Following Momentum and Outperforming on the Downside
NWM Momentum Fund
Author: Ticker Magazine
Last Update: Jun 12, 3:11 PM EDT
|One can outperform the market not by beating it on the upside, but in doing so on the downside. To avoid being caught in long downward moves, the NWM Momentum Fund switches between asset classes depending on the risk environment. Portfolio manager Timothy Ayles relies on a back-tested model that signals the risk appetite of the marketplace, the momentum in a name, and the best investments for the specific environment.
“We aim to manage a fund that outperforms the market on the downside. Our biggest goal is to navigate out of long protracted down moves and to find a way to be either breakeven or make money.”
Q: What is the history and the objective of the fund?
The fund was launched on April 1, 2014 with NWM Fund Group, LLC as the investment adviser. George P. McCuen and I have managed the fund since its inception.
The strategy is built on momentum and the key is looking at dual or triple momentum. We believe that this strategy is in the best interest of our clients, because it focuses on not participating in long protracted down moves. We seek investments that perform strongly not only against their peers, but also against risk-off type of assets like U.S. Treasuries and cash.
We aim to manage a fund that outperforms the market on the downside. Our biggest goal is to navigate out of long protracted down moves and to find a way to be either breakeven or make money.
Q: How do you accomplish this goal?
We measure the risk appetite of the market. For instance, when there’s real risk appetite in the marketplace, investors are willing to take on junk bonds. When people are scared and avoid risk, they would typically buy assets like short duration U.S. Treasuries.
If our initial signal tells us that the market is risk friendly, then we have a pool of higher-beta investments like biotechnology, emerging market or small-cap growth stocks. When we are in a risk off environment, we rely on lower-beta names like larger-cap stocks, U.S. Treasuries, cash, investment grade bonds, etc.
Our tests have shown that when we measure high-yield bonds versus short duration Treasuries, we are able to capture most of the upside in a good market and to avoid the downsides in the stock market, because we move in and out of risk-on and risk-off assets.
Q: What core beliefs drive your investment philosophy?
We believe that the way to outperform a market is not by beating it on the upside, but by beating it on the downside. We always explain that to clients and the fund is designed to outperform on the downside. I have no problem if the market is up 10% and I am up 8%, because I am not trying to outperform on the upside. We have been able to show that by avoiding the long protracted down moves, we can achieve outperformance over time.
My core tenet is to always follow the model. For example, when in 2015 the U.S. stock market was hitting all-time highs, U.S. Treasuries were performing better then junk bonds and our model was telling us to move into our risk-off position. In the beginning of 2016, we had a signal to go entirely into U.S. Treasuries at a time when the market was near all-time highs and everybody was excited.
My emotions were telling me to continue to own stocks, but the model said it’s not a good time to do so. I followed the model, which ended up being right. The market dropped about 10% in the first quarter of 2016, while our fund was actually up during that period. So, I prefer not to trust myself or my intuition, but to trust the model, because it does its job without the emotion.
Q: What is your investment process?
There’s no macro or fundamental overlay in our process. We focus on measuring the momentum in a name, the appetite for risk in the marketplace, and the best investments for the specific environment.
If we have a risk-on signal, we have a pool of 20 types of investments, but we only buy four of the top 20 investments. So, we not only determine the risk appetite in the marketplace, but also which are the strongest performing investments in the peer group.
When we are in a risk-off mode, we’ll invest in cash or U.S. Treasuries unless there’s a stock investment that is performing strongly. So, we are completely driven by momentum, not by fundamental or macro views.
Q: How do you identify the risk-on and risk-off environments?
Studies show and professional traders affirm that the fixed income market is smarter than the equity market. Typically, in the equity markets there are mom-and-pop investors, who buy stocks based on what they heard on the news. In the fixed income market the investor is usually more professional, so I focus on the fixed income market for cues on the environment by looking at the two ends of the risk spectrum.
On the risk-on side, there are junk bonds, CCC-rated bonds, ETFs, while on the risk-off side, we have short-duration Treasuries. We look at relative strength and the ratio between the two. We use three-, six-, and 12-month periods and we have different weights for the period, which is performing more strongly. Based on the ratio, the model might show that over the last three and six months, short-duration U.S. Treasuries have had better relative performance to junk bonds, even if over the last 12 months junk bond showed better relative performance.
When short duration Treasuries have better relative performance than junk bonds, that means that there is less appetite for risk and we need to start thinking about investments suitable for a risk-off environment. In such an environment, I wouldn’t want to own emerging market or small cap stocks or biotech or technology stocks. I want to own more established large-cap stocks, investment grade bonds or U.S. Treasuries. In a risk-on type of market, when junk bonds have better relative performance than short-duration Treasuries, I’d rather own junk bonds or small cap or biotechnology stocks.
Our model tells us when the market is going to turn based on the way we measure risk. It doesn’t make sense to take risk, because we are not going to necessarily get paid for that risk if we are heading into a risk-off type of environment.
Q: What is your investable universe? Do you invest internationally?
We invest only in country-specific ETFs, because if Italy, for example, is performing really well, we want to have concentrated exposure in Italy. We also have broad-based assets like small, mid, and large-cap stocks. We typically evaluate which U.S. sectors have higher and lower beta. In a risk-on mode, there is a chance to invest into an asset ETF like a small cap U.S. stock and we may also have investments in industry or country-specific positions.
When we are in a risk on mode, I aim to buy the top four ETFs out of a pool of 20 ETFs with higher beta. So, we may potentially own equal positions in biotechnology sectors, small-cap U.S. stocks, Italy and Brazil, for example. Within our stock exposure, we may be entirely invested in emerging market stocks if that’s the strongest performing asset class in our investable pool.
Overall, the investable pool includes country specific assets, broad-based assets in terms of small, mid and large cap, and sector or industry specific investments. We compare the assets to decide which ones we want to own. In some environments we could own only sector ETFs or only broad-based market ETFs, depending on the performance during our measurement period.