Building A High Performance Tactical Income Strategy

The initial version of our Adaptive Income Strategy was an attempt to see what could be done with a very simple fund basket using Adaptive Dynamic Momentum and our recently upgraded Tactical Model. The results turned out better than expected. When a subscriber asked about a fixed income strategy, I made it available and a number of us have been using it for some months now.

While the volatility was within acceptable range, I felt that it could be significantly improved in both Compound Annual Growth Rate (CAGR) and Maximum Monthly Drawdown (MaxMD). That led to development of the upgraded Adaptive Income Strategy which rings the bells on both high performance (11.1% full cycle CAGR) and very low drawdowns (2.9% full cycle MaxMD). Development of the Adaptive Income Strategy required the addition of several new features to the Tactical Model. The most exciting addition is the ability to optimize and extend fund holding periods by giving existing holdings priority for the next rebalance as long as expected performance is not impaired.

Work on the Adaptive Income Strategy required setting aside development work to improve the Market Conditions Model which is fairly well along but requires some finishing touches followed by extensive testing. I expect to release it late Summer or early Fall. A project is in the concept stage is a new strategy which will focus the capabilities of our Market Conditions and Tactical Models on sectors within high tech to provide lower-risk exposure to sectors and industries which lead our economy.

Now on to the story "Building A High Performance Tactical Income Strategy".

(References to yield, duration, and other information are as of month-end May 2019 and June 10, 2019)

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 on our Global Adaptive Strategy which earns its flagship position with hard-to-beat returns and exceptionally low investment risk.

Global Adaptive’s performance table shows 29.9% invested in Fixed Income Assets over the full bear/bull cycle beginning October 2007 so Global Adaptive does not lack significant Fixed Income exposure.

The Appeal of Fixed Income

That said, there are at least two good reasons to consider a tactical fixed income strategy to complement 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 of Tactical Asset Allocation.

Building A Fixed Income Fund 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.

The research and development of Adaptive Dynamic Momentum required nearly five years; however, it is a quantum leap in trend identification which opens up new avenues for development of tactical strategies. After releasing the new Global Adaptive Strategy in 2018; I became curious about how Adaptive Dynamic Momentum together with the upgraded Tactical Model capabilities might be deployed with a fixed income strategy.

The process of building the initial version of Adaptive Income began with a broad basket of over a dozen fixed income ETFs including preferreds, high yield, investment grade corporate, and a range of government issues. 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. This proved to be a very effective strategy for fixed income but fell short of my standards for a fixed income strategy with risk:reward on a par with Global Adaptive.

More recently, I began doing focused research to upgrade Adaptive Income. Aside from the usual challenges, I believe that the Fed’s aggressive management of monetary and interest rate policies have wrought critical long term changes in the credit markets. While the credit cycle will continue to play out, the days of 4% to 6% Treasury yields are unlikely to return during our investing lifetime. Adapting to reduced yields means returns must be earned by exploiting more corners of the credit markets as well as shorter interest rate cycles.

I decided to build an entirely new fund basket with a broader assortment of fixed income funds. An article on tactical bond strategies using open end funds by Cliff Smith on Seeking Alpha alerted me to some credit subclasses which I had not previously considered.

I went through a process of testing nearly 40 different  fixed income funds before settling on a basket of five funds including corporate high yield, municipal high yield, corporate senior loans, government mortgage backed securities, and short term Treasuries. Four are Exchange Traded Funds and one is an Open End Fund. The Tactical Model is being upgraded to handle the nuances of trading the Open End Fund.

Identifying The Trend

A high return fixed income strategy requires the use of high yield funds which generate much of their return from capital gains. Much of these gains occur during early to mid stage bull markets where high yield bond prices are recovering from panic declines. However, high returns can be quickly lost with large drawdowns. The paper on Full Market Cycles goes into more depth on this subject. Suffice it to say that the lower returns in bond strategies makes the avoidance of even moderate losses even more critical than with equity focused strategies..

Adaptive Dynamic Momentum, the trend identification methodology used by our Tactical Model, provides the critical pathway to finding (and sticking with) winners while avoiding (and/or quickly discarding) losers. During the development process, the Tactical Model quickly identified the fact that a shortened primary trend length is most suitable for our Adaptive Income basket. While Global Adaptive uses an average primary trend length(1) of 24 weeks, Adaptive Income uses an average primary trend length(1) of just 6 weeks.

(1) The optimum primary trend length identified by the Tactical Model varies by fund by week across a broad range of possible lengths so the “average” is not indicative of the actual primary trend length used for any individual fund or week. For example, Fund A may have a primary trend length of 17 for the same week in which Fund B has a primary trend length of 4, Fund C has a primary trend length of 9, and so on. The Tactical Model also identifies and applies a secondary trend length by fund by week. It is the combination of the primary and secondary trends, together with some additional filtering, which ultimately determine the Final TrendScore for each fund each week.

Allocating Funds

Generally, when building tactical strategies, I prefer to work with a large basket of at least a dozen funds and spread the allocation across the best 3-5 funds for diversification. This works well for Global Adaptive, which uses 24 funds, in moderating drawdowns while maintaining a high rate of return.

Not so for Adaptive Income. The initial Adaptive Income Strategy used just 3 funds while the upgraded Adaptive Income Strategy uses just 5. In both cases, I found that the best results are obtained by selecting a single fund. In fact, including the “2nd best” fund in a combined allocation actually reduced returns while increasing drawdowns.

I also tested using the Market Conditions Model to constrain eligible fund selections during Hostile periods. Doing so provided a 0.27% increase in return at the expense of a doubling in monthly maximum drawdown.

The conclusion from exhaustive modeling of Adaptive Income is that a single fund allocation combined with a relatively short term trend identification using Adaptive Dynamic Momentum produces the greatest risk adjusted returns.

One of the newest features in our Tactical Model reduces the number of trades. Before replacing an existing position with a higher trend scoring fund, the Model checks to see if can hold the existing position without compromising expected performance. For the Adaptive Income Strategy, this reduces trades by 8% while extending the average holding period for each fund by as much as 12%.

Scoring The Results

The Tactical Model is run full market cycle beginning October 2007 to calculate Compound Annual Growth Rate (CAGR), Maximum Monthly and Daily Drawdown, and a host of other statistics including monthly and annual returns.

The benefit of looking at the full cycle is the perspective on equity bear market performance showing that the Adaptive Income Strategy performed well. However, it is also clear that the full cycle performance benefits from two strong years in 2009 and 2010 as higher yield rebounded from panic levels. For another perspective, we examine statistics for the past 5 and 3 years:

  • 5 years: 7.9% CAGR, 2.9% Max Monthly Drawdown, and 485% Up/Down Ratio
  • 3 years: 8.7% CAGR, 1.0% Max Monthly Drawdown, and 854% Up/Down Ratio

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

Withdrawals

The statistical summary suggests a Sustainable Withdrawal Rate of 7.1%. How is this calculated?

  1. Assume that the Maximum Monthly Drawdown (2.9%) occurs on the day that investment in the strategy takes place. That leaves 97.1%.
  2. Multiply 97.1% by the CAGR of 11.1% leaving a CAGR of 10.8% on the original investment.
  3. Withdraw 2/3 of the CAGR which equals the Sustainable Withdrawal Rate of 7.2%. Leave the remaining 1/3 invested to cover inflation and a safety factor

The calculated Sustainable Withdrawal Rate is well above the yields on all of our funds. How is this possible? It is due to the large capital gains in the high yield funds during the early stages of the bull market (especially 2009). While capital gains are great, we want to identify a rate which is closer to the fund distributions. I use distribution adjusted closing prices so the discrete distributions are unavailable to the Tactical Model but we can use the Tactical Model to provide more information.

What if an investor had put $100,000 into the strategy and then withdrawn 5.0% annually in equal monthly installments over the full market cycle? The $100,000 would have grown steadily to $193,456 in February 2019 and then declined slightly to $189,345 in May of 2019. At a 5.5% withdrawal rate, the $100,000 would have grown steadily to $182,676 in February 2019, and then declined to $178,570 in May of 2019. At a 6.0% withdrawal rate, the $100,000 would have grown steadily to $172,603 in May 2018, and then declined to $168,407 in May of 2019.

This suggests that a withdrawal rate between 5% and 6% would have proven more sustainable than the 7.2%. That said, one should not lose sight of the fact that returns during the next 10 years are unlikely to match those of the past 10.

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

The Adaptive Income Strategy smoothly and effectively transitions between risk on and risk off while delivering exceptional returns.

It 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 coming bear market in equities and increased volatility in credit markets, investors should consider using Adaptive Income for part of their portfolios 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.

 

Open End Fund Notes

There are three issues attendant with mixing Open End and Exchange Traded Funds in the same tactical strategy. Rest assured that I have included an Open End fund in this strategy only because it significantly improves performance.

Early Redemption Fees: ETFs trade with no minimum holding period. Some brokers impose an Early Redemption Fee (typically $50) on purchases held for less than 90 to 180 days, particularly if purchased through a No Transaction Fee program.

Repurchase Limitation: Some funds and/or brokers impose a 60 day limitation on repurchase following a sale. The Tactical Model factors the 60 day repurchase limitation into the Strategy. The Tactical Model also optimizes fund allocations to extend holding periods wherever practical.

Settlement of T+1 versus T+2: ETFs, like all stocks, settle in two business days (T+2) while some OEFs settle in one business day (T+1). An issue arises when selling an ETF, which settles in T+2, to buy an OEF which settles in T+1.  The order to purchase the OEF can be held for 1 trading day or margin may be used to cover the 1 day difference in timing.

The Open End Fund trades an average of only 1.8 times per year and the extra performance is well worth dealing with the issues. Appropriate notes are included in the Rebalance Notice when the Adaptive Income Strategy allocates in/out of the fund.

 

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A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.

 

A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.

A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.