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Factor-driven Global Asset Allocation on a 3-5+ Year Investment Horizon

How ClearMacro Minimizes Natural Stupidity

● Appropriately used, ClearENGINE™ reduces cognitive biases, and provides support for attention, working memory and executive functioning

● Above all it is a decision-making tool that minimizes the risk of mistakes from mental heuristics

● Anchoring to a systematically derived set of 3-5-year return projections reduces the risk of confirmation bias

● A multi-horizon approach avoids having to reconcile cognitive dissonance

Multi-Asset ClearHORIZON Portfolio

ClearPORTFOLIOS™ are systematically constructed from ClearMacro’s 3-5+ year factor-based return projections, and put through a multi-level optimisation process which re-balances monthly. They are designed to be optimal anchor portfolios for public market investors with a long-term investment horizon. Model portfolios are available as research (index holdings) or investable (ETF) versions.

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ASSET CLASS OUTLOOK | 3-5+ years

» Investment Ratings Methodology

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Five Key Factors Influencing Long- Term Return Prospects Globally

1. Assets are Expensive

There is little value at the asset class level. Only EM equities offer positive valuation support.

Chart 1: DM Equities Moving into Expensive Territory

2. Profit Margins are Elevated

Profit margins are cyclically high in many of the developed markets, representing a key threat to long-term returns.

3. Trend Growth is Low

Trend real GDP per capita is a key component of ClearMacro’s Long-Term Earnings Growth Models. Our systematic, forecast-free, approach to generating long-term growth assumptions has DM economies at 1.4% and EM at 5.3%. This may be still too high for EM by around 1% based on IMF forecasts, but the gap with the DM makes this largely irrelevant on a relative basis. As per World Bank data, U.S. real GDP per

capita growth has averaged 0.8% p.a. over the last 20 years.

4. Income is Important

Evidence suggests that asset income levels locked-in at point of purchase explain a large part of subsequent returns. On that basis, ex-ante return prospects will be supported by income levels that, at least in parts of the equity and credit markets, still offer moderate value.

5. Attractive Alpha Prospects

Fortunately, while asset class returns are poor overall, there are wide divergences in outcomes in their components, particularly among emerging market equity markets (Chart 2) .

ClearMacro “Builds-Up” Forward-Looking Return Factors into Long-Term Return Projections (3-5 years+)

Only 3 factors explain returns over multi-year time horizons - growth, income, and value. Our framework measures and systematically extrapolates these factors into the future, “building them up” into total risk-adjusted return projections for each asset class, country, sector, and style.

Our approach is unique in the breadth of universe that we cover, and our avoidance of both econometric back-fitting or forecasting, replacing these with a set of systematic, consistent model assumptions.

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Chart 2: Plenty of Relative Value in Equity Markets

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● Appropriately used, ClearEngine reduces cognitive biases, and provides support for attention, working memory and executive functioning

● Above all it is a decision-making tool that minimizes the risk of mistakes from mental heuristics

● Anchoring to a systematically derived set of 3-5-year return projections reduces the risk of confirmation bias

● A multi-horizon approach avoids having to reconcile cognitive dissonance

● Thematic analysis can identify bubble candidates that stem from social proof which are a feature of every business cycle

● We do not forecast because we are not over-confident

● Bayesian probability is incorporated in all indicators using a 15-year normalized history

How ClearMacro minimizes natural stupidity

“The test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.” F. Scott Fitzgerald.

Introduction

Successful investors require strong skills across at least four cognitions:

● Concentration to screen for the most relevant information that underpins any investment decision;

● An efficient working memory to manipulate the relevant information and store it in a readily retrievable form;

● Executive functioning that plans for things like stop losses as well as avoiding instant gratification and taking profits too early;

● Decision making that balances intuition with the recognition that prior learning may not always be appropriate for the situation they find themselves in.

The effectiveness of each is, however, curtailed by severe limitations on the powers of concentration and working memory. Concentration can attend to only one thing efficiently at a time. Models of divided attention point to weaker performance across tasks, making multitasking an overrated skillset. Moreover, working memory can only manipulate and store 7 +/-2 items at any one time.

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ClearEngine has therefore been designed to support, and enhance each cognition. It is a sophisticated screening tool that reduces the pressure on concentration in identifying the most relevant data. The indicators and models manipulate and transform the data extending the capability and capacity of working memory. And adopting three time frames: tactical (0-6 months), strategic (6-12 months) and horizon (3-5 years)- each with its own investment process, limits the temptation to take profits too early.

Above all, though, ClearEngine is a tool designed to aid in investment decision making, minimizing the probability of heuristics that lead to investment errors. Dual process models emphasize the difference between fast and intuitive decisions based on learned behaviors, with the more cognitively demanding and energy-sapping deliberate thought processes shaped to address specific tasks1.

These deliberate thought processes effectively demand whether prior learning is appropriate to the task at hand. Anchoring investment decisions around systemic factor driven return expectations over 3-5 year thoughts mimics effortful thought, keeping heuristics in check.

The remainder of this article explores how this balancing act is achieved in more detail. It asks questions surrounding some of the more critical decision based biases and responds with illustrations about how ClearEngine addresses each.

1) How do you handle confirmation bias, or the tendency of humans to seek out information that validates their current perspective? This inefficiency can be a valuable source of return.

First, our long-term 3-5-year anchor, is based on four factors that have a high predictive power over the long term and which are not subject to confirmation bias. Value is a poor timing tool, but ultimately markets revert to the mean over the longer term. Income is a vital part of the compounding process and based on the work of Dimson and Marsh2 has accounted for up to a quarter of total U.S. equity returns over the past century. Liquidity is also critical, given that bid-ask spreads increase with portfolio size. Moreover, growth, except during times of extremely high valuations, is the dominant return driver.

If users do not like the assumptions we have made about these return components - and these are based on available data and not tied to a view - then they can input their assumptions and override ours. This option enhances choice, but like any other decision based on dual-process theory, runs the risk of introducing cognitive error. Optimism bias for example, could lead many to view current U.S. growth rates as temporary, and enter a higher expected trend.

We do, however, recognize that tactically, behavior can matter as much as fundamentals. Our default position is to give technicals the same weighting as fundamentals at 40%, but again users can increase or diminish the importance. Our portfolio positioning signals, for example, work on the principle that if equity or bond holdings are at extreme lows or highs relative to past positioning, then this represents an opportunity to fade the trend.

In a seminal work published in the 1980s, Thaler and De Bondt3 demonstrate how one “period’s winner is often a subsequent period’s loser.” Markets naturally overshoot and undershoot as investors look for evidence that supports their view, which is then corrected once the weight of evidence becomes overwhelming in the opposite direction.

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The mean is an exception rather than the rule. All our tactical and strategic indicators are back tested based on the top and bottom quintiles, which explicitly recognizes the overshoots and undershoots that result from confirmatory bias.

2) Can you and how do you resolve cognitive dissonance in noisy data using ClearEngine?

Humans are preprogrammed to look for consistency and this trait can lead to exploitation and poor investment decisions. “The-foot-in-the-door” sales technique, for instance, may involve that savvy salesperson giving you a break on a tie with a 50% discount and then pressurizing you to buy the suit that has been reduced by 10%. Because they have done you a favor and you want to be consistent you are tempted to reciprocate. In investment decision making, reconciling cognitive dissonance may represent a specific version of confirmatory bias. Contradictory data is often rationalized as noise, and confirmatory data points are chosen, as a preferred alternative to the emotional unrest that acknowledging the discrepancies would entail.

The output from ClearEngine does not force you to reconcile a dissonance. Our indicators are fully transparent. Because they have been tested at the extremes of the probability distribution, there is no ambiguity - you can either decide to accept a ClearSignal or reject it. The use of multi-time horizons also helps. For example, there have been several times over the past few months (though not currently) where our Tactical and Strategic Risk Matrices have been at odds. This was primarily due to elevated equity valuations which suppressed the Strategic rating. If you were investing tactically, there was no reason to find a compensating indicator for the divergence between heady valuations and robust growth, that is currently causing so much angst among investors.

Markets are driven by different factors over different time horizons and value is only vital over longer periods. 3) Richard Thaler has argued that behavioral

finance offers few insights into the macro-economy and is more useful in individual decision making. Do you agree?

Not really. Psychology can also offer a deep insight into crowd psychology which drives markets at the lower and upper turning points of cycles. No one wants to be different (social proof) and when someone cannot make sense of the world and others appear stable in their conviction of chasing asset prices, it creates a herd mentality. In our last ClearStrategic, we analyzed how information cascades based on individuals’ assumption that someone else must know something they did not and so join the party.

Each cycle has its mania candidates and Kindleberger4 identifies the essential pre-requisites as; “a new age story”, “it is different this time” and accommodative monetary policy. This cycle, the strongest mania candidate seems to be bitcoins driven by the narrative that they cannot be debased by central banks. U.S. equities are also on the list driven by the assumption that absolute values might be demanding, but relative to interest rates things do not look too bad. In any case, TINA or “there-is-no-alternative” still applies!

ClearMacro identifies investment themes which have the potential to turn into bubble candidates. In the early 1990s it was the restructuring of large-capitalization U.S. equities. In the first decade of this century, commodities and U.S. housing were the honey pots. As bubbles are only really identifiable after the event, it remains to be seen whether U.S. equities or bitcoins prove to be the bigger problem in this cycle.

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4) What is the most damaging cognitive bias from an investment perspective and how do you guard against it?

Overconfidence as it is ubiquitous. Ask any student whether they are above or below average or a driver the same question and most will say above average. Likewise, although forecasting is hard, most investors still think they are more skilled at it than others. There is also much evidence to suggest that personality plays an essential part in the process. The political psychologist Philip Tetlock observes that most successful market strategists are “hedgehogs” who know one big thing, but successful investors for the most part are “foxes” who know many things. It is hedgehogs, though, who claim the limelight and gain the market following.

However, the forecasting records of experts are weak and in many cases worse than average people5. Because we do not claim we are experts we avoid forecasting, instead looking to exploit anomalies in the current data. This approach represents an explicit repudiation of the semi-strong version of the efficient market hypothesis and a recognition that participants in different asset classes have varying mental models of the world, which will often lead to mispricing.

5) How does ClearEngine account for Bayesian probability?

The list of cognitive shortcuts that can lead to investment errors is almost endless. One of the most important is representative bias. Investors form probability judgments that are inconsistent with Bayes law that any probability is contingent on a prior event. Psychological models of forgetfulness argue that retroactive interference from new learning, causes individuals to over-represent the most recent event relative to history, thereby minimizing the probability of mean reversion.

However, all ClearMacro strategic and tactical indicators are designed to look at the most recent data point relative to a history in a normalized form that goes back over 15 years.

Some final observations

Of course, no investment tool can guarantee the elimination of cognitive errors. Misused, ClearEngine will magnify behavioral biases, notably if it is applied selectively to validate previous decisions6. Moreover, the superiority of effortful and slow decisions over intuitive rapid thinking is overstated. All too often, intuitive thought is viewed as the default position stemming from capacity limitations. As the product of a mixture of imprinted and learned behaviors, it is evolutionarily honed to stand the test of time, and demands more respect. There will be times when the intuitive approach will be a more efficient form of analysis than its effortful counterpart.

Finally, in case readers think that training on video games that have a high correlation with concentration and working memory skills can help, the answer is no. While practice effects on the games have indeed led to improved scores, this has not led to transfer effects to other tasks!

References:1. Kahneman, D. (2011) Thinking, Fast and

Slow, Farrar, Straus and Giroux, ISBN 978-0374275631.

2. Dimson E., Marsh P. & Staunton M. (2002) Triumph of the Optimists

3. De Bondt, Werner F.M. and Richard H. Thaler, "Does the Stock Market Overreact?" Journal of Finance, 40 (1985): 793-805.

4. Kindleberger C Manias, Panics, and Crashes: A History of Financial Crises (Macmillan, 1978)

5. Tetlock, P.E. Expert political judgment: How good is it? How can we know?. Princeton University Press. ISBN 9780691128719.

6. Kay J (2010) Obliquity: How our goals are best pursued indirectly

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Factoring Liquidity into Portfolio Construction

Factoring liquidity “costs” into portfolio construction is problematic. On the one hand, some investors argue that liquidity is meaningless for a “buy and hold” investor. Such a lucky individual should identify assets with the highest excess return premium above and beyond economic risk factors, safe in the knowledge that they will never need to sell the asset. But, in the real world, “buy and hold” investors are few and far between. Events – endogenous and external – ensure that assets must often be liquidated “prematurely”. As such, pre-purchase, the “cost” of liquidity should be factored appropriately into an analysis of return prospects.

We systematically factor liquidity “costs” into our ClearHORIZON projection of “cycle agnostic” risk-adjusted return projections over the next 3-5+ years based on today’s pricing of growth, income, and value factors, for each asset class, country, sector and investment style.

Figure 1 highlights the approach for a US investor allocating to Australian equities, with the liquidity “charge” in the red box, measured as a charge on “return”.

Figure 1: ClearHORIZON return projections measure the return contributions coming from growth, income and value factors, including the execution cost

A “round-trip” liquidity charge is approximated to 3 factors:

1) The bid-ask spread (expressed as a % of par value) that represents the cost of buying and selling back the same security (“round-trip”) to a dealer

2) Additional brokerage commission charged by the dealer3) The price impact of large transactions (the “depth” of the bid-ask spread)

We focus only on the bid-ask spread. It’s hard to adequately generalise about a buyer’s dealing arrangements to approximate commission rates, and in any case, we expect them to be relatively negligible. Similarly, for illustrative purposes only, we assume a non-price impact investment size.

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There is no industry-standard approach to approximating “through the cycle” bid-offer spreads. So, we have trawled through publicly available studies that provide “reasonable” approximations to normalising relative liquidity charges.

We provide a summary in the appendix, and below highlight some relevant charts. We look forward to feedback to help us improve the data. Specifically, we will be extending this approach to private assets, when they are added to the platform in 2018.

Figure 2 – CS global bid-ask spread analysis, long-term averages

Figure 3 – Global DM govt bonds spreads

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Figure 4 – bid-ask spreads in EM govt bonds Figure 5 – bid-ask spreads in US credit

Figure 6 – bid-ask spreads in global commodities Figure 7 – bid-ask spreads in developed FX

Figure 8 – bid-ask spreads in developed vs EMFX

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Appendix

These are our liquidity sources.

1. Western Asset – “Analysing Credit Market Liquidity” (April 2015)2. IMF – “Market Liquidity – Resilient or Fleeting” (Oct 2015)3. Committee on the Global Financial System – “Fixed Income Liquidity” (Jan 2016)4. Credit Suisse – “Global Equity Markets Handbook” (June 2011)5. PWC – “Global Financial Markets Liquidity Study” (Aug 2015)

These are our “through the cycle” bid-ask assumptions for our global public market opportunity set.

Figure 9 – ClearMacro bid-ask assumptions for the public market investment universe.

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Global Multi-Asset Investment Recommendations - Strategic Thinking in a Tactical World

ASSET CLASS OUTLOOK | 3-5+ years

Developed market and EM government bonds are expected to perform poorly

In the equity space EM and Frontier markets offer the best return projections

Stay away from High Yield credit

In the fixed income space sovereign credit has the highest return projection

How we Generate ClearHORIZON Investment Ratings

ClearMacro’s Investment Ratings identify which assets have the greatest breadth and strength of factors likely to influence future returns and are used in both investment screening and allocation decisions. They can also be applied systematically to evaluate a portfolio’s efficiency via our ClearDIAGNOSTIC™ application.

The 3-5 year investment horizon has the highest degree of ex-ante return predictability of our rating frameworks. As such, rating construction is fully systematic and based on the size and sign of projected Sharpe Ratios. Unlike our shorter horizon rating frameworks, ratings cannot be influenced by the user’s bias to individual return drivers, and ratings at the generic component level (Growth, Income, Value) are for informational purposes only.

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ClearPORTFOLIO: Multi-Asset Model

Key Factor Sensitivities:

Long-Term Performance Stats:

Top 10 Contributors to Portfolio Projected Return:

ClearMacro’s proprietary Multi-Asset, High Constraint portfolio is projected to realise an annualised return of 5.7%

● Compares to 3.6% for a 60/40 equity/global DM government bond allocation

● Click to see full list of portfolio holdings

● Loosening Portfolio Constraints reduces fixed income allocations and increases the tilt to equites, leading to a projected return of 10.8%.

● Model ETF proxy portfolios available on demand in high and low constraint form

Changes over Last Quarter:

- Projected return slightly down (from 6.6% last quarter)

- Asset class exposure held more or less steady- A slight increase in EM Govt bonds, and a

slight decrease in DM Govt Bonds- Largest return contributors are still expected

to be Russia Equity and South African Govt bonds

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EQUITY COUNTRY OUTLOOK | 3-5+ years

Income and value will suppress developed equity market returns.

Frontier markets are also projected to do well off the back of superior growth.

Eastern European equities in the form of Poland, Czech and Russian equities all stand out positively.

While liquidity can be a problem in individual frontier markets, there is enough homogeneity of expectations to treat them as a single entity.

Emerging markets will fare better, but there is a marked dispersion across the universe.

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EQUITY SECTOR OUTLOOK | 3-5+ years

US Consumer Discretionary stocks are weighed down by heady valuations and tightening monetary policy.

US Consumer Discretionary stocks are expensive and vulnerable to slow growth.

The best value is to be had in EM Energy, Telecommunications and Utilities

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ClearPORTFOLIO Global Equity Model

Key Factor Sensitivities:

Long-Term Performance Stats:

Top 10 Contributors to Portfolio Projected Return:

ClearMacro’s proprietary Global Equity High Constraint Portfolio is projected to realise an annualised return of 8.6%

● Compares to a return of 4.95% for Developed Market equities

● Click to see full list of portfolio holdings

● Loosening portfolio constraints increases idiosyncratic risks and exposures to emerging/frontier markets, leading to a projected return of 12.3%.

● Model ETF proxy portfolios available on demand in high and low constraint form

Changes over Last Quarter:

- Projected return is down slightly, from 9.1% last quarter

- Asset class exposures held more or less steady

- The DM Equity position was reduced slightly, and the Cash position went up slightly

- Largest expected return contributors are still Russia Equity, South Korea Equity and Poland Equity

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GOVERNMENT BOND OUTLOOK | 3-5+ years

There is no value to be found in developed market bonds.

There are pockets of opportunity in EM, notably in Poland and Hungary.

Inflation linked bonds inIsrael, Italy, Sweden and Chile are also attractive.

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CREDIT OUTLOOK | 3-5+ years

Global credit is challenged across the board. High yield is especially vulnerable with spreads this low.

There is some upside in EM credit, though once again value is missing.

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CREDIT SECTORS OUTLOOK| 3-5+ years

Investment grade sectors are preferred to high yield, with industrials, technology and financials looking very ropey.

Investment grade U.S. energy credits are a notable standout in an otherwise dismal picture.

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ClearPORTFOLIO Global Fixed Income Model

Key Factor Sensitivities:

Long-Term Performance Stats:

Top 10 Contributors to Portfolio Projected Return:

ClearMacro’s proprietary Global Fixed Income, High Constraint portfolio is projected to realise an annualised return of 2.3%

● Compares to 1.55% for the developed government bond universe.

● Contains a significant allocation to cash. Click to see full list of portfolio holdings.

● Loosening portfolio constraints increases exposures to cash and credit, out of government bonds, leading to a projected return of 2.7%.

● Model ETF proxy portfolios available on demand in high and low constraint form.

Changes over Last Quarter:

- Projected return is down slightly, from 2.6% last quarter

- DM Credit allocation has been increased, from 14.9% last quarter to 20.2% this quarter

- The Cash position has been decreased from 33.4% to 28.3%

- The biggest return contributors are Cash, South Africa Govt bonds and Spain Govt bonds

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COMMODITY OUTLOOK | 3-5+ years

Peaking global growth, and a steady tightening in monetary policy will expose extended valuations.

There is still some value in oil, although the overall outlook is only neutral

Base metals look particularly extended with lead looking especially vulnerable.

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FX OUTLOOK | 3-5+ years

The Japanese yen is the pick of the bunch among the developed market currencies, with the Singapore dollar also looking perky.

Sterling is a notable outlier on the downside and while the Canadian dollar is cheap much depends on the oil price.

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ClearMacro is an independent FinTECH solution empowering investment managers to make quicker, better- informed Asset Allocation decisions.

Everything we do is powered by ClearENGINE™, a mighty analytics hub which continually processes vast amounts of public, 3rd party, and proprietary data sets; screening, scoring and transforming them into alpha-generating signals, time-horizon specific investment ratings, trade ideas and optimally constructed portfolios. This output is also presented across a suite of integrated research deliverables, differentiated by investment time horizon, combining our quant-driven analysis with a qualitative human overlay to identify where the best return prospects lie globally, alongside the trade ideas to capitalise on the opportunities.

Our senior team harnesses decades of experience gained across the asset management and investment strategy industries with the very best expertise in data science. Please contact us to discuss how ClearMacro can add value to your investment decisions.

DISCLAIMER Copyright 2017©, ClearMacro Ltd. All rights reserved. ClearMacro Ltd. is not a registered investment advisor and the general information, recommendations and other materials contained in its research and reports are for information purposes only and should not be considered as an offer or solicitation to sell or buy securities or other financial instruments or products, nor to constitute any advice or recommendation with respect to such securities or financial instruments or products. ClearMacro’s research and reports have been prepared without regard to the circumstances and objectives of those who receive it, and do not provide individually tailored investment advice. ClearMacro Ltd. does not accept any liability for what is written in its research and reports, or for any actions that occur because of the information contained in its research and reports. ClearMacro Ltd. research and reports are provided to its clients through its website [www.clearmacro.com] and are also distributed electronically. ClearMacro Ltd. relies on a variety of data providers for economic and financial market information. The data used in this report are judged to be reliable, but ClearMacro. cannot be held accountable for the accuracy of data used herein. ClearMacro Ltd., its directors, officers, employees or contractors may have some financial interest in any or related securities mentioned in its research and reports. This document is the property of ClearMacro Ltd. and should not be circulated without the express authorisation of ClearMacro Ltd. Any use of graphs, text or other material from this report by the recipient must acknowledge ClearMacro Ltd. as the source and requires express written permission.

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