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Markets are still in somewhat of a holding pattern. The 800 pound gorilla in the room is still what the Fed will do and when. Every economic number coming out will be highly scrutinized to determine whether it is too strong, possibly hinting that the Fed will taper sooner, or too cold, possibly hinting that the Fed will taper later. The markets seem to be dominated by nervous bulls. They know that this is likely to end badly at some point but they also don’t want to miss the rally.
Anatomy of a Curve Fit
Things would be much easier if you could always invest with the benefit of hindsight but life doesn’t work that way. In investing we know that past performance doesn’t equal future results so just because some asset or methodology did well in the past doesn’t mean it will do well in the future.
Curve fitting is something that I see a lot on our side of the industry. It isn’t hard to have a computer look for what worked in the past and assume it will continue working the same way in the future. It is easy to convince yourself you have found the Holy Grail when you find the investment strategy that would have returned 50% a year for the past five years, but besides being a fun academic experiment such a strategy is usually useless going forward. For fun once developed a trading strategy that rotated between cash and Apple stock based on relative strength. The returns on the strategy were amazing but it was completely useless because I developed it with the hindsight of knowing the large up and down moves that Apple had.
Yesterday I was asked to review a strategy that was touting amazing returns by a member of our investment committee. In looking at it the strategy rotated between stocks, bonds and cash, but it also included an ETF that provided the inverse of the return of spot volatility (basically a bet that volatility would go down). Stocks, bonds, and cash made sense to me as they are uncorrelated asset classes. I know from experience that even a simple rotation strategy between those three asset classes will blow away traditional asset allocation and buy and hold. But why inverse volatility? This type of investment is highly correlated with leveraged stock exposure. In looking at the backtested results it became obvious. The inverse volatility ETF that was being used came out in 2012 and was up 90% that year as spot volatility declined. It was also up something close to 50% ytd. Most of the backtested returns came from being invested in that ETF as the strategy was often invested in it (which makes sense if the inverse vol is corrrelated with leveraged stock market exposure and the stock market is going up). Going forward this is pretty useless as:
1. If volatility doesn’t decline at the same pace in the future as it did in the past the future returns of this strategy will be nothing like the backtest.
2. Inverse volatility has been a great investment during a bull market but what happens if the market turns quickly? An investor could suffer massive losses in a short period of time.
Curve fitting can be extremely tempting but in evaluating any investment strategy what happened in the past is not nearly important as what is likely to happen in the future. In looking at any past return stream you need to ask yourself a couple of key questions:
1. How were the returns generated?
2. Are those returns sustainable in the future?
3. When market dynamics change how will the strategy adapt?