Seeking Alpha

Some Lessons Learned In 2016 About Tactical Strategies

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Includes: CPHYX, NEFLX, NHMAX, OOSAX, PTMDX
by: Cliff Smith
Summary

Tactical strategies using bond assets can provide moderate growth (10-12%) and very low maximum drawdown (less than 5% based on monthly returns) even in a rising rate market.

Tactical momentum approaches using high volatility assets like equity sectors and commodities are generally unreliable due to excessive market noise. Large drawdowns are a common result.

Reliable and robust momentum rules are most applicable to low volatility bond mutual funds. Very short duration look-back periods are possible with such funds without excessive whipsaw.

All funds in the same class are not created equal. For bond strategies, it's best to use funds with large drawdowns and steep, steady recoveries versus funds with low drawdown.

Introduction

As we enter 2017, I thought it might be useful to assimilate my thoughts about what I learned in 2016 about tactical momentum strategies. I learned a lot over the past year, and I appreciate the help and suggestions I have received from many of my followers. I hope this article will help Do-It-Yourself [DIY] investors in their search for tactical strategies that provide moderate growth with very low risk. My stated objectives in tactical strategies continue to be moderate portfolio growth of 10-12%, low volatility (less than 5%), very low maximum drawdown (less than 5% based on monthly data) and monthly win rates over 75%. If these objectives can be met, and I think they can, most retired DIY investors will have sufficient money to live on and donate to their church and charitable organizations, plus a lot of money will be left for our children and grandchildren when we die.

Some Lessons Learned

1. Equities and commodities are very volatile. There is excessive market noise day-to-day as well as month-to-month. The only equity tactical momentum strategies that appear to provide any value have to use relatively long look-back periods to rank assets, typically 10-12 months. Using such long look-back periods means the strategy is not very responsive to current market conditions, and that means there is a lot of whipsaw and large drawdowns. I cannot personally tolerate such large drawdowns. I am in retirement, and there are no more "second chances."

2. If we invest in equities, the best play is a diversified large cap index fund like S&P 500. All equities tend to become highly correlated under market stress. Under such circumstances, the best play in a tactical strategy is to be in some type of bond asset, or cash as a safety net.

3. Bond assets in tactical strategies can provide sufficient growth even under rising rate conditions. Many investors are fearful of bonds now that the 30-year bond bull market appears to be over. Rising rates tend to cause many bond assets to lose value. However, I think bonds can still do quite well in a rising rate environment as evidenced by the nice returns of senior floating rate loans and high yield corporate bonds in 2016. What is needed is a momentum methodology that quickly responds to market conditions and moves money into the appropriate bond class.

4. Using a fixed risk-off asset under all market conditions is probably not wise. Many tactical strategies (mine included) relied on a single bond asset as the out-of-market [OOM], risk-off asset. In the past, a long-term treasury has worked well as the OOM asset, while some investors like to use a total bond market fund or a short-term treasury asset. Cash (money market) has always been the safe heaven, but cash does not bring much return these days.

My solution is to use a tactical bond strategy as the OOM asset, switching between bond classes depending on momentum. I call these strategies defensive bond strategies. Here and here are my latest articles on defensive bond strategies.

5. High yield bond assets (corporate as well as municipal) are vital assets in bond tactical strategies. Many strategists fail to include high yield assets, considering them as "too risky." And they are risky; in fact that they can lose close to 50% of their value as many did in 2008. However, under more normal circumstances, high yield bond assets do as well, if not better, than the S&P 500, and with a lot less volatility.

The key is to avoid the drawdowns that inevitably occur with high yield assets, and that is where a good tactical bond strategy comes into play. In most instances, high yield municipal bonds or GNMA bonds or mid-term treasuries are negatively correlated to high yield corporate bonds, so momentum should move you from high yield corporate bonds to, say, GNMA bonds at the appropriate time.

6. Reliable (and robust) momentum rules are most applicable to low volatility bond funds. This is a key feature for successful implementation of tactical strategies. Because of low volatility, short duration look-back periods can be used without excessive whipsaw. Typically, look-back periods between 15 market days and three calendar months are viable, and the backtest results show little effect caused by duration length. This means you don't have to worry if you miss a trade by a few days, or if you go with a monthly, bi-monthly or quarterly trading schedule (although monthly trades are preferred).

7. It is best to trade bond mutual funds rather than bond ETFs. They have much lower volatility and better growth. I also like the fact that the mutual fund trade is done after market close, so you can place the order at any time. There are also more mutual funds from which to choose. I try to look for mutual funds that carry no fees or loads. Also, all mutual funds in the same class are not created equal. This is especially true in high yield funds and senior floating rate funds.

8. It is best to find funds with slow and steady upward trends, and not worry about maximum drawdown. This is a little counterintuitive. Let me explain.

A tactical momentum strategy is commonly used to indicate when to switch between assets. In simple terms, we want to own an asset when it is trending upward, and sell it when it is trending downward. So as long as we can respond quickly to market conditions, we will not own an asset that is trending downward. We don't really care how much drawdown occurs if we don't own that asset. And in reality, assets that have large drawdowns provide a great opportunity for profit when the trend changes and heads upward.

Funds that have large drawdowns tend to have relatively poor overall performance compared to funds with smaller drawdowns. Many times this results in ranking organizations such as Morningstar giving such funds a low ranking. But, in reality, funds with high drawdowns tend to have greater growth potential after the drawdowns occur. If the higher growth comes with low volatility (i.e. the volatility associated with the upward trend is low), then we have a good fund to include in our universe of funds, regardless of its Morningstar ranking.

Conclusions

2016 was a good year for tactical bond strategies. Many of my bond strategies returned over 10% in 2016 with very low volatility. Many bond strategies have monthly win rates over 80%. Here is an example of a typical tactical bond strategy that selects from these five funds:

1. Nuveen High Yield Municipal Bond Fund (MUTF:NHMAX);

2. Principal High Yield Corporate Fund (MUTF:CPHYX);

3. PIMCO Mortgage Backed Securities Fund (MUTF:PTMDX);

4. Oppenheimer Senior Floating Rate Fund (MUTF:OOSAX); and

5. Loomis Sayles Limited Term Government and Agency Fund (MUTF:NEFLX).

The only caveat is the difficulty in making selections each month. The selections made by Portfolio Visualizer are not reliable because end-of-month distributions are not included in the data in a timely fashion. In previous articles and comments, I have tried to spell out the methodology of calculating returns using Stockcharts PerfCharts, and it is really quite easy once you get the hang of it.

I hope 2017 continues to be prosperous for my many followers. Again, thank you for your encouragement and many comments and suggestions.

Disclosure: I am/we are long OOSAX, CPHYX. 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.