Alternatives to Buy and Hold

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 |  Includes: EFA, GSP, ICF, IEF, IYR, SPY, VNQ
by: Scott's Investments

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.