The strategy seeks superior medium-term performance by quantitatively identifying and mitigating equity market collapses. During such times, assets are shifted from equities to asset classes that historically perform well during times when equities are severely out of favor. When equities are in favor, the strategy constantly seeks to outperform its benchmark by taking aggressive, momentum-based over-weights in the context of a diversified portfolio comprised of foreign and domestic equity asset classes representing various style concentrations and market capitalizations, as well as managed exposure to alternative asset classes.
The investment approach is based on the observation that over time, equity markets alternate between efficient eras and inefficient eras depending on whether investor behavior is rational or irrational. The central thesis is that irrational periods can be identified by excessive price volatility, which leads to market inefficiency. When markets are inefficient, assumptions about mean reversion become irrelevant. This produces market booms and collapses as prices tend to rise or fall beyond rational levels. As inefficiency rises, the strategy actively seeks to generate alpha (in booms) and mitigate downside risk (in market collapses).
The cornerstone of the strategy is its Equity Risk Management System, which is based on 90 years of price data for the dominant equity market benchmarks over time. Momentum-based strategies were developed to identify eras of market efficiency and inefficiency. During efficient markets, it was found that bear markets tend to lead to new and sustained highs within a reasonable period of time and are thus not worth attempting to mitigate. Inefficiency tended to produce market collapses that did not result in new, sustained highs within a reasonable period of time, thus increasing the efficacy of downside mitigation strategies.
During risk-on regimes, the portfolio is built on a set of baseline allocations weighted according to long-term risk, return, and inter-correlation expectations. Baselines allocations are provided for standard equity categories including domestic large caps, domestic small caps, foreign developed markets and emerging markets; and for alternative assets classes which may include listed private equity, REITs, and commodities. Equity over-weights are awarded based on momentum. Position sizes are usually limited to less than 4% (cash excepted), and positions are typically rebalanced when they exceed plus or minus 5% of ideal weighting relative the entire portfolio. Six to eight positions are taken on average.
The Equity Risk Management System determines whether or not equity positions should or should not be taken, creating risk-on and risk-off regimes. During risk-on regimes, positions are closed based on changes in over-weights. When a position no longer ranks among the top equity classes in terms of momentum strength, it is considered an equal-weight and is reduced to make room for a new over-weight. Over-weights take precedence, and may result in the complete elimination of an equal-weight position. Alternative exposure is managed, and commodities and REIT positions may be closed at any time based on poor momentum.
The strategy has an inflation override, designed to replace equities with commodities during times of hyper inflation. In backtesting, it has not been activated since the 1970’s. After a market shock (a one-month bear market at the end of a bull market), the portfolio is placed in a risk-off status for at least nine months. In backtesting, this override has only been activated twice in 90 years. During temporarily oversold transitions from risk-on to risk-off regimes, the system may show a strong preference for beta, which may result in a large cap domestic equity-concentrated portfolio for one to four months.