Several months ago a risk reduction model was presented in this article explaining the basics of how to avoid deep bear markets as we experienced in 2000 - 2002 and again in 2008 through early 2009. How is this model working after eight months of operation?
Several portfolios were selected to participate in the ITA Risk Reduction experiment since they were lagging both Vanguard's Total Market Index Fund (VTSMX) and a customized benchmark known as the ITA Index. Once a portfolio falls behind a benchmark, it is difficult to bring it back. If one loses 10%, it takes a little over 11% to get back to even. That drives home the importance of minimizing losses. I recall the days when it was common for actively managed mutual funds to charge an 8.5% load fee. To get back to even, the fund needed to generate a 9.3% return.
When the recent market decline hit, shares of a number of ETFs were sold out of the "risk reduction" portfolios as the prices of several ETFs dipped below their respective 195-Day Exponential Moving Average. This called for a sell. As a result of those moves, the portfolios gained on the VTSMX benchmark between 0.1% point and 0.4% point annualized. The gain on the ITA Index ranges from 2.4% points to 5.2% points. While those gains are not overly dramatic, each portfolio improved performance or moved in the right direction. It is important to keep in mind that the cycle is not complete and this experiment is quite young. While the market may drop lower, the real test will come when the signal to move back into the market arrives. Tactical Asset Allocation (market timing) is extremely difficult as one needs to be right twice, both getting out and going back into the market.
Gerald Appel first introduced me to moving averages back in 1979 when he published a pamphlet, The Moving Average Convergence-Divergence Trading Method, now commonly known as MACD. Another proponent of simple moving averages was Dick Fabian, writer and publisher of The Telephone Switch Newsletter. Variations of Appel, Fabian and more recently the Ivy Portfolio authored by Faber and Richardson gave rise to the model used with several portfolios followed on the ITA Wealth Management blog. I used variations of this model in the mid-1980s, and then failed to stick with the program during periods when they were of most use. Discipline is required to be successful.
Knowing when to move back into the various asset classes recently vacated is challenging. In the following table we see a list of ETFs that represent a wide range of asset classes of interest. As one might expect, those securities indicating a Buy signal under the "Delta Factor" column are exactly those holdings that experienced recent and sharp price declines. Since the "Delta Factor" is a reversion-to-the-mean type of calculation, we expect those ETFs with the large Delta percentages to eventually prove rewarding. The "Delta Factor" is one of several metrics used to alert investors when it is time to go with the laws of probability and move back into the asset classes that are under target due to sold positions. This is how we propose to hold down portfolio risk and avoid major bear market declines.