The two major conclusions were that first, asset allocation needs to be more defensive in nature when faced with the probability of multiple equilibria, and second, explicit tail hedges that look expensive in a normal world may indeed turn out to be cheap if the unimodal morphs into the bimodal.
-Vineer Bhansali, managing director & portfolio manager, PIMCO
May 1, 2012
Obtaining exposure to momentum is not that hard, but it forces one to think very differently about markets and investing. The momentum strategy consists of (1) buying what is going up and selling what is going down, (2) buying more of what is going up more and selling more of what is going down more (called pyramiding), and (3) stopping the buying and selling at predetermined position sizes for risk management. This is the perfect antithesis of value investing where “buy low sell high” is the mantra, yet there is incredible value in this style of investing if (1) done cost efficiently and (2) in a controlled fashion.
In a set of illuminating papers written over a decade ago, academics Fung and Hsieh demonstrated that this strategy is theoretically and empirically the same as buying an “option straddle” (a call and a put), and hence offers exposure to rising market volatility. The potential benefit of the strategy is that by following a limited set of transparent rules it can avoid high option premiums that one would pay in a straddle. When implied volatilities are high, such dynamic strategies can indeed become cost efficient.
Of course the implementation is not free – if markets do not trend but mean-revert repeatedly, the “whipsaw” can cause the strategy to buy high and sell low continuously, creating losses that can add up. Empirically, these whipsaw effects have been relatively low compared to the potential for attractive gains as in 2008. Other researchers (C.S. Asness, T.J. Moskowitz and L.H. Pedersen, “Value and Momentum Everywhere,” NBER, 2008) have shown that momentum is not limited to any one market, but is actually “everywhere,” and thus the strategy is best implemented across all asset classes (stock indexes, bonds, commodities and currencies). In addition, the momentum factor tends to do better when there are periodic bouts of illiquidity as is typically the case when risk-aversion rises. Since all of these markets have liquid futures contracts, the momentum strategy can actually be implemented very cost efficiently as a collection of long and short positions in futures contracts.
In a world of zero interest rates the potency of bonds (or duration) to provide diversification-based hedges is very limited (e.g., at a 2% yield the maximum capital gain if 10-year yields fall to 1% is only about 15%). In this world of low, pegged interest rates, an investor who is going to take risk needs other means to make the portfolio more inured to unforeseen shocks and market storms. In my opinion, the only hope for investors to stay in the air long enough to avoid the forces of wind shear that accompany these uncertain prospects is to look at effective alternative beta strategies, such as momentum, that can be implemented efficiently. Way back in in 2003, when we first started to implement tail hedging strategies for our clients, the phrase “tail hedging” was an outlier, and indeed the practice was not part of the investment vernacular as it has become today. If we are correct in our forecast of a bimodal world, the value of being invested in the momentum risk factor will likely prove to be just as relevant as tail hedging has been over the last five years.