757 percent. This doesn’t mean this is the max, but overall the system has always done a good job at protecting the downside.

When I quote “Process Over Attitude and Opinion,” this does not mean that there are not valid processes that you can to apply to your portfolios to maintain stability as well as control risk. My suggestion is that if you're going to utilize some sort of shorter-term strategy wrapped around a VPM weekly signal, then I would use the daily model to determine when to modify a position that was issued by a weekly signal.

I am working on several articles that will be released over the next couple of months. These will help you understand and deploy a more dynamic overlay to properly maintain your strategies as you walk your screens forward along with other dynamic events in VPM.

 

Bob Kendall

 

I have continued to monitor the balance sheet of the Federal Reserve. You’ll see in the chart below that the light green area represents mortgage-backed securities. In the most recent quantitative easing program the Fed has decided to buy up to $40 billion of mortgages each month and the program is perpetual at this point in time. When looking at what’s been going on since the beginning of this year we actually see a moderate contraction of the Federal Reserve’s balance sheet. Even in the most recent weeks after QE3 was announced we are still seeing a moderate contraction.

This suggests to me that deflationary pressures are continuing to grow and draw down the value. This is somewhat of an ominous sign as it appears that the reflation trade is not getting traction. This could lead to the recent declines in the markets and the lack of assets expanding. While the Federal Reserve actions suggest they are trying to reflate the markets the opposite is occurring. This suggests to me that we could see further actions occur by the Federal Reserve to maintain their overall strategy of reflating the markets.

At the initial glance it appears that this balance sheet is negative and in real terms it is. However, if the Fed is committed to the reflation trade, then it will be necessary for them to step in and do additional simulative purchases beyond what was announced last month to get the balance sheet to grow again.

The chart below shows from December 2010 through May 2011 the balance sheet expanded from 2.2 trillion to 2.85 trillion. During the concerted effort of central banks around the planet last October we did see a minor spike up to $3 trillion. Since that point the balance sheet has flattened off and has actually declined back to the 2.85 trillion mark. I am positive that the federal reserve is keeping a close eye on this and is likely to come up with some further stimulus program in next month’s Federal Reserve meeting.  Should this trend continue, with no action from the fed in November, it will suggest higher probability for further action in December.

This in my opinion sets the tone for yet another stimulus related rally in the stock market. There has been a major combat made by all of the major central banks in keeping the reflation trade on. At this stage there is no way they can abort the strategy as it will cause a massive loss of confidence in the overall system. For them not to continue this trade could signal a major deflationary period and therefore a major depression.

It appears to me that the likelihood of them not following through with their commitments is close to nil as they have now put us all at so much risk that they have to continue the trade.

Back in the days of my market making activity on the Pacific options exchange I used to talk about the Incredible Growing Trade. These trades always grew out of control as the days and weeks would unfold because you had no choice but to continue to add to the trade to hedge the risk that would grow inside of the strategy. You would continue to add to the strategy until you ran out of capital. At this point there was only one action; start to liquidate the position. The result of this action usually represented a losing trade because it was more of a liquidation of a strategy that had grown out of control than a profit taking exercise.

I believe the Federal Reserve has found itself in a similar position.

 In the case of the Federal Reserve, there is no way to get out of the trade as they are making at least a 10 to 15 year commitment by buying mortgages and putting them on the balance sheets. The reason why they are stuck with these assets on their balance sheets as there is currently there are no takers willing to purchase these mortgages. With well over $1 trillion of mortgages on the balance sheet; with current market conditions it will be nearly impossible to find a market to move these off the balance sheet.

You can clearly see that from before the Bear Stearns debacle/ the beginning of the ‘08 crisis that the balance sheet was well below $1 trillion. It has nearly tripled. If you look at the assets that make up the balance sheet you will see that most of these have no choice but to be held for the long term based on what they are.

chartsopeningbe

In my opinion, these longer-term assets held in the balance sheet appear to have no liquid market to sell into. This will perpetuate slow growth and keep a large amount of risk on the economy for at least 10 the 15 more years.

From my viewpoint, it appears that it will be fairly easy to determine how the next one to three years will play out based upon whether or not the Fed is willing to step in further into this trade and demonstrate that they are willing to expand the balance sheet to 3.5 trillion or more.

I believe this is why Bernanke has continued to warn about the potential risk with the fiscal cliff issue that is coming on January 1st. His commitment to the strategy as clearly illustrated in this chart is going to keep this strategy in place. Regardless of who runs the Federal Reserve in the future, he will have no choice but to continue on the same path as there is no exit.

At this time it is impossible for us to determine on the long-term basis whether the strategy plays out positive or negative, but the current portfolio will certainly control Federal Reserve policy for many years to come.

The only hope is that somehow the housing market comes back and that their risk in the mortgage portfolio decreases enough that the institutional investors want to own this paper. If that occurs then there is an exit strategy. However, based on what we know today and the evolution of new federal regulations that will control the purchases of these mortgages as a result of the Dodd-Frank bill and other regulations that are in place, it will make it difficult for the investment community to take this paper off the Fed’s hands.

Of course the beauty is that if you have a legislature and a printing press, you ultimately can do anything you want. For now it appears that the strategy will stay in place. It is likely to keep a general positive trend in most underlying assets including stocks, commodities, and housing for the next several quarters so long as they are will to keep up the growing commitment to the incredible growing trade.

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For 20 years, our VPM portfolio management process has given thousands of advisors the ability to build and maintain quality and scalable strategies. Through integration with partnerships and dozens of prebuilt strategies, VPM and its consultants can guide you through the entire process in building a true scalable and deliverable product suite.

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