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Email Articleby Victor A. Canto, La Jolla Economics (Guest Contributor)
All investors face capital-market risk. Managing the risk, evaluating opportunities in the context of their goals, and assessing specific investments efficiently requires broad, objective, close-to-the-capital-market thinking. A country allocation framework does not need to be a black box that processes a large number of statistical variables and then spits out an investment plan. It should be a logical framework that lays out choices for investors. The LJE ValueTimingTM Process strives to accomplish these objectives. It summarizes in a logical and consistent way the investment choices recommended by our assessment of the coming economic environment.
We now take an additional step to extend the modularity of the LJE asset allocation approach and focus solely on country selection. In effect we are going downstream to the country level as opposed to the regional level reported in ‘The Quarterly LJE Asset Allocation Process’. Remember that additivity means that our individual forecasts aggregate to the region and then the world. In the process we are providing greater choices to individual investors. They can still invest at the regional level or they may choose to go downstream and focus on the country level. If the process makes reasonable choices, the country allocations will add value over and above the regional allocation in ‘The Quarterly LJE Asset Allocation Process’.
The First Quarter 2010 Allocation
The LJE Country Allocation is a two-step process. First, our quantitative model estimates the probability that a country will outperform the world. Second, we tilt the benchmark allocation for the countries in direct proportion to the probability estimates. Column 1 in Figure 1 shows the benchmark weight used in our global asset allocation process.
A summary of the probability estimates is presented in Table 1. The first line of the probability table shows our estimate of a 45.0% likelihood of Argentina outperforming the world. Hence, our model prescribes a reduced exposure to Argentinean stocks. Given our estimation procedures, the relative ranking of the different markets are invariant to the reference country. In other words no matter which country is taken as reference, the least attractive country will always be the same. Column 2 in Figure 1 shows the culmination of the LJE asset allocation process. Looking at Asian countries, it decreases the Argentinean allocation to 0.048% from a benchmark allocation of 0.05%. When all the probability estimates are taken into consideration, the allocation to the U.S. is decreased a negligible amount, to 42.19% from its 42.30% benchmark allocation. The difference between Columns 1 and 2 reveal the overall asset allocation tilts produced by the LJE country allocation process.

The exposure to the U.S. suggests that, collectively, the rest of the world is expected to perform in line with the U.S. market. In fact, using the individual estimates, we have calculated the likelihood of different regional indices outperforming the world. The results are reported in Table 2. The numbers suggest, that among the developed countries, the U.S. is likely to underperform North America (i.e. Canada) and the Pacific Region. It is poised to outperform Europe. Within the emerging regions, the U.S. is expected to perform in line with most regions except for emerging Latin America whose probability is well below 50%, and thus, expected to underperform the world and the U.S. indices.
Applications
Taking the countries’ market capitalizations in account, we can then replicate many of the regional indices for the developed and emerging markets. The tilted allocations are easily derived by summing up across countries in the region. However, that does not give an investor the estimated probabilities. While one could derive the implied probabilities from the global allocation, we make the investor’s job easier by reporting them in Table 2. As seen in the first row of the table, we estimate at 52.95% the likelihood that the developed world ex-U.S. will outperform the world.
Using the regional indices as a benchmark, we can then implement an active cyclical country allocation strategy of the countries in the index by tilting the world, developed market, emerging markets or different regional sub-groups. The tilts around the regional benchmark are based on the magnitude of the probability estimates. One natural extension of the approach is to develop either a global and/or regional long short strategy. This can be accomplished in a number of ways. One way is to go long in the overweighed countries or regions and short the underweighted countries or regions. Another application suggested by Table 1 is to simply use the rankings to identify winners and losers. One simple strategy that comes out of this is to classify the groups into buy and sell. There are a number of potential problems with this approach. First, it does not take into consideration the strength of the rankings (i.e. how far above or below average the ranking is for a particular country or region). A second issue is the weighting scheme. One way to calculate the performance of these portfolios is by equally weighting the countries within each group.

The Fourth Quarter and Year-to-Date Performance
The results for the fourth quarter 2009 LJE country allocation process can be found in Figure 2. The first column denotes the benchmark weight for each of the countries in the global strategy. The second column reports the tilted weights based on last quarter’s estimates of the different countries’ probabilities of outperforming the U.S. market. In order to visually facilitate the LJE country allocation process we have chosen to color the countries with overweight allocations green and the countries with underweight allocations red.
Figure 2 reports the returns of the various countries (Column 3). The performance of the benchmark allocation and the LJE allocation using the various indexes are reported in the last row of Figure 2. A summary of the quarter-to- date and year-to-date performance is reported in Table 3. On a cap-weighted basis, during the fourth quarter of 2009, the world benchmark gained 3.9%. The world ex- the U.S. increased 2.74% while the U.S. appreciated 5.49%. The underweight of the U.S. allocation, shows that the LJE model expected the U.S. to underperform the world. The numbers suggest that was not the case. Nevertheless, the U.S. tilt is only part, not the whole, of the asset allocation tilts. The more serious and interesting issue is whether the tilts deliver the promised added value.
Looking at the results reported in Table 3, the world benchmark increased 3.9% during the third quarter while the LJE tilted world portfolio gained 3.91%. That is a 1 basis point excess performance during the quarter, nothing to crow about.
The results are slightly different when the U.S. is excluded from the calculations. The world ex- U.S. benchmark increased 2.74% while the tilted LJE world ex- U.S. portfolio delivered a 2.89% gain, outperforming the benchmark by 15 basis points. The differential performance between the benchmark and tilted portfolios suggests that the tilts did add some value to the performance.
An obvious question to ask is where the value added comes from? To find out, we looked at the performance of the buy and sell portfolios. We also looked for regional differences. However, before we discuss them, we have to be mindful of the small sample properties of the forecast. For example, since we have an international focus in the forecast, developed North America consists of a single country, Canada. Other differences are the quality of the data and the deepness of the futures market in the countries in the sample.
The results reported in Table 4 show that for the regions or classification where the tilts worked, more often than not, the bulk of the value added was generated by the buy portfolio. Hence we conclude that the source of the excess performance is largely attributable to the buy portfolios.
Regional differences are also evident. Whether one considers solely the developed countries or all countries in the region, the developed countries as a group yield the best results, on a year to date basis, the tilts and the buys outperform while the sells underperform. Next in line is Europe, then the developed Pacific region and the emerging countries.




Victor A. Canto
La Jolla Economics
www.lajollaeconomics.com
Thank you
very informative, has me thinking