Excess returns: All about market timing

Can market timing generate excess returns? This article argues that excess returns are possible as long as assets price our idiosyncratic behaviour such as loss aversion. A portfolio manager should follow time diversification strategies to capture such idiosyncrasies and follow strict money management rules to control risk.

B. Venkatesh

Asset prices are galloping at a fast pace in the Indian market. Many investors have not participated in the recent uptrend for the fear of a sharp turn in prices. Market timing is, hence, a relevant topic in the current environment.

Professor Javier Estrada’s paper “Black Swans and Market Timing: How not to generate alpha” concludes that “market timing is an entertaining pastime but not a good way to make money.” He argues that if a portfolio manager misses the ten best days in the market, the portfolio annual returns reduce by 3 percentage points.

Likewise, avoiding the ten worst days increases the annual returns by 4 percentage points. As no portfolio manager knows the best and worst days’ ex-ante (before the event), Estrada states that market timing is a wasteful exercise. This article argues that disciplined money managers following time-diversification strategies can generate alpha from market-timing.
Alpha Generation

Alpha is the excess returns that the portfolio generates because of manager skill. Alpha will be 5 percentage points if the portfolio generates 25 per cent when the Nifty moves 20 per cent. Alpha can be generated through market timing or by holding stocks that outperform the market. Some argue that alpha returns will decrease with the proliferation of institutional investors and hedge funds; for more funds will chase alpha-generating assets.

But this argument may not be entirely true. Why? The total available alpha is unknown.

So, even as new funds emerge to harvest alpha, newer sources for alpha generation will evolve. The argument is the same as in the case with oil. As crude oil prices climb, the world is working hard to develop alternative sources of fuel.
Market timing

Generating alpha from market timing involves using technical analysis, which trades on human behaviour.

Take Essar Oil. The stock hit Rs 70 this September and declined to Rs 49. The next time the stock hit Rs 70 in November, it jumped to Rs 250 in 16 days. Why? Experts in behavioural finance have shown that we suffer from loss aversion. That is, we tend to keep losers in our portfolio too long and sell winners too soon. Perhaps, that is what happened with Essar Oil. This stock failed to move past Rs 70 early this January; investors who bought then saw the stock decline to Rs 46. So, the next time the stock moved to Rs 70 in September, most investors sold. The higher supply of shares at Rs 70 pushed the stock price down yet again. Technical analysts would call Rs 70 as the “resistance level”.

After naïve investors offloaded their supplies in September, smart traders gathered critical mass and eventually pushed the stock beyond Rs 70, which now becomes the “break-out” level. A money manager can generate alpha from market timing as long as we all suffer from loss aversion and other idiosyncrasies.
Pareto Principle

Estrada is right. Only a few trading days contribute substantially to portfolio returns. But you know that Pareto Principle holds true in all walks of life. Eighty per cent of your work gets done in 20 per cent of the time that you spend in the office! In the markets, 20 per cent of the stocks in your portfolio contribute nearly 80 per cent of your total returns. Likewise, 20 per cent of the total trading days account for 80 per cent of the positive returns in the market.

Money managers, hence, follow time-diversification to minimise the risk due to loss aversion. Understand that loss-aversion leads to selling winners early and losing the best 10 days in the market. It could also lead to carrying losses and staying in the market during the worst 10 days. Time diversification means that the portfolio manager has exposure across various time horizons. The portfolio will have stocks for the short-term (5 to 30 days), some for the medium-term (30 days to 12 months) and some for the long-term (over 12 months).

This ensures that the manager is engaged in active trading through the year and so does not take profits too soon. Remember, we take profits too soon because we need to see cash flowing into our account at regular intervals. Time diversification also ensures that the portfolio rides through the 20 per cent positive days in any year.
Black swans

Black swans refer to extreme events, such as a market crash. If a money manager does not manage the ten worst days effectively, she is likely to lose all the profits. Professional money managers, hence, follow strict money management methods, such as stop-loss rules to control portfolio risk. The problem is that all managers are not disciplined — they suffer from loss aversion too! And that is when market timing leads to negative alpha.

This entry was posted in Uncategorized. Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s