Building A High-Performance Tactical Income Strategy

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Includes: AGG, HYG, IEI
by: Earl Adamy
Summary

Investors are seeking lower-volatility investment opportunities due to increased risk and volatility in the equity market.

Fixed-income bond funds generally offer reduced volatility and risk at the cost of lower returns.

A fixed-income bond ETF strategy is presented which produced equity-like returns of 7.6% CAGR (beating SPY’s 7.0% including dividends) during the last full bear/bull market cycle.

Adding Tactical Asset Allocation tools to a fixed-income portfolio can significantly improve returns and reduce risk.

Each investor has his/her own investment priorities, and the fact that there are now more exchange-traded stocks than there are listed companies speaks to the wide spectrum in investor interest. My strong preference for a blended portfolio of global equities, fixed income, and commodities is reflected in the emphasis I place in our Global Adaptive Strategy, which earns its flagship position with hard-to-beat returns and exceptionally low investment risk.

The Appeal of Fixed Income

That said, there are at least two good reasons to consider a tactical fixed-income strategy to supplement a broad market tactical strategy:

  • Eating distributions - Some investors would prefer to withdraw distribution income for living expenses than "eat the seed corn".

  • Tactical diversification - It is exceedingly unwise to put all your eggs in one basket, even when that basket looks far better than all the other baskets on display.

Before moving on, let's set the stage with an explanation of Tactical Asset Allocation.

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.

Perhaps the single biggest distinction between Tactical Asset Allocation and Modern Portfolio Theory is that while Modern Portfolio Theory seeks to reduce risk by spreading it across several asset classes, Tactical Asset Allocation seeks to reduce risk by cutting it.

Please see "What Is Tactical Asset Allocation? How Does It Improve Returns?" for a more complete discussion on the subject.

Building A Fixed-Income ETF Basket

Fixed income is viewed by many equity-focused investors as the backwater of the markets, although the bond and credit markets are, in fact, very challenging.

I began the process with a broad basket of over a dozen fixed-income ETFs, including preferreds, high yield, investment grade corporate, and a range of government issues and duration.

The more I tested, the more ETFs I discarded, until I was down to just three, each representing a distinctly different portion of the credit risk spectrum. Coincidentally, each corresponds to one of our standard market conditions, although the Market Conditions Model is not used for this strategy.

iShares High Yield Bond

The iShares iBoxx $ High Yield Corporate Bond ETF (HYG) is sought after for its high yield resulting through "exposure to a broad range of U.S. high yield corporate bonds".

The fund performs very well during favorable economic conditions and very poorly in hostile market conditions. From its all-time weekly closing high of 105.71 in May 2007, it fell to a weekly closing low of 66.25 (-37%) in November 2008. However, the yield soared from 6.6% to a mouth-watering 12.6%. Prices peaked in April 2013 at 95.85 with a yield of 5.9%, and have since declined to 82.39 and a distribution yield of 5.6%

High yield credit is very cyclical and tends to offer such remarkable opportunities every 8 to 10 years. The ideal time to sell the fund was May 2007, and the ideal time to buy was between November 2008 and February 2009.

Here is a statistical summary for buy-and-hold with distributions included:

iShares Core Total U.S. Bond Market

The iShares Core Total U.S. Bond Market ETF (AGG) offers "broad exposure to U.S. investment-grade bonds" and is recommended by iShares for use as a "core of your portfolio to seek stability and pursue income".

The fund falls between High Yield and Treasuries in quality and tends to be a higher-yield fallback from Treasuries. This fund cycles through moderate advances and declines every few years, much like the bond market. Its fear-driven decline during the 2007-2009 bear market was just over 7%. It generally trended upward from October 2008 through July 2016, and has since declined by 7.5%. Yield peaked in October 2008 at 5% and has since declined to a distribution yield of 2.3%.

As this credit cycle has matured, "investment grade" ratings have seen marked deterioration in average quality. Nearly half of all investment grade-rated bonds now lie at the lowest eligible rating of BBB. AGG provides much higher average investment grade credit quality, with 72% of its holdings rated at the highest AAA rating and only 14% at BBB.

Here is a statistical summary for buy-and-hold with distributions included:

iShares 3-7 Year Treasury Bond Fund

The iShares 3-7 Year Treasury Bond ETF (IEI) provides "exposure to intermediate-term U.S. Treasury bonds" with "three to seven years" until maturity. As a relatively short-duration Treasury fund, it tends to perform best under hostile conditions when credit risks are elevated.

Unlike the other two funds, this fund gained value during the 2007-2009 bear market, rising from 98.87 in June 2007 to 114.73 in December 2008. It subsequently rose modestly to 127.35 in June 2016, and has since declined by 4.5% as the Fed has pushed rates higher. The current distribution yield is 2.1%.

Here is a statistical summary for buy-and-hold with distributions included:

Equal-Weighted Portfolio

What if we created a portfolio based on equal-weighting each of the three ETFs? This is what the results would have looked like:

Clearly, we’ve smoothed the annual returns, while achieving a 4.2% CAGR and 8.9% MaxMD. Now we’re going to see if we can improve on that with Tactical Asset Allocation.

Allocating Funds

Generally, when building tactical strategies, I prefer to work with a large basket and spread the allocation across the best 3-5 funds for diversification. I also consider using volatility-based weighting, which allocates inversely to volatility, rather than equal weighting.

In this case, I had just 3 funds to work with, and each fund represents a significantly different risk metric. Under hostile market conditions, blending higher-risk funds with Treasuries would accomplish nothing but would increase risk. Likewise, blending lower-risk funds under favorable market conditions would accomplish nothing but would reduce returns.

I have learned from years of building and testing thousands of strategies that accurate trend identification beats diversification hands down. It makes sense to select just one fund but only with highly accurate trend identification. In this case, sticking with just a single fund improved returns while containing risk.

Identifying The Trend

With our basket of ETFs settled, we need a way to select the best-performing ETF once a month to rebalance the portfolio.

There are a variety of trend identification methods employed in Tactical Asset Allocation. Among the most popular is "rate of change", where a trend is identified and ranked using the percentage change in value over a fixed period. Because daily data introduces unnecessary volatility and incentivises frequent trading, I strongly prefer weekly closing data in all of my tactical strategies. I use distribution adjusted data exclusively.

Three methods were used during testing:

  • Change across a blended 1/3/6/13/26 week fixed length period.
  • Change across a blended 1/4/13/26/52 week fixed length period.
  • Adaptive Dynamic Momentum, which examines a broad range of weekly periods and makes a selection based on both momentum and confidence.

Scoring The Results

The model is run full market cycle beginning September 2007 through December 2018 to compare the Compound Annual Growth Rate (CAGR) and Maximum Monthly Drawdown ((MaxMD)):

Method

CAGR

MaxMD

Blended 1/3/6/13/26 week fixed

5.6%

10.6%

Blended 1/4/13/26/52 week fixed

5.3%

10.6%

Adaptive Dynamic Momentum

7.6%

6.8%

The statistical summary and chart for Adaptive Income, which has the highest CAGR, looks very solid:

By way of benchmarking, the Vanguard Total Bond Market Index Fund, which invests 70% in government bonds and 30% in corporate investment grade bonds, shows a CAGR of 3.7% and a MaxMD of 4.0%.

Here is the really surprising metric. The tactical strategy held the High Yield ETF for 84 of the 129 months (65%), yet managed to bring MaxMD down to a very tolerable 6.8%. Opportunistic switching to Treasuries (30 months) and investment grade bonds (15 months) was key to minimizing the drawdowns, while still generating income.

Withdrawals

I use distribution-adjusted closing prices, so the discrete distributions are unavailable. The statistical summary suggests a Sustainable Withdrawal Rate of 4.7%, which is slightly below the yield on HYG and well above the yields on AGG and IEI . How is the Sustainable Withdrawal Rate calculated?

  1. Assume that the Maximum Monthly Drawdown (6.8%) occurs on the day that investment in the strategy takes place. That leaves 93.2%.

  2. Apply the CAGR of 7.6% to the 93.2%, which leaves a CAGR of 7.1% on the original investment.

  3. Withdraw 2/3rd of the CAGR and leave the remaining 1/3rd invested to cover inflation and a safety factor.

What if an investor had put $100,000 into the strategy and then withdrawn 4.7% annually in equal monthly installments over the full market cycle? The $100,000 would have grown to $143,537 in 2013 and then declined to $134,050 in December 2018 for a CAGR on the residual balance of 2.6%. Reducing the withdrawal rate to 4.0% maintains the trend of portfolio growth.

When it comes to withdrawals, I strongly prefer a fixed monthly amount which levels the portfolio volatility risk. Those with RMDs can always adjust or supplement the final withdrawal to meet requirements.

Conclusion

This tactical fixed-income strategy smoothly and effectively transitions between risk-on and risk-off, while delivering exceptional returns.

Tactical Asset Allocation combines the use of low-cost, passive index funds with an active management strategy to reduce losses and improve returns. There is a large body of academic research which is both substantive and compelling in making the case for the use of Tactical Asset Allocation to manage all or part of an investment portfolio. With a bear market in equities and increased volatility in credit markets, investors would do well to consider using Tactical Asset Allocation to improve returns and reduce risks.

The Adaptive Income strategy presented here can be used as a standalone income strategy or it can be paired with other tactical strategies for portfolio diversification. As an income strategy, it provides superior risk-adjusted returns by blending a high income-producing ETF with investment grade and Treasury bond ETFs.

About Tactical Asset Allocation Strategies: I build tactical strategies to lower investment risk and improve returns. Our flagship Global Adaptive Strategy is broadly diversified across domestic and international equity, fixed income, and commodity funds. The exceptional results are due entirely to the complementary strengths of our Market Conditions Model and our Tactical Model. We offer three month and annual subscriptions with a 60-day unconditional money-back guarantee.

Disclosure: I am/we are long IEI AND AGG IN DIFFERENT TACTICAL STRATEGIES. 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.

Additional disclosure: All charts and tables include distributions. Charts and the tables have been prepared using the TAAS Tactical Model. Past performance is no guarantee of future performance, and the examples provided should not be construed as investment advice.