TAA In 2018: Another False Trigger In The Current Bull Market?

by: Paul Novell

** All the return data for this post comes from AllocateSmartly, Portfolio123, and my own calculations.

At the end of October, many TAA strategies either triggered to completely risk-off or started moving towards risk-off assets. In today's post, I'm going to dive a little deeper into the TAA return data and compare some past periods that may or may not prove similar to what markets are doing in 2018. I think there is some learning to be had here for practitioners of TAA or those interested in using it in the future. I'm not going to dive into drawdowns - that's a topic for another post - but in general, all TAA strategies significantly reduce drawdowns versus "buy and hold" portfolios.

We'll start with a round-up of what happened with TAA strategies in October. See this great summary post from AllocateSmartly for all the gory details on October's pain. Returns for the month varied from -0.9% to -9% across the strategies, with about half of the strategies underperforming the 60/40 benchmark's return of -4.3%. What I want to focus on is the change in risk-on versus risk-off allocations across the various TAA strategies tracked by AllocateSmartly. See the chart below starting at the end of 2006.

This month, in particular, but also starting in February 2018, TAA strategies have shifted heavily into risk-off assets. This looks similar to the risk-off shifts that took place in 2007, 2010, 2011, and 2015. What we see here is the big correct call on the financial crisis, followed by 3 false triggers, i.e., where the market reversed course and made mew all-time highs, and thus, switching to risk-off assets lowered returns for TAA strategies. Let's see what impact all this has had on returns since the end of 2007 and various sub periods since then. Below are returns for two "buy and hold" strategies and a sampling of TAA strategies for various periods since the end of 2007. The red highlighted cells are instances where TAA underperformed 60/40 for that time period. 2018 performance data is through October 2018.

Portfolios: 60/40: 60-40 US stock bonds. All Weather - Ray Dalio's portfolio. GTAA5/13/6/3 - Faber's TAA portfolios. VAA - Keller and Keuning Vigilant Asset Allocation. Tactical PP - Tactical Permanent Portfolio. Antonacci's GEM. GRP-TF - Global Risk Parity Trend Following. ACDM - Antonacci Composite Dual Momentum, GTT - Philosophical Economics Growth Trend Timing.

For the full time period (2008 to October 2018) of 11 years and 10 months, the average TAA strategy has underperformed the 60/40 portfolio and just beat out a more diversified "buy and hold" portfolio (Dalio's All Weather Portfolio). GRP-TF (Global Risk Parity - Trend Following) and GTAA5 did the worst, while GTT and VAA did the best. The strength of the current bull market, the 2009 to 20018 row in the table, has made up for the big correct risk-off shift in 2007. Also, you can see in the table why that happened. The risk-off shifts during 2010, 2011, and 2015 caused the bulk of TAA underperformance. We'll see where the 2018 risk-off shift gets classified. You can try and read all sorts of things into these numbers, but I want point out a few things.

  • Watch out for 10-year performance comparisons starting in January 2019. TAA is not going to look so good.
  • It would be a mistake to use one market cycle as a measuring stick for TAA versus "buy and hold".
  • This is all perfectly normal and should be expected. There are periods, sometimes long ones, where one or the other approach will outperform.
  • You need to step back and use longer-period data for more valid comparisons

So, let me do that. I want to present historical TAA returns in a way that allows us to look at different time periods and different market environments. The table below shows compounded annual returns for the TAA strategies I chose above. I think they are representative of various TAA approaches. The first two columns are the "buy and hold" benchmarks I've selected, and the last column is the average return of the TAA strategies listed for that time period. The highlighted red cells are instances where TAA underperformed the "buy and hold" benchmark. 2018 returns are through the end of October.

** Many of these approaches have been tested much further back in time. You can find that data on Allocate Smartly, I've also update longer-term data for some portfolios, and recently, Gary Antonacci posted on a longer-term test of his GEM strategy going back to 1950.

Starting with the maximum period, there is data for all the strategies, 1980-2018. We see one of the things that makes TAA attractive: higher returns than diversified "buy and hold" portfolios. Over the last 2 recessions (1998-2018), where in each stocks were down 50%, TAA performed really well. Also, over the longest bull market in history (1982-2000) and the last bull market (2002-2007), TAA did very well. Combine that with the lower drawdowns of TAA and it seems like a no-brainer. But it's never that easy in investing. From here, it gets a bit murkier. Since the end of 2007, basically the start of the financial crisis, the average TAA strategy has underperformed the 60/40 benchmark and just slightly outperformed the All-Weather portfolio. What does this mean? Is the underperformance of TAA during the current bull market a sign of things to come or a permanent change? Well, it's way too early to make that call, and it is not very likely. These approaches are based on strong fundamental factors, primarily asset class momentum, which have stood the test of time. I think it's prudent to stick with the long data.

Finally, there is some differentiation to be done with TAA strategies. In my simplistic summary in the table above, one potentially attractive feature of a TAA strategy is to outperform over as many different periods as possible. This would reduce the pain and uncertainty of using the strategy. One strategy outperforms over all periods, GTT, and VAA and GTAA3 only underperform in one period. For high returns with only a few periods of underperformance, VAA, GEM, and GTAA3 look pretty good. Of course, there are many other selection criteria as well. I've covered one in Choosing Your First TAA Strategy that is very important for many investors: simplicity.

That's about it for this post. Many TAA strategies have migrated to a risk-off stance in 2018, just like they did in 2015, 2011, and 2010 in the current bull market. Time will tell whether this proves to be a good call or a bad one. Whichever outcome it is, the current cycle on its own should not be used to judge the effectiveness of TAA. A look back at the long-term track record is still the best approach. However, investors can look into how TAA strategies have performed over various periods of time to help them choose a strategy that is best for them.