TACK: A Sector Momentum Strategy That Manages Risk

Summary

• TACK is a tactical ETF that holds sector funds.
• It also may give exposure to T-bills and gold in bad markets.
• TACK gets my approval as a dynamic strategy that works hard to protect investor capital.

TACK attempts to lower risk with trend-following technical analysis in this sector rotation strategy.

NicoElNino

Fairlead Tactical Sector ETF (NYSEARCA:TACK) is a dynamic strategy to manage risk. Clearly, investors have caught on as in less than a year they have amassed over $200 million in assets.

How does the fund work? Who might this be suitable for?

TACK and Sector Trends

At its heart, this is a sector rotation fund. There are 11 potential sector ETFs that are analyzed. There are typically 5-8 of these held at any given time. The entire strategy is driven by technical analysis. Below are the sector funds that are analyzed.

• The Communication Services Select Sector SPDR Fund (XLC)
• The Consumer Discretionary Select Sector SPDR Fund (XLY)
• The Consumer Staples Select Sector SPDR Fund (XLP)
• The Energy Select SPDR Fund (XLE)
• The Financial Select Sector SPDR Fund (XLF)
• The Health Care Select Sector SPDR Fund (XLV)
• The Industrial Select Sector SPDR Fund (XLI)
• The Materials Select Sector SPDR Fund (XLB)
• The Real Estate Select Sector SPDR Fund (XLRE)
• The Technology Select Sector SPDR Fund (XLK)
• The Utilities Select Sector SPDR Fund (XLU)

The primary goal is to identify sector leadership. Now I don't have special insight into their process so I am going off the prospectus, the website and the commentary of the portfolio manager.

• The first filter is to ensure the sectors are trending upwards.

Which trend-following indicators do they use? I don't know. It could even be as simple as being above the 200-day moving average. This filter should cut exposure to sectors which are not in an up-trend. This is a risk-reduction measure.

But what happens if all 11 ETFs are trending upwards as is the case possibly 80% of the time?

Sector Momentum

The prospectus states that for those ETFs which pass the technical trend filter, a momentum calculation is performed and applied.

• Momentum typically refers to relative price out-performance over a trailing period of time such as 3, 6 or 12 months. The most recent month is often removed since very short-term movements tend to revert while longer-term movements tend to trend.

Every month when they reconstitute the portfolio, they would likely select the top 8 ETFs based on some momentum calculation on all the sector funds which are trending upwards.

In normal bull markets, this strategy tries to provide alpha to the investor with a superior sector weighting than the S&P 500. By focusing on strong sectors and removing a few of the lagging sectors, they hope to provided better risk-adjusted returns than a broad index fund.

Now, this is just my own personal take. I don't believe that they will typically out-perform the broad market in a bull cycle. But I do think that they will likely suffer fewer drawdowns as they prune low-performing sectors in a down-trend. Alpha is a measure of performance and volatility. I think the big advantage here is the reduced volatility.

But what about when markets are at a higher risk of falling? What does this ETF do then?

Risk-Off Environment

When people are taking risk off the table, the strategy can use other ETFs to diversify into.

• SPDR Portfolio Long Term Treasury ETF (SPTL)
• SPDR Portfolio Short Term Treasury ETF (SPTS)
• SPDR Gold Shares (GLD)

Now this is not an all-or-nothing scenario. If fewer than 8 sector funds are in an up-trend, then those allocations can be filled with gold, short-term treasuries and long-term treasuries. There is a maximum allocation of 33.3% in this risk-off environment.

www.fairleadfunds.com/strategy

My Simple System

Please keep in mind that I have no special knowledge of which technical indicators they use to identify trend or momentum. But what I want to do is to take the concepts of their strategy and create my own for illustrative purposes, so you can see one example of how my own version of this strategy would have performed in the past.

This is how I construct my strategy in the strategy-building platform at Portfolio123 which uses FactSet data.

• Create a universe of 14 ETFs which includes 11 sector ETFs as well as a gold, short-term and long-term treasury ETF.
• Have a maximum of 8 ETFs that can be traded or 12.5% minimum allocation.
• Have a maximum of 33.3% allocation to any one ETF.
• For sector ETFs, they must be above the 200-day moving average and 50-day moving average to be considered for inclusion. No such rule applies to gold or treasury ETFs.
• If there are more than 8 ETFs for possible inclusion (this could include gold and treasuries), only the top 8 will be added based on a simple momentum formula of the trailing 6-month performance minus the most recent 1-month.
• Reconstitute every 4 weeks.

In this instance, a risk-on environment is simply one where there are at least 8 sector funds trending up. A complete risk-off environment is where all sector funds are below their moving averages. And there is a mixed environment when some sectors in an up-trend but not enough to fill the 8 potential allocation slots which will then be filled with gold and treasuries.

My own sector allocation system (portfolio123.com)

Now, I can almost undoubtedly assure you that this is not their exact strategy. It does however give you a window into what sort of risk to reward scenario a similar strategy might give you. You get similar returns to the overall market, but with a fraction of the drawdown. This leads to a much higher risk-adjusted return (Sharpe Ratio) which means positive alpha.

Risks of the TACK system

This type of strategy back-tests really well. But that doesn't mean it isn't without risks. Here are some possible risks.

• Gold, short-term and long-term treasuries may not provide adequate protection in bear markets. As we have seen, equities can fall at the same time as treasury bonds. Gold could do the same.

To mitigate this, I would prefer to see more equity alternatives for risk-off environments. Another possibility is that you could apply the trend-following filter to gold and T-bill funds as well. Go to 100% cash if all asset classes are dropping.

• Sector momentum might not produce superior returns. You run the risk of under-performing in bull markets.
• Markets do not always trend. Whipsaw markets might favor sectors which have low momentum and punish sectors with high momentum.

Final Thoughts

I welcome tactical strategies. It removes the burden of individual investors trying to come up with their own dynamic allocation strategies. It adds diversification of more than just stocks and sectors…it diversifies according to strategy. As long as the approach makes sense, I am a big advocate of allocating toward different strategies. This is a largely untapped resource of new diversification that is under-utilized by many investors who prefer to buy and hold.

Because I do not know exactly how TACK is constructed, I cannot directly comment on which technical analysis indicators they use and the past performance of them. Perhaps their methodology is much superior to my simple approach. Maybe they will achieve even higher risk-adjusted returns than my simple simulation. I cannot say.

But what I do know is that I like their approach to limiting risk by using trend filters and by adding in equity alternatives for a risk-off environment. I hope more firms follow suit and allow individual investors to follow intelligently designed strategies.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.