I began investing and trading in equities, bonds, options, commodity futures, managed accounts, and hedge funds some 35+ years ago. I’ve been through 3 Bear markets in equities; however the only bond market I’ve known has been a Bull bond market. That could be about to change (more below).
Seven years ago, I began looking for a methodology which would require less work while protecting my investments from the ravages of bear markets. That led me to Tactical Asset Allocation which quickly became a new passion. I’ve spent thousands of hours studying Tactical Asset Allocation, building sophisticated models, and back-testing through bull and bear markets. I have been using Tactical Asset Allocation to manage an increasing share of my family’s investment portfolio since early 2012.
This article will explore the performance of 40 publically available Tactical Asset Allocation strategies across three full equity market cycles and two entirely different interest rate and inflation environments.
Jeremy Grantham has made a strong case that this market is either in, or entering into, a blow-off phase and could move a good deal higher before crashing (a 40% or greater decline). One of his key tenants is the concept of price acceleration during the terminal phase of the blow-off. I suspect that Grantham has it right although I’m inclined to think that his range of 3400-3700 for the S&P 500 may be a bit high.
Whether you agree with Grantham’s hypothesis, or not, there is compelling evidence that valuations are stretched to historical extremes. Further, it would be difficult to make a convincing case that the current bull market is not in late innings. The prudent, self-directed investor is already planning for the end of this game and beginning of the next which is all part of investing over a full market cycle.
The Full Market Cycle
Absolute returns tell only half the story so no performance appraisal is complete without an assessment of risk. Measuring investment returns and drawdowns over a full market cycle significantly improves the assessment of portfolio performance.
Your portfolio gains little if it has terrific Bull Market returns only to give much of it back during the next Bear Market. Your first question when considering an investment should always be “what is the drawdown?”. In other words, insist on knowing what you are going to risk before listening to the potential rewards.
In investing terms, a full market cycle is typically defined as the period between two peaks which includes both a Bear Market and a Bull Market.
Please see this whitepaper for an illustrated discussion of Full Market Cycles.
Tactical Asset Allocation
Tactical Asset Allocation (TAA) is among the best investment tools available for navigating Full Market Cycles. While TAA tends to lag in late bull markets, it offers opportunities for higher Compound Annual Growth Rates and lower Maximum Drawdowns across a full bull/bear market cycle.. Among the greatest strengths of TAA is its mechanical, rules-based approach which not only keeps the portfolio attuned with market conditions but reduces the anxiety of managing the portfolio.
“Tactical Asset Allocation is an active management strategy that dynamically adjusts a portfolio’s asset allocation to current market conditions with the objectives of minimizing the potential for large losses and maximizing opportunities to improve returns. Tactical Asset Allocation employs a mechanical approach to selection of funds within a basket of low cost index funds.
The allocation algorithm reduces exposure to weak funds and increases exposure to strong funds. Tactical Asset Allocation baskets include funds selected from among different asset classes (e.g. equities, fixed income, commodities) and subclasses (e.g. domestic equity, international equity, emerging equity) of assets.”
Please see this whitepaper for a more detailed discussion of Tactical Asset Allocation, an illustrated comparison to Strategic Asset Allocation across two full market cycles, and review of tax considerations.
TAA strategy performance across 3 Full Market Cycles
Many investors will be familiar with the most recent full market cycles of 2000 to 2007 and 2007 to 2017. Both of these cycles share many characteristics in common including a V-shaped equity rebound, a long term trend of falling interest rates, and moderate inflation. Rising bond prices (prices rise as rates fall) helped to cushion losses in diversified portfolios during both of the recent bear markets.
However, the bond market has been in a 37 year bull market which is getting long in the tooth. Not only have interest rates reached historical lows but interest rate cycles generally run their course in 30-40 years. Ambrose Evans-Prichard, in “The global bond rout has begun, leaving equities on borrowed time” succinctly states the conundrum faced by investors:
“Each super-cycle for bonds over the past two centuries has lasted the span of a career. The tide is immensely powerful. When it turns, the world economic system faces what amounts to a regime change.
The current "ice age" - to borrow from Albert Edwards at Societe Generale - began in 1981 when the US Federal Reserve delivered a crushing monetary shock and defeated the Great Inflation. Benchmark US yields have been falling in a staggered fashion ever since.
It is the only experience that most investors, traders and PhD economists at central banks have ever known. But if the chartists are right - and you ignore them at your peril - the downtrend line has finally broken. US Treasury yields across the maturity spectrum are smashing through historic lines of resistance, with instant knock-on effects through the $US49 trillion ($62 trillion) market for global bonds.”
As investors, we must be prepared to adapt to market cycles in varied forms. It is wise to keep in mind that the Fed has a recurring habit of losing control of the markets which eventually negates the “Fed put”. This is why I chose 1973 to 1980 for the third market cycle. This cycle included concurrently declining Equity and Fixed Income classes which provided little shelter for diversified portfolios.
40 TAA Strategies On One Platform
AllocateSmartly.com provides a platform for researching, evaluating and monitoring 40 publicly available (non-proprietary) TAA strategies. Many of these strategies have come from authors who are well known and respected within the TAA community. While a subscription is required to access all but a few of the strategies; each strategy is well described, often with links to the original papers. Available strategies employ a variety of tactical allocation techniques including momentum, volatility, correlation, and breadth.
The ETF baskets employed range from small (2) to large (24). ETF basket construction is just as challenging as the weighting algorithm construction in building an effective TAA strategy. The simple switching model profiled in the TAA whitepaper is limited to just 2 funds (stocks and bonds) plus cash, yet, when compared to SPY, the Compound Annual Growth Rate (CAGR) increased from 5.4% to 8.3% and Maximum Monthly Drawdown fell from 50.8% to 11.3%.
A fund basket is a group of competing assets only a few of which will be selected for use in the next portfolio rebalance. While more funds can introduce more competition, some funds have characteristics which tend to rob returns from the others or add to overall volatility. The trick when adding funds to the basket is to find funds which add acceptable volatility while adding constructive diversification. I’ve generally found that 8 to 12 funds provide the necessary diversification while minimizing destructive competition although I’ve built good baskets with as few as four.
AllocateSmartly’s strategies employ Exchange Traded Funds exclusively. Many of the lowest cost Open End Mutual Funds impose trading restrictions which may not be compatible with the higher turnover in many TAA strategies.
Because most Exchange Traded Funds have come into existence during the past 5 to 10 years, most of their backtesting results are based on using surrogate mutual funds, indexes and stocks. While the results should be informative in comparing TAA strategies, results for the 1973 to 1980 and 2000 to 2007 cycles should be taken with particular caution when it comes to absolute performance. Those focusing on a specific strategy should check the “inception date” for each of the ETFs used.
Sifting Through The Strategies
The website provides Sharpe and Sortino ratios for both 20 years (roughly corresponding to 2 full cycles) and 10 years (roughly corresponding to 1 full market cycle). The Sortino ratio is a variation of the Sharpe ratio that emphasizes downside risk in calculating risk adjusted return and I have long preferred using it when comparing prospective investments over full market cycles.
I began by ranking the 40 TAA strategies by 20 year Sortino and then by 10 year Sortino. I then identified the best 50% (light green) for each period and selected the 14 strategies which performed consistently well across both the 20 and 10 year periods:
AllocateSmartly considers the ratios to be proprietary so only a few values are shown at top and bottom.The 60/40 Benchmark is rebalanced monthly and the other four Static portfolios are reblanced annually.
I then built a spreadsheet using the monthly performance data for each strategy to construct a profile of Compound Annual Growth Rate and Maximum Monthly Drawdown for each of the full market cycles. Three of the strategies did not have monthly performance data for the Jan 1973 through December 1980 cycle. Each of the six columns is color ranked from best (green) to worst (red). I also calculated the median performance for each column and added the benchmark performance. These TAA strategies clearly beat the pants off the Benchmark.
The final table is designed to provide a clear view of consistency across all three full market cycles by highlighting the strategies which ranked in the top 50% in each column.
Investors focused on high returns will find three strategies with consistently high Compound Annual Growth Rate (CAGR) across all three full market cycles:
Vigilant Asset Allocation
Generalized Protective Momentum
Stoken’s Active Combined Asset (Monthly)
Investors focused on capital preservation will also find three strategies with consistently low Maximum Monthly Drawdown across all three full market cycles.:
Allocate Smartly Meta
Protective Asset Allocation CPR
Classical Asset Allocation - Defensive
Unfortunately, none of the high CAGR strategies match the low drawdown strategies across all three cycles. Those looking for the best of both worlds will have to settle for top ranking in 2 cycles of CAGR and 2 cycles of drawdown:
Protective Asset Allocation
Protective Asset Allocation CPR
Generalized Protective Momentum
Protective Asset Allocation CPR and Generalized Protective Momentum have the distinction of delivering high CAGR and low drawdown during the 73-80 rising interest rate cycle as well as one of the two falling interest rate cycles (00-07 and 07-17).
Protective Asset Allocation CPR is a monthly momentum trading strategy which considers positive/negative breadth within the diversified basket of risk assets to introduce “crash protection”. This is a strategy which should perform particularly well during a series of bull/bear cycles similar to those seen during the secular bear market of 1966-1980; however it will tend to underperform during protracted bull markets during periods when only a few risk assets are performing well.
Generalized Protective Momentum comes from the same JW Keuning and Wouter Keller who developed Protective Asset Allocation CPR but introduces correlation as a second factor when selecting assets. It is more likely to choose assets which are less positively correlated to produce a more diversified portfolio.
One of the often-cited negatives of TAA is its tendency to underperform periodically during strong bull markets. We see this with a number of these strategies. This is not lost on investors who tend to have a “recency bias”. Fear rules following bear markets and euphoria rules during extended bull markets. Investors, seeing “the market” beat the TAA returns for a few years, will discard the very strategies which are most likely to provide superior returns over a full market cycle. Successful TAA investors maintain the investment discipline to stick with the strategy while it is lagging in the knowledge that it will provide higher returns and lower drawdowns across the full market cycle.
One size does not fit all
As a general rule in TAA, as well as in the markets, one must accept higher risk to earn higher returns. One could throw darts at the 40 strategies and handily earn higher returns with lower drawdowns than the Benchmark so the TAA alternatives are likely to be suitable for investors who can manage the “recency bias”. It is a fact that avoiding large drawdowns will do more to improve your portfolio returns over a full market cycle than racking up better than average gains. You will also sleep better during Bear Markets.
Some investors, particularly those with a long horizon to retirement, may be inclined to choose higher returns over lower drawdowns while investors in or near retirement may be inclined to weigh in on the side of portfolio protection. The final table should provide useful guidance to both types of investors in prioritizing strategies.
Once a strategy has been selected as a candidate, I highly recommend studying the publicly available papers which describe the concepts and methodologies employed in the strategy. This is another part of the due diligence required to make a final decision regarding suitability for your personal portfolio.
Public Domain vs. Proprietary
AllocateSmartly promotes itself as having “The industry’s best tactical asset allocation strategies, in one place.” I would suggest that “public domain” would be an appropriate adjective. Tactical Asset Allocation comes in many forms and there is a very large body of published material from strategy developers in both the financial and academic communities. However published material may not include all of the developer’s findings and enhancements.
Development of sophisticated TAA strategies is a time-consuming and expensive process. Many of the best performing TAA strategies are proprietary and are available only through managed accounts or subscriptions targeted to investors able to commit $100,000 and up. For example, Adam Butler et al at Gestaltu/Resolve have published pioneering work on both the Risk Parity and Adaptive Asset Allocation strategies included on AllocateSmartly. However the Risk Parity and Adaptive Asset Allocation strategies offered by Resolve to investors willing to fund managed accounts differ somewhat from the strategies published on AllocateSmartly.
The improvements in performance and reductions in drawdowns can be significant and more than offset any additional costs. I utilize a number of TAA strategies to manage a significant portion of our investments and all of them, including my own, are proprietary. Of course, there are proprietary strategies which will underperform as well those which will outperform so it is important to examine monthly and annual returns and drawdowns across a full market cycle.
Stock pickers - Divide and Conquer
Even those who thoroughly enjoy the process of researching and selecting individual stocks, will do well to consider placing a portion of the portfolio in a Tactical Asset Allocation strategy. Aside from lightening the workload and improving portfolio diversification; the TAA portfolio will provide critical intelligence regarding market conditions across a spectrum of asset classes as well as the equity and fixed income markets. This intelligence can be extremely useful in positioning other investments as markets cycle.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.