Alternatives to Buy and Hold

I read a recent Seeking Alpha article by Matthew Hougan of IndexUniverse.com that was, to borrow a phrase from Mr. Hougan, 'laughable'. The inherent contradiction in the article is clear: Hougan declares that 'if there were ever a time for buy-and-hold, that time is now'. Hougan states that 'Far from being dead, now is the best time in a generation to be a buy-and-hold investor.' Just to summarize, while he scoffs at the idea that any active trading strategy could provide superior alpha to buy-and-hold for the average investor, he is encouraging his readers to do the one thing he scoffs at and which is completely contradictory to a 'buy and hold' mantra: he wants us to time the market by buying and holding right now.

Apparently Matt is convinced now is the bottom of the market? It very well could be the bottom of the market and the point here is not to debate that, but he sure seems absolute in his conviction by declaring now the best time to buy and hold. I'm sure Matt has been out of the market the last 10 years since he's declared now the best time to buy and hold (clearly we've been waiting for this moment since previous moments could not, by definition, be 'the best'?). The point is that there are tangible, documented strategies with low turnover that have superior risk-adjusted returns to buy and hold and I will provide links for further research on one such strategy. That is not to say there aren't many other good strategies, but since Matt brought up Tom Lydon I though it would only be fair to focus on one alternative, the moving average system.

Beyond the obvious contradiction in Matt's article there are other obvious oversights or just gross misrepresentations of alternative investment strategies. For starters, he quotes Tom Lydon extensively. The implication in the rest of the article is that Lydon is somehow associated with active trading strategies that average investors could never hope to succeed at due to high turnover. I'm not sure if Hougan is familiar with Lydon's website or strategy (actually, it is clear from the article that he is not or he just chose not represent them accurately), but Lydon lays his trend system out fairly clearly on his site. The strategy is far from a daytrading strategy that will leech returns with high turnover as Matt implies.

For Matt and other readers I would advise doing some research on alternative strategies such as the moving average system before grossly misrepresenting those alternatives. Start by reading Mebane Faber's blog and article (he will be issuing an updated version of the paper in the next couple of weeks) on Tactical Asset Allocation. The strategy in a nutshell is to go long when each index is trading above the 10 month simple moving average. There are many variations one can use, which I will detail in follow-up articles in the coming weeks. A brief summary: Faber splits his study into 5 assets: the S&P 500, EAFE, 10 year Treasury bonds, NAREIT, and GSCI index. When each index is trading above its moving average, an investor would go long the index. When it is below, sell and go to cash. For a basic ETF portfolio representing this strategy an investor could invest in the following ETFs in equal parts:

S&P 500 Index – SPY

EAFE – EFA

10 Year Treasury – IEF

NAREIT – VNQ, IYR, or ICF

GSCI – GSP

Of note, only the IEF is currently above its 10 month SMA, meaning the majority of the portfolio would be in cash (which it also was in 2008, allowing it to make positive gains in 2008). Some points in Faber's article I'll highlight here: the point is not just to 'time the market' but just as important is a diversified portfolio including commodities (which I'm sure Matt and I would agree on). Secondly, from 1900-2005, his basic timing model using the 10 month SMA on the S&P 500 had a compound annual growth rate of 10.66% with stdev of 15.38% and a sharpe raio of .43. Buying and holding the S&P 500 had a CAGR of 9.75% with a standard deviation of 19.91% and a sharpe of .29. Thirdly, from 1972-2005 his timing strategy on the S&P had an average of .59 round trips per year, clearly evidence that it is a relatively low turnover strategy. Combining all 5 asset classes in one portfolio from 1972-2005 the timing model had a CAGR of 11.92% with a a 6.61% standard deviation vs a basic buy and hold portfolio of the same investments of 11.57% and 10.04% standard deviation.

In addition to Faber, check out Tom Lydon's strategy and momentum research done by Blackstar Funds. The site dshort.com does a great job of monitoring moving averages and I would also advise reading their article 'The Rational for Moving Averages' which discusses the effect of serial correlation in moving average signals using data as far back as the 19th century (take note of how little the serial correlations have changed the last 130 years). Jeremy Siegel in his book Stocks for the Long Run discusses using a 200 day moving average strategy on the DJIA as a way to reduce risk: 'the major gain of the timing strategy is a reduction in risk. Since you are in the market less than two-thirds of the time, the standard deviation of returns is reduced by about one-quarter. This means that on a risk-adjusted basis the return on the 200-day moving average strategy is quite impressive.' The site Fundadvice.com has several articles detailing moving average strategies they use for clients (in addition to buy and hold). These are just a few resources to get one's research started and I don't intend it to be a comprehensive list.

Let me be clear on two points: Buy and hold as a strategy will outperform moving average trend systems in certain years on a nominal basis and vice versa. However, the evidence is apparent that low turnover moving average strategies will have comparable returns over the long run (and in some cases better returns) while significantly reducing risk. Surely this is a strategy Hougan should applaud if he is concered about the 'average' investor. The primary flaw with him declaring 'now is the time to buy and hold' is that we are at his mercy to declare some day in the future 'the market is oversold, buy and hold will underperform, sell!' In essence, Matt wants us to time the market based on his advice (and of course, to watch the expense ratios of the funds we purchase. However, most market pundits now recognize that diversification and low expenses alone are not enough, especially when correlations approach one (see 2008). Secondly, I would like to say that I applaud the work of IndexUniverse.com, there is much on their site worthwhile so please check it out. However, I know that investors, and Matt, can do better.

I will be detailing more moving average portfolios in depth in the coming weeks.

Comments

[investor88:]

Moving average system better for the average person because it should prevent the stock from being wiped out. This alone is powerful reason for moving average over buy-n-hold!!?

Feb 12 09:57 AM

[oldman:]

how would you adjust this for a retirement portfolio that should have 70% fixed income?

Feb 13 09:56 AM

[Scott's Inv...:]

oldman: The portfolio Faber uses is not necessarily an optimal one but is good for example purposes - I will post some alternative strategies and portfolios in coming weeks for us to discuss. It depends on how the 70% of your fixed income is allocated - if part of that is cash/CDs then the MA system would not be applicable, but if you have a percentage in bond funds (mutual funds or ETFs) you could still apply moving averages as buy/sell signals. Also, you could divide the portion of your equity allocation into domestic and international ETFs that have a dividend focus with a percentage still allocated to commodities and/or gold - more on this later.

Feb 13 01:04 PM

[donzelion:]

Hmmm...while I'm still not convinced on a moving average strategy, I don't like the claims that "today is the right time to buy'n'hold." While it's tempting to think that a drop of 40% or more for many equities means that there's 40% less downside risk, the truth is that an equity will always be an equity - and will always reflect guesses about risk/reward. The risk doesn't go away when the price goes down, hence, claiming that "today is the right time to buy (because risks are lower)" would be misleading (but other arguments would be better).

That said, I like Lydon's notion of buying with stop orders in place, and moving those stop orders as the ETF increases. Given market volatility, I also like the notion of putting a limit on all buy orders for ETFs - buy various sectors after they drop 10% (if they don't fall, then money collects interest in a sweep account). That seems a fair approach to mathematically buying low(er) and selling high(er).

Feb 13 05:42 PM

[Urbane Gori...:]

You don't adjust it. There is no point to collecting dividends if the underlying value of the stock is collapsing. I do believe we will continue to see reductions in dividends for a variety of reasons. And, when dividends are cut, the stock also drops (I don't care about the chicken and egg issue here... Just the results.) I'd suggest looking at Dr. Schaap's 50-50 program to protect your underlying assets. SeekingAlpha truncates URLs, so there is no way to post the site.. Just Google it. His site is free, and he has a free weekly e-letter which has examples. You can also buy the book, which is a very easy read.

jegan


On Feb 13 09:56 AM oldman wrote:

> how would you adjust this for a retirement portfolio that should
> have 70% fixed income?

Feb 13 06:07 PM

[bigmoney:]

this has been my current investment style since around January, with a couple of differences. I divide SPY into sectors, both SPDR and ishares global sectors, and just hold those that are trading above m.a. So for now, I hold things like XLU and XLV (Health and Utilities) but just monitor XLF and XLI (financials and industrials). The approach may not outperform, but it gives me a better feeling of control, and I can stay in the market without excessive jitters. Some of these sectors trading at their m.a. are yeilding 3% dividends, about what one would get in a SPY. Also, I am a little more hands on right now, so I trade relative to the 50day.

Feb 13 08:15 PM

[bigmoney:]

>> about what one would get in a SPY

that is supposed to read SHY , the iShare 1-3 Year Treasury

Feb 13 08:16 PM

[omooc:]

A friend of mine whose day job is wealth-management showed me his personal portfolio, holding 10 ETFs and showing good results month in and month out. I did not have occasion to study these 10 ETFs in detail, however.

Feb 13 08:25 PM

[Scott's Inv...:]

The portfolio could definitely be adjusted, without putting words in Faber's mouth, I think the portfolio he uses is just an example of how a 'diversified' portfolio performs using a MA system over time and isn't intended as 'The' Portfolio. Someone could definitely add sectors and ETFs to the system and I'll lay out some alternatives in the next few weeks. That being said, 2008 was one of the banner years for a MA system, but I think one could adjust the system (for more on that see Tom Lydon's site) to catch more of the upside when the day comes that 'the market' finally rebounds.

Feb 15 07:57 PM

[Preppy:]

Not knowing a year ago what's in this article has cost me many $100K! The question at this point is how to transition from a buy & hold portfolio to an actively managed/low turnover one...

Feb 20 04:10 PM

[Scott's Inv...:]

For advice on how to transition, I would highly suggest visiting Tom Lydon's ETF website www.etftrends.com/

Mar 09 10:59 PM