Long-term investors who save money all of their life for retirement need a way to grow savings while avoiding the sudden drawdowns that seem to happen in five-year cycles. At the present time, now that the equity market has had a tremendous five-year run, should an investor get out of the equity market? And if so, where should the money go? In the past, many investors would switch to long-term treasuries or corporate bonds, but they seem very risky in the current financial environment. Historically, many investors have used a static buy and hold strategy encompassing a mix of stock and bond indices, but such a strategic asset allocation strategy has not produced satisfactory performance and risk aversion.
I am convinced that tactical asset allocation (TAA) is the way to go. With the advent of ETFs (Exchange Traded Funds), it is relatively easy for the individual investor to move money around into different assets by buying and selling ETFs. And now there is software available, such as ETFreplay that allows you to develop TAAs and to backtest them very easily.
I have recently been developing rules-based TAA strategies that select what ETFs to buy depending on the current market conditions. Here are the goals/rules I have set up for myself:
- Every year must produce positive annual returns (no negative years).
- The maximum drawdown should be 15%. This compares to the S&P 500 that had drawdowns of about 40% in 2001-2002 and 55% in 2008.
- The annual returns need to average at least 20% per year.
- Backtesting should be performed from 2003-2013 to show overall feasibility.
- No leveraged or short ETFs should be used.
I have developed these strategies using bi-monthly updating. I prefer to respond quickly to market conditions, and not wait around if the ETF/market is doing poorly. I know most TAA strategies update monthly, but for the time being, I'm only going to look at bi-monthly updating. Another reason I like bi-monthly updating is that bi-monthly updating produces more data points for backtesting purposes, giving more confidence in the backtested results.
In this article, I'm going to present the methods and backtested results of one strategy. I have developed five different strategies using different ETF universes and allocation methods. The methods I have developed extend from the conservative (for retired/nearly retired investors) to the moderate (for mid-age investors) to the aggressive (for younger investors). The TAA strategy I am discussing in this article is what I would classify as a moderate strategy. I plan on writing articles on the other TAA strategies in the near future. I am currently using these strategies on my own retirement savings in Schwab accounts.
This first strategy I call the AllAssetsExceptBonds Strategy. It uses an ETF universe of 15 ETFs, and includes ETFs from the following asset groups: U.S. equities, international equities, emerging market equities, commodities, and real estate. There are no bond assets except for cash (where I use the ishares 1-3 year treasury bond ETF named SHY). The ETFs are compared to each other and to SHY using 4-month relative strength and volatility. The ETFs are also screened by the 4-month moving average to eliminate any ETFs that are currently less than their moving average. The best two ETFs are selected for purchase; if no ETFs are better than SHY, then SHY is selected. This procedure is done bi-monthly.
The backtested results from 2003-2013 are shown below. The green depicts the results from my strategy and the blue represents the benchmark results, in this case the S&P 500 Index ETF (SPY). Please note that the total return over 11 years is 774%. This means that $100,000 at the start of 2003 would have grown to $874,000 at the end of 2013. Also note that SPY has only grown to $252,000 in this time. Although the return of the TAA strategy is impressive, the most important result is the low drawdown of 15.3% compared to the S&P 500's drawdown of 55.2% in 2008. The overall volatility of this TAA strategy is only 15% compared to the S&P 500's 20%.
The annual returns are also presented. The TAA strategy produced positive returns every year, and the compounded annual growth rate, CAGR, was 21.8%. Every year produced a yearly return greater than 14.9% except 2011 in which the TAA strategy produced a yearly return of 5.1%. For comparison, the S&P 500 had a CAGR of only 8.8%, and had a large negative yearly return in 2008 (-34.3%). The TAA strategy beat or equaled the S&P 500 index in every single year.
The cost of selling the individual ETFs each month is minimal compared to the gains of the strategy. The average number of trades per year is 30, meaning an investor will spend about $540 per year in a Schwab account. For a $50,000 account, the annual expense would be 1.08% to trade the ETFs. This compares to an average gain of over 20% per year in the strategy.
My next article will discuss a more aggressive strategy named the CSD-Bond Strategy. This TAA strategy has a backtested CAGR of 30.9% from 2008-2013 with a maximum drawdown of 12.9%.
Additional disclosure: I currently am using this strategy on my own retirement savings.