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Active Investment Managers and Market Timing

| | Posted in: Investing Expertise, Sentiment Indicators

Do active investment managers as a group successfully time the stock market? The National Association of Active Investment Managers (NAAIM) is an association of registered investment advisors. “NAAIM member firms who are active money managers are asked each week to provide a number which represents their overall equity exposure at the market close on a specific day of the week (usually Wednesday). Responses can vary widely [200% Leveraged Short; 100% Fully Short; 0% (100% Cash or Hedged to Market Neutral); 100% Fully Invested; 200% Leveraged Long].” The association each week releases (usually on Thursday) the average position of survey respondents as the NAAIM Exposure Index (NEI).” Using historical weekly survey data and Thursday-to-Thursday weekly dividend-adjusted returns for SPDR S&P 500 (SPY) over the period July 2006 through August 2020 (736 surveys), we find that:

We exclude from calculations five weeks during the sample period with no survey results.

The following chart compares the weekly level of SPY and the weekly NAAIM Exposure Index (NEI) over the full sample period. The average weekly value of NEI over the sample period is 65 (about two-thirds long). It appears that the two series generally move together, but the high volatility of NEI makes comparison by visual inspection difficult.

To test the aggregate foresight of survey respondents, we relate weekly NEI to next-week stock market return.

The following scatter plot relates SPY next-week return to weekly NEI over the full sample period. The Pearson correlation for the two series is -0.02 and the R-squared statistic 0.001, indicating very little or no linear relationship between NEI and next-week stock market return. In other words, the index offers practically no information about stock market return next week.

However, it appears that high (low) values of NEI indicate low (high) variability in SPY returns.

Might the sentiment measure be more useful at longer horizons?

The next chart summarizes Pearson correlations between SPY weekly return and weekly NEI for lead-lag relationships ranging from stocks lead investment posture by 13 weeks (-13) to investment posture leads stocks by 13 weeks (13) over the full sample period. Results indicate that, assuming a linear relationship:

  • When stock returns have been strong (weak) over the last 13 weeks, and especially over the last month, NEI tends to be relatively high (low). In other words, survey respondents tend to be near-term trend followers.
  • There may be a slightly negative relationship between NEI and SPY over the next few weeks, but correlations are very weak.

In case there is an exploitable non-linearity in the relationship, we consider average next-week stock market return by ranked fifth (quintile) of weekly NEI values.

The next chart summarizes average SPY next-week return by quintile of weekly NEI over the entire sample period (147 observations per quintile), with one standard deviation variability ranges. The average weekly return for all weeks is 0.21%. Average returns do not vary systematically across quintiles. The best (worst) average return occurs after average investment posture is somewhat low (somewhat high). Variability of next-week returns does decrease systematically as NEI increases (from standard deviation 4.47% to 1.53%).

The chart also shows average value of NEI by quintile of the index. Average NEI is positive even for the lowest quintile.

Results suggest that active investment managers may be able to predict stock market volatility, but not near-term average return. A possible interpretation is that these managers tend to miss much of strong market rebounds (in quintile 2).

Does the ability to predict volatility translate to good performance?

The final chart summarizes gross compound annual growth rates (CAGR) and maximum drawdowns (MaxDD) for SPY timing strategies, as follows:

  • SPY – buy and hold SPY.
  • NEI – each week allocate (prior-week NEI)/100 to SPY and the balance to cash.
  • 0-100 – Each week allocate to SPY or cash according to whether NEI is above some threshold. The numbers 0 through 100 on the horizontal axis indicate NEI thresholds for this binary strategy. For example, 30 means being in SPY (cash) when the prior-week NEI is above (at or below) 30. We treat five missing NEI weekly values as 0.

Calculations ignore return on cash (generally small over the sample period), trading frictions and tax implications of trading. Results suggest that a few binary strategy variations (low thresholds that avoid high SPY volatility) may be attractive compared to buying and holding SPY. However:

  • Strategy trading frictions may be material. The NEI strategy reallocates weekly (737 times). The 30 threshold (highest Sortino ratio) switches between SPY and cash 57 times over the sample period (about four times per year).
  • Testing many binary switching thresholds on the same data introduces snooping bias, such that the best-performing strategy overstates expectations.
  • Weekly NEI signals may not always be available in as timely a manner as assumed.
  • The sample period is not long, especially in terms of number of bull and bear U.S. stock market environments.

With these cautions, buying and holding SPY may be preferable to typical expert active allocation.

The following table summarizes data used to construct the prior chart.

NAAIM notes the following additional reservations about the reliability of inference from this data:

  • “Use of a single, composite number for each adviser may not accurately represent the market view of a manager who has short term and long term strategies that are providing conflicting signals or a manager who uses both contra-trend and trend following strategies for different portfolios.”
  • “Investment Styles very [sic] widely among managers participating in this survey. They may include managers that trade very frequently and can switch long and short positions daily. Other managers stay fully invested at all times and only change allocations among market segments or sectors. Still others trade around core positions and only a portion of their portfolios change, but that portion could potentially go from long to short very quickly.”
  • “Although the number of participating managers, known as NAAIM Trend Setters, is steadily growing the sample size is not large…”

In summary, evidence from simple tests on NAAIM survey data offers little support for belief that active investment managers as a group successfully time the U.S. stock market return over the near term, but they may add value by avoiding some stock market volatility.

Cautions regarding findings include:

  • As noted, the number of survey respondents is not large and may not be representative of active investment managers.
  • As noted, survey respondents may change their positions quickly (less than a week), such that weekly return measurements do not capture their actual timing performance.
  • As noted, applying NEI to time the stock market involves trading frictions and may introduce data snooping bias.
  • The above tests do not address long-term asset allocation decisions or asset selection, which might produce portfolio outperformance even without successful near-term return prediction.

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