These are troubling times in the stock market, with lots of uncertainty and volatility. Are we heading for a bear market with 50% downturn (like 2008), or is this just a correction followed by the continual march to equity Zion (like 1995)? Those of us who are retired face difficult decisions in our portfolio, and wrong decisions can greatly impact how we live out our remaining years. Buy and hold equity strategies could result in excessive drawdowns.
I personally think the equity market is going lower, and perhaps much lower. And the volatility in equities is not something I want to see translated to my portfolio. I want to protect against downside risk. This article focuses on a defensive approach to asset allocation: a tactical bond strategy using low volatility bond funds from Vanguard. This strategy has the potential of being a safe haven while, at the same time, providing moderate portfolio growth (~9-10% compounded annual growth rate, CAGR).
For this strategy, I first selected a basket of low volatility bond funds from Vanguard:
1. Vanguard High Yield Tax-Exempt Fund (MUTF:VWAHX)
2. Vanguard High Yield Corporate Fund (MUTF:VWEHX)
3. Vanguard Convertible Securities Fund (MUTF:VCVSX)
4. Vanguard GNMA Fund (MUTF:VFIIX)
5. Vanguard Intermediate Term Treasury Fund (MUTF:VFITX)
Two of these funds typically perform well in bull equity markets (VCVSX and VWEHX) while VFIIX and VFITX generally do well in bear markets. VWAHX is a wild card fund that can show good performance under nontrending conditions (such as the present time). The correlations of these funds to each other and their performance from 1992 - present is shown in the table below from Portfolio Visualizer [PV]. I have also included Vanguard S&P 500 Index Fund (MUTF:VFINX) in the table for comparison purposes. It can be seen that the five funds have low correlation to each other, as desired. Also note that the daily standard deviations are quite low for four of the funds (0.23% - 0.32%). The only exception is VCVSX, which has a daily standard deviation of 0.68%. But even this value of daily standard deviation is small compared to the daily standard deviation of VFINX (1.15%).
Since these five funds have relatively low volatility, it is possible to create a momentum strategy that employs a relatively short duration look-back period and a short duration simple moving average [SMA] as a cash filter. I chose a momentum period of one calendar month for relative strength and 25 trading days for the SMA cash filter. Two funds are selected at the end of each month. The funds are first ranked according to relative strength (one-month total returns), and then the two top-ranked funds must pass their SMA filters in order to be selected. If a top-ranked fund fails its SMA filter test, then the money for that fund goes into cash (short term T-Bills).
I used PV to backtest the strategy. In order to extend the backtest to 1988, I substituted Dreyfus U.S. Treasury Intermediate Term Fund (MUTF:DRGIX) for VFITX. The results of the backtest are shown below. Also shown are the results of a buy & hold strategy of the five funds as well as a benchmark (S&P 500).
The CAGR is 9.7%, the annual Standard Deviation [SD] is 5.0%, the worst year (1994) is +0.1%, the Maximum Drawdown [MaxDD] based on monthly returns is -3.8%, the Sharpe Ratio is 1.2, and the Sortino Ratio is 2.5. The MAR (CAGR / MaxDD) is 2.5. The monthly win rate is ~73%.
Comparisons with buy and hold and the S&P 500 are shown in the preceding table. It can be seen that the proposed tactical strategy has higher CAGR (9.7% vs. 7.2%) and better MaxDD (-3.8% vs. -12.1%) than the buy and hold strategy. Also note that the MaxDD of the S&P 500 is -51.0% compared to -3.8% for the tactical strategy.
For additional comparison, I now show the backtest results with Vanguard Total Bond Index Fund (MUTF:VBMFX) as the benchmark.
It can be seen that the CAGR for VBMFX is 6.4% and the MaxDD is -5.0%. The worst year is -2.6% in 1994, and there are three negative years (1994, 1999, and 2013). So significant improvement in performance and risk is seen for the proposed strategy in comparison to VBMFX.
The timing period, i.e. the momentum period, was varied between one and four months in one month increments, and the SMA was varied between 1 month (21 days) and 3 months. 3D surface plots of CAGR and MaxDD are shown below for these variations. It can be seen that the overall results are rather insensitive to these variations. CAGR changes between 8.6% and 9.7%, and MaxDD goes between -3.8% and -7.8%.
Some Practical Issues
As I have discussed in previous articles, it is quite easy to trade Vanguard funds every 30 days. To maintain 30 days between trades, I have developed a trading schedule through 2020 that trades either at the end-of-the-month (EOM) or the first trading day on the next month (EOM+1). If you send me a SA message with an email, I will send the schedule to you.
There are no costs involved if this is done on the Vanguard platform. I have now been trading three tactical strategies on Vanguard accounts for the past three months, and everything works as advertised. The only restriction in trading the funds is that Vanguard does not allow you to repurchase a fund for 30 days after it has been sold.
What is somewhat problematic is determining which funds to purchase because there is a monthly distribution that occurs at EOM for most of these funds (VCVSX is the exception). For EOM+1 trading based on EOM data, one month total returns (including distributions) can be found on the Vanguard website. The SMAs based on 25 trade days can be calculated by hand or in Excel based on EOM data from Yahoo Finance. However, the dividend distribution must be included in the SMA calculation, so this requires some modification to the posted data at Yahoo (distributions are not included in Yahoo data for a few days).
For EOM trading based on EOM-1 data, the best solution is to use stockcharts.com. Both the one month returns and the 25-day SMAs can be plotted. Sometimes the ranking changes between EOM-1 and EOM, but we will just have to live with this discrepancy.
The selections for February 2016 were VFIIX and VFITX. For December 2015 and January 2016, the selections were VWAHX and VFIIX.
Disclosure: I am/we are long VFIIX, VFITX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.