Enhanced Low Volatility Bond Strategy With 13% Annual Growth And 90% Monthly Win Rate

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Includes: GSSDX, NHMAX, OOSAX, VBMFX, VFIIX, WHIYX
by: Cliff Smith

Summary

A previous Low Volatility Strategy [LVS] ranked bond funds based on returns over one look-back period. The fund with the highest ranking was selected at the end of each month.

The previous LVS was shown to be very robust, i.e. a change in duration of the look-back period did not greatly affect backtest results.

In this article, an enhanced version of LVS is presented that ranks the funds over two look-back periods, and selects the fund with the best overall ranking.

The enhanced version is backtested from 2000 - 2016; the annual growth is 13.0% and the monthly win rate is 90.2%. The maximum monthly drawdown is only -3.2%.

Although the LVS version traded monthly gives the best results, good performance is also seen in bi-monthly or quarterly trading. Quarterly trading eliminates the $50 early redemption fee.

Introduction

In the current market, money is obviously moving from bonds to equities, especially in the rising rate market that we are now experiencing. But although bonds have generally shown poor performance over the past six months, there are two classes of bonds that have done quite well: senior floating rate loans and high yield corporate bonds. Many mutual funds in these two classes have produced returns in excess of 13%, significantly out-performing the S&P 500 in 2016 while, at the same time, having very low volatility. So although bonds in general have fallen out of favor, if an investor utilizes tactical momentum strategies to switch between bond assets, he would have realized some pretty good returns in 2016. And, after all, isn't this how tactical asset allocation strategies are supposed to work, i.e. moving between assets based on momentum principles?

I decided to try and make my Low Volatility Strategy [LVS], presented previously in this SA article, even more robust by introducing two look-back periods into the tactical methodology. LVS seems to be quite popular among my followers. This may be due, in part, to the strategy's overall robustness, i.e. the strategy is effective over a wide range of look-back periods. So it makes sense to include two look-back periods in the strategy (instead of one look-back period) to further improve robustness.

Enhanced LVS Universe

LVS has been developed to use five mutual fund bond classes that have low correlation to each other. Versions of LVS have been developed using No Transfer Fee [NTF] mutual funds on 1) the Schwab platform and 2) the Vanguard platform. For the Schwab version, the universe of the strategy is:

1. High yield muni bonds: Nuveen High Yield Municipal Fund (MUTF:NHMAX);

2. High yield corporate bonds: Ivy High Income Fund (MUTF:WHIYX);

3. Senior floating rate loans: Oppenheimer Senior Floating Rate Loan Fund (MUTF:OOSAX);

4. GNMA bonds: Vanguard GNMA Fund (MUTF:VFIIX);

5. Short-term treasuries: Goldman Sachs Short Duration Government Fund (MUTF:GSSDX).

On a subjective basis, these funds seem to be the best in class in terms of yield and low volatility. Some of the funds are different from my previous LVS version. The high yield funds like NHMAX and WHIYX have high percentages of lower rated bonds in their holdings. This means these funds will have higher drawdowns individually, and also higher returns during recovery. But this is exactly what we want for funds in our tactical strategy. When we own these funds, we want higher return; when we don't own these funds, we don't really care how large the drawdowns are. This means rankings like Morningstar based on performance and risk are not as meaningful in the selection process of funds in a tactical strategy compared to buy & hold investors. Some of you may not agree with me on this.

And all funds except VFIIX are NTF funds at Schwab. NTF funds have no loads or fees except a 90-day early redemption fee of $50. For accounts with reasonable size, say $100K, the early redemption fee is a relatively minor expense. For VFIIX, a $75 fee is charged whenever it is bought (no other fees or loads).

Momentum Rules

The rules of this improved version of LVS are:

1. The funds are ranked based on 15 market day total returns;

2. The funds are ranked based on two calendar month total returns;

3. An overall ranking is determined for each fund. The overall ranking is based on a weighted average; the first ranking has a 51% weighting and the second ranking has a 49% ranking. For example, if a fund is ranked #1 in the first ranking and #3 in the second ranking, then the overall weighted average ranking is 1 x 0.51 + 3 x 0.49 = 1.98.

4. The fund with the highest overall ranking (i.e. the lowest number) is selected at the end of each month. The 51%/49% weighting means, in case of ties, the fund that is ranked highest in the first ranking wins.

Backtest Results

The strategy can be backtested to 2000 with these funds. The results using the commercially free Portfolio Visualizer [PV] are presented below. The strategy is labeled "Timing Portfolio" in the figures. Also shown are the results of a buy & hold equal weight portfolio (rebalanced annually) and the Vanguard Total Bond Market Index Fund (MUTF:VBMFX).

The Compounded Annualized Growth Rate [CAGR] is 13.0%, the maximum drawdown [MaxDD] is -3.2%, the worst year is +5.8%, and the monthly win rate is an amazing 90.2%, the highest I have ever seen in a tactical asset allocation strategy. The 2016 return is 14.6%.

Although the best results are produced when the strategy is traded on a monthly schedule, good performance is also seen when a bi-monthly or quarterly trading schedule is used. On Schwab accounts, a quarterly trading schedule will mean no early redemption fees (if that is a concern).

Backtesting was also performed (not shown) using proxy mutual funds that have longer histories. Backtesting, limited by the senior floating rate loan proxy, could only be performed back to 1991. Please note that these proxy funds are not the funds I would employ when using real money. I only wanted to see if there were any years with issues if we carried the testing back to 1991. And there are not.

Conclusions and Final Comments

This enhanced, more robust version of LVS shows some improvement in performance and risk-mitigation over my previous LVS. I have shown results when only one fund is selected each month, i.e. LVS-1. Alternatively, when two funds are selected each month, i.e. LVS-2, there is lower CAGR (10.3%) but improved MaxDD (-1.9%). The enhanced version uses two short-duration look-back periods (15 market days and two calendar months) instead of only one look-back period as previously utilized. The best aspect of this enhanced version of LVS-1 is its monthly win rate of over 90% from 2000 - 2016. Here is a PV link that presents the results shown in this article.

As always, a strict 30-day trading schedule is recommended to avoid any frequent trading restrictions imposed by the mutual fund companies.

PV is not reliable in terms of its selections at end-of-month [EOM] because EOM distributions are not included in the PV data until well after EOM. So my recommendation is to use stockcharts.com PerfCharts (it's free) to compare returns at EOM, remembering that EOM distributions are not always included in PerfCharts numbers (and must be added to get correct returns). I have found that the easiest way to get the EOM distribution percent is to take the distribution and NAV price off of the Schwab website and add the distribution percent to the PerfCharts returns. The 15-day returns are obtained by inserting 16 days in the PerfCharts box. The two calendar month returns go from the end of the month to end of the month (over a time period of two months).

To determine if PerfCharts includes EOM distributions or not, plot both the fund symbol (e.g. NHMAX) and _fund symbol (e.g. _NHMAX) on the same figure. NHMAX plots the adjusted price data (that include distributions) while _NHMAX plots the closing price data (that don't include distributions).

Disclosure: I am/we are long WHIYX.

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.

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