Questions continue to come in about systematic approaches to tactical allocation portfolio changes – methods not based on biases, media frenzy, forecasts, chart patterns, valuation or fundamentals.
Probably the simplest approach, and one that is about as objective and non-judgmental as systems can be, is to hold those risk assets that are doing best, unless none of them are doing better than T-Bills; in which case hold T-Bills until the risk assets start doing better than T-Bills.
The most reliable aspect and driver of returns of the approach is minimizing major drawdowns, as shown by the flat lines in the blue timing portfolio when the red benchmark portfolio experienced major drawdowns.
Secondarily, the approach may increase total return. However, each trade triggers a tax event, so only those cases where the average holding time between trades is over 1 year avoid ordinary income taxes on the trades; and those that have the longest position hold times benefit most by compound growth.
The approach can be used in an outright decision to hold risk assets or risk-free T-Bills (or other “cash”), or it can be used for guidance in a strategic allocation portfolio to make overweight and underweight decisions.
The approach is not tax efficient for regular taxable accounts, but in some cases the outperformance may be worth the tax cost. Trading systems such as this are best used in tax-deferred accounts.
Relative and absolute momentum can be done at an extremely simple level, such as rotating between one specific risk asset and T-Bills (e.g. the S&P 500 and T-Bills).
That method could be used in layers, with more than one pair of two assets (e.g. S&P 500 and T-Bills as one pair, and emerging markets stocks and T-Bills as another).
It is also possible with the method to choose one or more risk assets within a larger group of risk assets or T-Bills (e.g. the two strongest momentum risk assets out of five or T-Bills).
Working with simple pairs of one risk asset versus T-Bills is more likely to create longer position hold times, and therefore be more tax efficient for regular taxable accounts than alternating between risk assets or T-Bills. Alternating between risk assets creates more frequent trades and would be more suitable for in tax deferred accounts.
The method helps avoid the severity of Bear markets, but it also needs Bears to generate enough of a performance difference to make the effort and potential tax cost worthwhile.
The approach does not work with all assets. Testing is required to see if it worked in the past.
Here are some actual 09/03/18 relative return and absolute momentum indicated holdings:
It is possible to operate this approach by visual inspection of charts, but for more precision and to avoid seeing what you may want to see, using quantitative data is preferable.
You would need to find the performance evaluation period (e.g. the number of days, weeks, months quarters, years) that produces the best combination of high return and low maximum drawdown, based on long-term history, and the best frequency of decision making (e.g. daily, weekly, monthly quarterly or longer). The “best fit” evaluation period and decision frequency will probably drift over time, so it needs to be regularly evaluated for adjustment.
The information that follows gets a bit into the weeds of the approach.
The securities we used for the test were selected in part because they had adequate history to capture a sufficiently long study period:
- VFINX: S&P 500
- VGTSX: total international stocks
- VEIEX: emerging markets stocks
- VGSIX: US real estate
- VFINX: intermediate-term Treasuries
- Treasury Bills
ETF alternatives may be more tax efficient for current use, but did not have sufficient history for long-period analysis. These ETFs are classes that invest in and share the same underlying portfolio as the mutual funds used in the study (except for BIL):
- VOO: S&P 500
- VXUS: total international stocks
- VWO: emerging markets stocks
- VNQ: US real estate
- VGIT: intermediate-term Treasuries
- BIL: Treasury Bills
If the investor wishes to use options (for example, covered Calls) on the S&P 500 position, then SPY would be needed because it has the options and liquidity that would be suitable.
There are other ETFs from other sponsors that could just as well be used instead of the Vanguard ETFs in a forward practice.
First, Portfolio Visualizer is among the sites that provide good tools for experimenting with the approach, and it is free. There are subscription sites that have a number of pre-built models that can be followed as well.
The data that follows is entirely from Portfolio Visualizer.
The tables above and below illustrate how the evaluation period and frequency might be regularly reviewed for possible adjustment, and provide evidence of the efficacy of the approaches from 1997 to 2018 YTD, as well as return, maximum drawdown and several other important metrics for the results for method and their benchmarks.
The illustrative cases are for the S&P 500 as a single risk asset versus T-Bills (above); and the best 2 of 5 risk assets versus T-Bills (below).
The charts and tables that follow are for S&P 500 versus T-Bills, and for selecting the best 2 of 5 assets (S&P 500, DM stocks, EM stocks, US REITs, and Intermediate-term Treasuries) versus T-Bills.
In each case, the backtest period was about 42 years (1997-2018 YTD).
In the best 2 of 5, the result could be 2 risk assets, 1 risk asset and T-Bills, or all T-Bills.
Single Risk Asset vs T-Bills
The timing model produced a 19.67% return over the period 1997-August 2018 versus 8.42% for the equal weight portfolio, which in this case is 100% S&P 500. Note that these results are based on investable assets, not indexes.
While results such as this could have been available to you if you did this on your own, they would not have been effective for a “hedge” fund type investment with their 2% management fees and 20% of gains above a preferred return, because the return difference of 2.22% would have been wiped out by their fees.
The volatility (standard deviation) of the method was lower than buy-and-hold. The best year was better, and the worst year was dramatically better (negative 7.67% versus negative 37.02%). The superior maximum drawdown was critical (down 16.31% versus down 50.97% for buy-and-hold).
The average trade lasted 29.9 months, which tended to create capital gains as opposed to ordinary income when trades were executed.
The Sharpe Ratio (return in excess of T-Bill return, divided by the standard deviation of return – how “bumpy” the ride was) was better for the method (0.79 versus 0.48), as was the Sortino Ratio (like the Sharpe Ratio but only divided by the size of downside volatility) at 1.29 versus 0.70.
Last, as a small form of diversification, the correlation to total US stocks was only 0.74 versus 0.99 for buy-and- hold
The complete trade history from 1997 is in this table:
However, not all backtests are inspiring. The specific time period you test and whether or not a Bear intervened are critical to how attractive the method appears.
It can be years of effort with little if any outperformance to show (and taxes in regular accounts) if a Bear is not in the period.
It takes a Bear to make relative momentum versus T-Bills look good.
Best 2 of 5 Risk Assets vs T-Bills
As with the single risk asset (S&P 500) versus T-Bills, the best 2 of 5 risk assets was superior (excluding any tax considerations) to the equal weight, buy-and-hold approach.
Compound return was better by 4.73%. Standard deviation was almost the same. The best year was better by 16.73%. The worst year was better by 13.68%. The maximum drawdown was better (less severe) by 26.15%. The Sharpe Ratio was higher by 0.37. The Sortino Ratio was better by 0.79. The correlation to total US stocks was lower by 0.30, and the Beta to total US stocks was lower by 0.22. All good.
There were many trades for an average trade holding time of 2.37 months. That created a lot of ordinary income for someone doing this in a regular taxable account. The trades over the past year are in this table.
Selecting the best 2 of 5 risk assets might be expected to be more effective during periods without a Bear market, but the evidence in our test suggests that is not the case. Looking at the period 2010 through August 2018 (a period without a Bear), we were able to find an evaluation period that produced a 2+% higher return (before any tax costs), but it produced a 1+% more severe maximum drawdown -- it did not provide the downside protection the method is intended to provide.
The most useful evaluation period we found for the best 2 of 5 model was 12 months. It produced a 9.56% return versus 7.49% for the equal weighted benchmark, but experienced a 16.69% maximum drawdown versus 15.50% for the benchmark.
The following charts show the results for evaluation periods of 1, 11 and 12 months.
1 Month Evaluation Period (2010 –Aug. 2018)
11 Months Evaluation Period (2010 – Aug. 2018)
12 Months Evaluation Period (2010 – Aug 2018)
Because we consider maximum drawdown protection key to the utility of relative momentum versus T-Bills, our conclusion is that the method needs a Bear market to be attractive.
Relative momentum allocation between a risk asset and T-Bills can produce meaningfully higher return and substantially less severe maximum drawdowns, but the fact is that the avoidance of large drawdowns (Bear markets) is the most important contributor to the potential of the method to outperform.
If there is no Bear market during the time the method is used, the potential for outperformance is limited.
Tax costs are a problem in taxable accounts (more when selecting among multiple risk assets, because position holding time is shorter with more ordinary income tax cost).
No universal evaluation period is effective for all risk assets, and the evaluation periods that work best drift over time, making continuous curve fitting part of the challenge and work load.
Not all assets have good potential with the method (basically only those that have occasional major drawdowns appear to work well).
Because of the role of Bear markets in creating advantage for the method, it is important when reviewing reports about the method to distinguish between long-term studies incorporating one or more Bears, and short-term studies of Bull markets.
Winning by not losing is the most important benefit of the method. The benefit derived is greatest when the loss experienced by buy-and-hold is greatest.
As must always be said, past performance is no guarantee of future performance.
I hope that for those of you who have been asking about the popular idea of risk reduction with relative momentum versus T-Bills, that this is helpful.
Disclosure: QVM has positions in some of the securities identified in this article as of the publication date. We certify that except as cited herein, this is our work product. We received no compensation or other inducement from any party to produce this article, and are not compensated by Seeking Alpha in any way relating to this article.
Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer, found on the QVM site, available here.