Tactical Strategies Update

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Includes: EEM, EFA, MDY, SPY, TLT
by: Matt Erickson

Summary

The vast majority of tactical managed ETF portfolio strategies have generated negative returns over the past several months.

What is causing a number of these formerly leading strategies to perform poorly.

We provide an update on our tactical portfolio illustration from our popular article, "How To Beat The Market Using Tactical Asset Rotation".

One day while walking in the woods Chicken Little was struck on the head by an acorn. It scared her so much she trembled all over, causing her to shake so hard that nearly half of her feathers fell out. Confused and panic-stricken, she began to shout "Help! Help! The sky is falling! I have to tell the king!" Her fear was so great that she began to run all over town sharing her message with anyone and everyone who would listen. By the end of the story, she had riled up a lot of people, but ultimately they all learned that the sky was not falling after all.

In 2015 and throughout the first few months of 2016, we have seen the vast majority of industry-leading tactical managed ETF portfolio managers and strategies turn in negative returns. This has led to some rather hasty generalizations and rash proclamations that these tactical methods simply do not work anymore, that in fact "the sky is falling!". Rather than take a step back and put the sequence of returns generated by these tactical portfolio strategies into context with the environment we have found ourselves in, many investors have been quick to draw conclusions. In this article, we will attempt to put this in perspective and further illustrate our points by providing updates on some basic tactical models we first highlighted in one of our most popular Seeking Alpha articles, "How To Beat The Market Using Tactical Asset Rotation".

In prior articles and in our book Asset Rotation, we've cited the exponential growth we have witnessed in the managed ETF portfolio segment of the investment industry. In Morningstar's most recent year-end report, the Morningstar ETF Managed Portfolios Landscape Report, Q4 2015, they cited that they have been tracking 755 strategies from 154 firms with total assets of $73 billion through December of 2015. To put this in perspective, when Morningstar first began publishing this report in January of 2012, they were tracking 370 strategies from 95 firms, with total assets under advisement of $27 billion. Yet at year-end 2014, per this same report published by Morningstar, total assets were as high as $91 billion. So over a year's time, between outflows and the vast majority of institutional managers in this space posting negative returns, we've seen a loss of roughly $18 billion, or a decline in assets of roughly -20%. Not surprisingly, investor confidence has waned as performance has lagged.

In an article we wrote that was published on Seeking Alpha back in January of this year, "Why 2015 Was The Worst Market In The Past 25 Years", we very clearly illustrated the tremendous instability that has been evident in the investment markets for the past several months. Not only has there been no discernible favor either towards risk assets or those that have historically provided a margin of safety, further yet there have been no underlying trends; as the various sectors of the market continue to vacillate as well, revealing no consistent winners. In Asset Rotation, we talked about this type of market environment and referred to it as the Achilles heel for an asset rotation based tactical managed ETF portfolio.

As discussed in the book, and speaking in general terms everyone can understand, we mentioned that there are really only 4 types of market environments: up, down, and sideways with no underlying trends. In a stable upward trending market, a tactical asset rotation based portfolio will capture a meaningful percentage of the upside; in a progressively downward trending market, an asset rotation based portfolio should be expected to rotate into underlying holdings that demonstrate a relative margin of safety and preserve capital; in what may otherwise appear to be a sideways market with no discernible gains a tactical rotational portfolio stands a good chance of achieving outperformance through exposure to underlying trends (whether in favor of a specific market sector, capitalization, or geographic location). However, in a sideways market with no underlying trends, there is simply nowhere to go. With increased market volatility and no underlying trends to be exploited, an asset rotation based portfolio stands the chance of being whipsawed, consistently finding itself out of position with respect to the desired asset exposure with favorable returns.

Fortunately for investors, out of these four investment climates, the rarest market environment is sideways with volatility and no underlying trends. Unfortunately, this is what investors experienced during 2015, and 2016 has gotten off to the same start.

To illustrate this further and measure the potential impact on a tactical portfolio, let's go back to the very basic asset rotation model we first illustrated in "How To Beat The Market Using Tactical Asset Rotation" and provide an update on how performance would look today.

Recall, there are only 5 ETFs eligible to be held in our portfolio:

  • SPDR S&P 500 ETF (TICKER:SPY): representing primarily large cap domestic equities
  • SPDR S&P Mid Cap 400 ETF (TICKER:MDY): representative of mid cap domestic equities
  • iShares MSCI EAFE ETF (TICKER:EFA): reflecting developed international equities
  • iShares MSCI Emerging Market ETF (TICKER:EEM): denoting emerging market equities
  • iShares 20+ Year Treasury Bond ETF (TICKER:TLT): representing long term US Treasury Bonds

Our rules for tactical management of this portfolio are the following:

  • The portfolio will be reconstituted on a monthly basis
  • Each month we will select and hold only one out of our 5 eligible ETFs
  • Our holdings will be based solely on purchasing the best performing ETF out of our five over the trailing 3-month period at the time of portfolio reconstitution
  • Our portfolio will be traded on the last trading day of each month

When last we illustrated this portfolio we measured historical performance from December 31, 2003 through March 11, 2015. Over this period, our simple 1 holding tactical portfolio produced a compound annual growth rate of 22.7% versus 7.7% for the SPDR S&P 500 ETF and generated a cumulative return of 884.5% versus only 129.2% for SPY. Suffice it to say, we can all agree this dramatic outperformance is wildly impressive. Not only did this portfolio generate positive returns of +26.6% in 2008 versus a loss on SPY of -36.8%, when markets rebounded in 2009 and SPY was up +26.4%, this portfolio was up +57.7%! Further, in 2011 when last we saw a sideways market that DID HAVE UNDERLYING TRENDS, our rudimentary tactical portfolio was up +44.8% versus a return on SPY of +1.9% (which incidentally ALL gains came from dividends).

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While long-term performance of this portfolio has been outstanding, on March 11, 2015, when we modeled it for our first article it was down -8.7% year to date. As we can see below, this decline in performance continued throughout the remainder of the year, with our modeled portfolio down -16.6% for 2015. These losses have continued into 2016, with the portfolio now down another -8.2% through May 17th of 2016. In just 14 months, what was once a cumulative gain of 884.5% has been reduced to 725.5%; a compound annual growth rate of 22.7% is now down to 18.6%, while the corresponding return on the S&P 500 has only declined from 7.7% to 7.2%. The losses have been startling and many have questioned how this could be possible.

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When you look at the context of our environment, it is very easy to see precisely why this has occurred. We covered this in depth in our article "Why 2015 Was The Worst Market In The Past 25 Years", but generally speaking, this was because there were more whipsaws in performance (directional changes on a month by month basis) than at any other time in the past 25 years. This whipsawing price action took place not only in broad equity indices and Treasury prices, but also in the underlying sectors of the market. The vast majority of investors today have never witnessed this before and this is explicitly why we referred to this as the rarest of market environments, and yet here we are.

If you give it some thought, it makes sense why the markets have been behaving in this manner over the past several months. The reality is that by and large, the US equity markets have been on a significant run over the past several years and many have begun to loudly question whether it is sustainable. Consider that since March of 2009 (at the bottom of the Great Recession), the S&P 500 through the end of April 2016 has averaged an annual rate of return of 17.98% and generated a cumulative rate of return of 227.05%. Many investors are fearful this cannot last and quite a few continue to speculate whether this growth in the US markets has been manipulated and may ultimately be setting us up for a great fall.

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To put this into even greater perspective, you may be surprised to learn that since the last time the global equity markets were putting in new highs in October of 2007, the US markets are now up over 60%, yet both the MSCI EAFE Index (the primary benchmark for developed international equities) and the MSCI Emerging Market Index have yet to get back to even, with cumulative returns of -5.90% and -14.73% respectively. So while the rest of the world has continued to struggle, the US has somehow seemingly decoupled from the global economy and one can only wonder how long this might last.

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The bond market presents further concerns. For years, we have heard the Fed talk about increasing interest rates and now they are doing it (or they have at least begun to). Academically speaking, in a rising interest rate environment, the laws of duration imply that a 1% increase in interest rates would mean a 10% decline on an existing 10-year bond and even bigger loss of -20% on a 20-year bond. For those that ascribe to this belief, this means that not only do the stock markets potential represent increasingly implicit risks, but the bond markets do as well.

Fortunately, we do not believe this is the case. Historically, even during the bear market in bonds that basically lasted forty years and took place in the United States from 1942 to 1981, when the stock markets declined Treasuries provided investors with a margin of safety and in many cases generated positive rates of return. We first discussed this in depth in our article "The Treasury Run: Part II". During this period of time, the S&P 500 averaged an annual rate of return of 11%, inflation averaged 5%, and long-term Treasuries averaged 2%. For a buy and hold bond investor, this was troublesome, but for a rotational investor, Treasury bonds continued to demonstrate a strong inverse relationship to stocks when needed the most. We strongly believe this will continue. However, after seeing the iShares 20+ Year Treasury ETF go up by 27% in 2014, while at the same time the S&P 500 was up almost 14%, the unwind we witnessed in Treasuries in 2015 was long overdue. In order for Treasuries to return to their nature as a flight to safety from equities, we needed them to come down in price. The problem was, to a large degree this occurred at the same time equity markets were struggling in 2015 and in large part out of fear from what impact a rate increase might have. Of course, one should also note this took place after the U.S. Federal Reserve finally ended their immense and historically unparalleled "quantitative easing" program, in which over a 4-year period they purchased a whopping $3.5 trillion of our own Treasury bonds. Therefore, it should come as no shock that not long after we stopped buying our own bonds that prices began to fall.

As you can now see, there have been some very clear and material reasons as to why the vast majority of tactical asset rotation based strategies have generated negative rates of returns over the past several months. This confluence of factors has generated an environment so rare it had never been seen by today's generation of investors, and so it should come as no surprise that the average investor is not initially able to put all of these overriding factors into the appropriate context. After having now explained the potential impact all of these factors can have, we hope this is no longer the case and that investors can make more educated decisions going forward and more appropriately evaluate this unique method of portfolio management.

Is "the sky falling" in on these once industry leading strategies? Will they no longer continue to work in the future? Of course not. At some point, our next move in the markets will be more clearly defined. At which point, the vast majority of these tactical strategies will likely return to generating performance metrics similar to what they have done in the past. The current wildly volatile, range bound environment we have been in since 2015 will not last forever, and should our next big progressive move be down, the irony is that it is likely the tactical component of an overarching portfolio that will prove itself to be the most resilient.

Rather than abandon this style of portfolio management, what recent performance should teach us all is that it is imperative for the majority of investors that they employ a number of different approaches within their overarching portfolio; blending together various strategies that over time have proven to have lesser correlations to each other. When integrating various independent approaches to portfolio management together in this manner, one truly stands the chance to optimize portfolio performance, and in our opinion to mitigate downside risk.

Lastly, we should note that the portfolio illustrated in this article is NOT a recommendation for any investor in any capacity. Rather we think a portfolio concentrated in only one security at all times should be considered a serious liability. However, because the process itself is simple and easy to understand, and also includes well-known securities and two distinct asset classes, this illustration does depict very clearly how and why tactical asset rotation based portfolios can dramatically underperform at times.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.