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.
“We are always guided by the fact that success isn’t 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.”
Q: How does a rising rate environment impact your process?
If rates are rising because of strong global growth, that’s good for stocks. However, if growth is still tepid but there are inflationary spikes, that would be bad both for stocks and bonds. In that case, the fund is able to step aside and go to into short duration Treasuries.
In our history, we have gone to short duration Treasuries in 7% of the time. If there is strong global growth and rising rates in the years ahead, the market will be vulnerable to inflationary or growth scares, where growth disappoints and the markets react. We haven’t seen that in a number of years, but that is probably coming back now. That trend will require a flexible set of options, guided by discipline and rules.
Q: What signals guided your portfolio last year?
In 2017, our portfolio produced strong returns despite the fact that we were in equities only about 60% of the time. As we moved into the back half of 2017, utilities and U.S. Treasuries were weak and the equity markets responded by going up. But all the momentum was in emerging markets, so the risk trigger kept us in equities, while the momentum factor kept us in emerging markets.
2017 was a textbook example of the positive side where weak utilities, weak U.S. Treasuries, low volatility, strong equities and momentum all pointed to the emerging markets.
We are looking forward to a more normal stock market year, which could have two or three corrections of about 8% or more. For our strategy, that is an environment in which we can thrive. We are built to be forward looking and go to Treasuries while stocks go down and to come back to equities when the conditions are more favorable. The entire point of our risk management process is to avoid losses, so if there are no losses, the defensive thinking has no value.
That’s why we are looking forward to a more “normalized” market action, where corrections actually persist and our risk management overlay can make that work.
Q: How do you identify a “normal” correction?
“Normal” corrections are often preceded by price action or by the strength in utilities and Treasuries. After a period of market weakness, that weakness ultimately subsides and the markets move back up. That hasn’t been the case in the last several years, when the corrections would typically come almost out of nowhere.
That was partially due to the nature of U.S. Federal Reserve liquidity and the money available for chasing equities and yield instruments. But we believe in mean reversion; it’s one of the few absolute truths in the markets. Everything mean reverts and every cycle will change into a cycle. With the end of quantitative easing and the beginning of quantitative tightening, we expect the return to a more traditional cycle.
Q: What is your portfolio construction process?
The investable universe is strictly stocks or bonds, but we construct the portfolio of stocks or bonds via large liquid index ETFs. We don’t believe in security selection, but in getting that stock and bond allocation correct. We believe in diversification and low-cost and ETFs, which allow a strategy like ours make the required rapid changes.
We were early adopters and have capitalized on ETFs as a way to actually build, manage, and run a portfolio.
We are absolute return investors. It is very difficult to benchmark a portfolio like ours, because we would need to have consistency or the benchmark would be irrelevant. A portfolio, which switches its asset class from 100% in stocks to 100% in bonds, or from long bonds to short bonds, makes benchmarking virtually impossible, so we are benchmark agnostic.
Our turnover is more than 2,000%, which is not deliberate but a result of the strategy.
Q: Is diversification built in your strategy?
Diversification is a risk mitigation tool, because the nature of this strategy is to position aggressively ahead of the periods with a possible drawdown or stock market risk. Being 100% in either stocks or bonds through ETFs, gives us the broad diversification to mitigate the concentration risk that we take.
For most investors, the 60/40 portfolios are a good deal because of the bond bull market, lower rates, and higher-price environment for 30 years. Of course, stocks have gone up over these 30 years, but they have also gone down along the upward trend, while bonds have tended to go up in price.
We are coming off historical low interest rates and the 60/40 portfolios might be struggling in a true secular change. If interest rates rise, a 60/40 portfolio stocks may undergo correction, but bonds may be the return detractor, because they would be delivering flat returns after the coupon at best.
Our portfolio has been designed for people, who want to dynamically diversify the constant beta risk of being in equities and the duration risk of being in bonds and would let us make the decision of when to be opportunistically in stocks or bonds. For us, it is about relationships and creating rules around those relationships, which we use to guide the portfolio.
Q: How do you define and manage risk?
We are guided by the principle that large losses are devastating and destroy the compound annual growth rate of a portfolio. With our type of strategy, it is inevitable to be wrong sometimes, so we may miss out some stock gains, but we are perfectly okay with that, because it is not about frequency, but about magnitude.
For us, risk management is being able to deal with losses by positioning ahead of them, because de-risking after the loss is problematic. First, we would have already taken the loss. Second, large up moves tend to follow large down moves, so we could miss the momentum. Third, we could hold the stock forever.
So, the purpose of our process is to position ahead of the periods in which we might generate losses and to take advantage of the typical negative correlation of stocks to Treasuries. In that way, we can actually make money in a downturn via Treasuries, instead of losing money in stocks.
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