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.
Overall, we aim to buy whatever is working. If energy, biotechnology, technology and pharmaceuticals are performing strongly, then we’ll buy these sectors as opposed to buying the S&P 500 or the MSCI World Index. If the broad-based assets are performing better than individual sectors, we will only own the broad-based markets. Currently, we have 30 ETFs in our universe.
Q: Can you describe your model in more detail?
The model has been tested over multiple markets and timeframes. Typically, the model is always trying to get us out of stocks. That means that we own stocks only when they are performing really well. Again, we have a pool of investments that we rank against each other. For instance, if we have 20 risk-on ETFs, I will look at the top four based on our performance measures. These could be China, Italy, U.S. small cap and biotechnology, for example.
But the fact that they are the best performing risk-on investments is not enough to buy them. I put them through one more filter, which measures the performance of these ETFs against the strongest U.S. Treasury ETF. So, if the short duration U.S. Treasury is the best performing risk-off asset, I will compare the performance of the short duration U.S. Treasury ETF against the top four risk-on ETFs that I am considering.
The result may be that only three of the assets are actually performing better than the short duration U.S. Treasury. In that case I am only going to buy three of the risk-on ETFs and I will substitute the fourth with the strongest performing U.S. Treasury.
So, even if the model points to a risk-on mode, the portfolio may not be 100% in risk-on assets, if the strongest performing risk-on assets are not performing better than the strongest performing risk-off asset. We always make sure that the strongest performing ETFs are still performing better than the risk-off asset. If there is a chance that the market is going down, I would rather own the best performing assets in the bond market as well.
We put every investment through a dual filter as we aim to buy what’s working. We can’t guarantee that it will continue to work, but we want to own what’s currently working relative to everything else.
We have an absolute return mindset. If stocks and bonds are dropping massively, then cash may be the strongest performing asset that will actually provide some return when both stocks and bonds are dropping.
Q: How often do you review the strategy and the portfolio?
Our prospectus allows us to change the portfolio bi-weekly or quarterly. The difficult aspect of an active strategy is the whipsaw action of the market. If the market starts turning down and we don’t get out quickly enough, we are going to ride along that down move. If we get out too quickly because of a short downward move, we would miss opportunities. So, the key is figuring out how quick our trigger should be so that we don’t get constantly whipsawed.
We’ve tested both the bi-weekly and the quarterly options. We found better performance and lower drawdown with the longer holding periods, but we found higher win rates with the shorter periods. So we created a volatility measurement to identify the long protracted down moves that really damage people’s accounts.
Basically, we try to measure volatility to see when we need to move quickly and when we would be willing to wait out to avoid a longer protracted move. The most challenging aspect of our model is the risk of getting whipsawed out of the market or staying in the market when we should have been out. I believe that our volatility trigger really helps to know if we should hold on or we should exit.
Q: How do you construct your portfolio?
During a risk-on mode, we typically have 60% in equities and 40% in fixed income. We can never be 100% in equities. We also have limits on our sector and industry exposure. But within our 60% equity exposure, we could be entirely in small cap U.S. stocks, for example, or we could have 15% in biotechnology, 15% in oil and gas, 15% in China and 15% in the S&P 500. On the fixed income side, we own investments like high-yield bonds, convertible debt or emerging market bonds. During a risk-off mode, we can be a 100% in U.S. Treasuries.
Currently, we own four equity ETFs with allocation of 15% to each of them, and four fixed income ETFs with weight of 10% each. So, we have a total of eight ETFs and 60% of them are in equities and 40% are in fixed income.
We would never be more than 60% U.S. equities in a risk-on mode, but we can be up to 100% in fixed income in a risk-off mode.
Q: How far back have you tested your model?
We’ve back tested the model with the ETFs that we have back to 2003, because that’s how far back the data goes. We did the 2000 collapse synthetically, through our own recreated data, because we didn’t have ETFs that went back far enough. For the testing of the 2008 crisis, we used the actual ETFs to see how the models would have done during these periods of time. In both cases, the models transitioned out of equities and 100% into U.S. Treasuries and other safe fixed income investments.
Q: Does the model give warning signals on impending market conditions?
The one thing the model cannot predict is a situation like the Black Monday in 1987, when the markets went down 20%. The market tops are rarely an event; they are usually a process. Our measurement shows that typically people first get out of small cap stocks but stay in the larger-cap names. They get out of the riskier names and move into the bigger names, because they are getting worried. A bottom is usually an event, not a process, so it is more difficult to predict, but there are definite warning signs near market tops.
Again, our goal is to outperform on the downside, not to beat the market on the upside. Over the last three years we’ve captured about 90% of the upside, while our downside capture is negative 19%. We have actually made money during the downside movements in the S&P 500 and that’s always been our goal.
I built the model based on historic data, so I don’t know what the future drawdown is going to be, but there is a good chance that what happened in the past will continue happening in the future. For us, it’s not about making more than the market on the upside; it’s about losing less than the market on the downside.
