One of the most rapidly growing segments in the investment industry over the past few years has been in the "tactical managed ETF portfolio" space. So much so, that in September of 2011 Morningstar announced plans to track and rank ETF managed portfolios. In January of 2012 Morningstar published their inaugural "ETF Managed Portfolios Report". At the time of publication, Morningstar was tracking nearly 370 strategies from approximately 95 firms, with assets under advisement of $27 billion (as of September 2011), a 43% growth rate over the prior 12-month period.
Fast forward to today. Morningstar has recently published their Q4 2014 "ETF Managed Portfolios Landscape Report", and they are now tracking 699 strategies from 146 firms with total (AUM and AUA) of $91 billion through December 2014. Obviously, this segment of the market has experienced some truly explosive growth, but to the vast majority of investors the idea of how one might manage a tactical ETF portfolio remains a mystery.
In our recently published book, Asset Rotation, after providing what we felt was the appropriate educational backdrop, we provided our readers with a couple of rudimentary examples of tactical portfolios that have historically outperformed the markets, and with significantly less risk and exposure to prolonged equity market declines. In the book, we illustrated tactical portfolios focused on only one defining factor to determine portfolio holdings - trailing one month price momentum. In other words, amongst a limited eligibility list, we proposed investors hold those securities which had on a relative basis performed the best over a trailing one month time frame.
Surprisingly, this overwhelmingly simplistic approach, just buying what was up the most over a relatively short time frame and reconstituting the portfolio on a monthly basis, produced extremely strong risk-adjusted returns. However, as one might imagine, such an illustration was meant to be an example only; an illustration to get the wheels turning. As a follow up to those illustrations, in the context of this article we will explain to you precisely how an investor can construct a highly efficacious tactical asset rotation portfolio. Again, for purposes of simplicity we will focus on only one vetting criteria; in this case we will take into consideration only trailing 3 month price momentum.
In order to construct a tactical asset rotation portfolio, an investor must begin by identifying a handful of ETFs that will serve as an appropriate eligibility list (from which to identify monthly holdings). Ideally, the selected securities should possess relatively low correlations to one another and represent different segments of the market and multiple asset classes. Eligible securities should include those representative of risk, as well as those with a historical precedence of providing a modicum of capital preservation. In this case we will utilize global equities to fulfill the risk portion of the eligibility list and US Treasuries to represent our flight to safety.
Our illustrated portfolio is made up of only 5 eligible ETFs:
- SPDR S&P 500 ETF (TICKER: SPY): representing primarily large cap domestic equities
- SPDR S&P MidCap 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 we 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
Now that we know our rules of engagement, let's take a look at how this tactical asset rotation portfolio would have performed from 2004 through March 11, 2015:
From 2004 through March 11, 2015 our simple 5 security asset rotation portfolio illustrated above averaged an extremely impressive compound annual growth rate of +22.7%, versus a relatively paltry average annual return of only 7.7% for the SPDR S&P 500 ETF . Surely, we can all agree this divergence represents significant outperformance! This dramatic outperformance is even more compelling when you take into consideration compounding of returns; over little more than eleven years this portfolio generated a total return of 884.5% versus a total return on SPY of only 129.2%!
Other notable observations:
- Over the course of the period, this portfolio did not experience a single calendar year of negative returns
- Our tactical portfolio illustration was only 30% correlated to SPY
- The max drawdown on the tactical portfolio was -21.3%, versus -55.2% for SPY
- The tactical nature of this portfolio provided concentrated exposure during multiple periods in the mid 2000's when emerging markets were on a tear.
- In 2008 when SPY was down nearly -37%, our illustrated tactical portfolio was impressively up +26.6% (due in large part to the fact that TLT was up more than 33% for the year and the tactical nature of the portfolio rotated out of equities and into TLT for much of the year).
- The volatility of our illustrated tactical portfolio was slightly higher than SPY, with a standard deviation for the period of 21.0% versus 19.6%.
Our simple 5 ETF tactical asset rotation illustration demonstrated the propensity to participate in favorable long term trends, and avoid those periods during which eligible assets were experiencing prolonged declines. Despite the tremendous outperformance demonstrated over the entire period, this portfolio has rather significantly lagged in recent years; trailing SPY in 2012, 2013, 2014, and year to date would be down -8.7%, versus SPY down only -0.5%. Such underperformance may be alarming for some investors, as many believe a tactical mandate should allow for outperformance over all periods. This where it becomes imperative that investors understand that to a large degree, tactical asset rotation portfolios should be regarded as benchmark agnostic. How can one compare a portfolio with ability to rotate between 100% in equities and 100% in fixed income to behave like a benchmark that represents 100% exposure to equities at all times? The obvious answer is they shouldn't. With a long-term correlation of only 30% to the S&P 500, one should not expect our illustrated tactical portfolio to behave like the market, whether up or down. Over time efficacy has proven itself out, but tactical portfolio management in this regard is highly dependent on the stability of underlying trends, which frankly have been less stable during the past couple of years.
That being said of course, despite the dramatic history of outperformance, there are flaws to the rudimentary process illustrated in this article. Most notably, investors may take issue with the fact that during all periods this portfolio would have held only a single ETF; making for a highly concentrated portfolio. Further yet, the historical performance of TLT over the past decade plus would have provided a tremendous tailwind for this portfolio; though some might argue in a rising interest rate environment, this likely will no longer be the case. At which point it may make sense to include a Treasury ETF with a shorter duration (as price movements tend to be less volatile and less impacted by a rising rate environment). Of course, the higher volatility may also be an issue for some investors. Therefore, let's take a look at a slightly more refined version of this portfolio.
Rather than reinvent the wheel, let's continue on with the exact same screening process and eligible ETFs, but with two exceptions: 1. we will add the iShares 7-10 Year Treasury Bond ETF (TICKER: IEF) to our eligibility list, and 2. rather than hold only one security each month, we will be required to hold two. Making these changes will enable the portfolio to at times reflect a 50% stock / 50% fixed income allocation, as opposed to dramatically shifting only between 100% equities or 100% fixed income. These changes will also dilute portfolio concentration and make the portfolio less reliant on the long dated Treasury.
Let's take a look:
In our second illustration of this simple tactical asset rotation approach to portfolio management we have utilized six ETFs, rather than the previous five. We've also increased monthly holdings from one to two. These changes somewhat significantly reduced our level of historical outperformance, as our average annual return declined from 22.7% to 17.8%, but was still well ahead of SPY's average annual gain of 7.7%. However, while overall average annual performance may have declined, it should be noted our aforementioned changes to how the portfolio would be constructed and managed reduced both our standard deviation and our max drawdown; overall reducing the level of risk inherent in the portfolio. One should also note, since this portfolio is less reliant on TLT as the lone flight to safety vehicle, the volatility of TLT year to date has been much less impactful, as our more diluted portfolio illustration is down a much more acceptable -1.7% year to date, versus our prior illustration of the five ETF portfolio that would be down -8.7%.
In this article we have provided two rudimentary examples of how an investor can manage a tactical asset rotation portfolio based on only one determining factor - trailing 3 month total return. Of course there are more refined and complicated approaches to managing a tactical ETF portfolio, but the irony is even an elementary process such as this has proven to be highly successful.
Efficient tactical investment management is more than possible, it is a reality, and there are a growing number of skilled practitioners out there painting the landscape of tomorrow. As our landscape changes, it is imperative that investors begin to learn more about this rapidly growing segment of the investment markets and how tactical strategies such as these can provide a compliment to an overall portfolio approach.
Disclosure: The author is long TLT, MDY, SPY.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.