14 June 2012
We saw the following article in Forbes and wanted to share it with our Blog readers. My Portfolio Guide does not own a crystal ball and will never claim to be able to "time the market". On the other end of the spectrum we don't believe that being cemented in a rigid and static portfolio (otherwise known as "passive") is the only answer either. Each camp ("active" versus "passive") has their merits but even the science and data behind all of this cannot always convincingly end this old investing debate. All that being said, we believe that the truth can be found somewhere in between those two philosophies. While we won't trade entire portfolios based on some new tarot card system or a Mayan calendar, we also won't stare at a runaway train racing towards us. If there appears to be a market event that is obvious to most everyone, it may not be prudent to be stubborn and say ...."we're trying to get market returns" (regardless of the calamity ahead). My Portfolio Guide will write more on these topics but for now please take a peek at the merits of Tactical Asset Allocation.
Investors and their advisors have one ultimate goal–to achieve acceptable risk-adjusted returns. The term risk-adjusted consists of two components. One is the total return and the other is the risk that you have to assume to achieve that total return.Total return is the net of gains, losses, income and expenses. The risk that the investor has to assume is typically measured as the volatility of the portfolio. The volatility is calculated and reported by various methods.
Two of the most common investment industry measures are standard deviation and beta. Standard deviation defines a “standard” or “normal” movement around the average. The larger the standard deviation, the more volatile a portfolio. Beta measures the movement of a portfolio and describes how it relates to the movement of another portfolio, security, or index. Beta is very often used to discuss a portfolio’s movement as to how it relates to the S&P 500 Index.
At Hanlon, we find standard deviation and beta to be of merit but we also believe the typical investor measures risk by maximum drawdown, which is the measure of the maximum drop in account value from the highest peak to the lowest bottom, before reversing course again, over the entire account history. We believe that the most important element to achieving solid risk-adjusted returns is avoiding large maximum drawdowns.
Not only does the math work in the investor’s favor, but providing some counter-measures to large drawdowns, and avoiding the resultant negative psychological impact on the investor, is equally as important.
Because maximum drawdown is not widely used as a risk measure by many in the financial industry, the strategy of moving portfolios to 100% money market funds occasionally is not widely accepted. However, tactical asset allocation strategies applied to portfolios can be an incredibly valuable method of achieving improved long-term, risk-adjusted returns.
Below in table 1 is an illustration showing the benefits of tactical asset allocation. In this illustration we compare the hypothetical return and risk (measured as maximum drawdown) investors would have achieved if they had invested in a buy and hold strategy in the S&P 500 Index versus investing in a tactical asset allocation strategy in the S&P 500 Index.
The buy and hold strategy stays invested in the S&P 500 Index for the entire time period. The tactical asset allocation strategy moves between the S&P 500 Index and a money market fund, triggered by a moving average crossover on the S&P 500 Index.
A moving average takes the prices for a certain number of look-back days, averages them and makes today’s price equal to that average. It “makes smooth” the volatile market price action to give better insight into the trend.
The shorter the moving average, the more reactive it is to recent changes in the price of the S&P 500 Index. Table 1 displays the results of a specific strategy using a 50-day moving average and a 200-day moving average against the S&P 500 Index for the twenty three year period beginning 9/1/1988 and ending 12/31/2011.
Each time the 50-day moves above the 200-day–indicative of an appreciating market–we buy the S&P 500 Index. Each time the 50-day moves below the 200-day–indicative of a depreciating market–we sell the S&P 500 Index, and invest in a money market fund.
This is not the precise method we use to manage client accounts; our methods are more sophisticated. This method is shown to illustrate an example of the merits of tactical asset allocation. Please know these results are not intended to imply any past or future returns. Instead, they simply show that there is merit to tactical asset allocation strategies versus buy and hold.
Table 1 – S&P 500 Index including Dividends – Tactical Asset Allocation using a 50 day/200 day Moving Average Crossover versus Buy and Hold – Sept. 1, 1988 to Dec. 31, 2011
Annualized Return Total Return Maximum Drawdown
Tactical Strategy (1) 11.14% 1,076% -20%
Buy & Hold Strategy (2) 9.38% 710% -55%
(1) The Tactical Asset Allocation results were achieved with only 16 trades during this 23 year period, with the most recent buy on the S&P 500 Index occurring on 12/23/2011.
(2) Further reviews find that the Buy & Hold strategy not only experienced very large negative 55% maximum drawdown, but it also had many instances of exceeding the maximum drawdown of negative 20%, which was the single worst maximum drawdown for the Tactical Asset Allocation strategy for this period.
Many investors rely on their portfolios for income. Some even make their portfolios their primary income source. Including an annual distribution rate of 4% in the above comparison would show the benefits of tactical asset allocation as even more attractive compared to buy and hold because when the portfolio drops considerably the buy and hold strategy must sell at considerably lower prices to meet the 4% annual distribution needs.