Reflections On The Past Twelve Years

This is a comprehensive update and replacement of a February 2017 post titled "Reflections On The Past Decade".

The Market Can't Be Timed?

I've read a number of articles recently about the under-performance of market timing strategies including Tactical Asset Allocation (see Tactical Asset Allocation: How Does It Improve Returns?). Street "wisdom" is that one should simply buy and hold the the market with a heavy dose of equities supplemented with fixed income.

I'm going to delve into that issue in considerable detail in this blog post. Those who are successful market timers and dedicated shepherds in shifting asset allocations within their portfolio should skip this article. To all others, I say "not so fast" and I've got numbers to back that up.

Safety or Return?

Let's start with a question. "If forced to make a choice between the safety of your money and return on investment, which would you choose?" Most of us have a "recency" bias which creeps into our investment decision making depending upon where we are in the full market cycle. (see What Is A Full Market Cycle And Why Should I Care?). Given a few years of elapsed time from a Bear Market, we are more concerned about return on investment than protecting ourselves from the next bear. Fear is a far more immediate emotion so it takes just a few quarters in a Bear Market to forget about the bull and worry about safety. Your answer to the question is likely to be tempered by the time elapsed from the last Bear Market.

Consistency Is Critical To Investing Success!

It (almost) goes without saying that no one strategy (or investment manager) is going to consistently provide the best performance.

There are several keys to maintaining investment consistency:

  1. Set realistic expectations for returns. Understand where you are in the market cycle. Markets (equity, fixed income, and commodity) which are at or nearing selling exhaustion (end of a bear market) are likely to perform spectacularly well while markets which are at or nearing buying exhaustion (end of a bull market) are likely to perform inconsistently or poorly. Keep your eye on performance across the full market cycle.
  2. Understand the strategy risks. One of the biggest failings in financial regulation is the absence of metrics designed to inform investors regarding historical drawdowns. Looking at 1, 3, 5, and 10 year average returns is not going to tell you how much the investment lost in the last major bear market. Yet every investor has a "get me out" point where losses exceed the "sleep well at night" point. Obtain this information before you invest and decide if the possible loss is within your zone of comfort. Making this decision when deep losses are already in progress is too late.
  3. Be prepared for good spells and bad spells. While it is possible to identify periods where a strategy is more likely to have good spells and bad spells (see What Is A Market Conditions Model And How Does It Lower Risk?) , it is simply not possible to identify all good spells and all bad spells in advance. What is critical, is consistently sticking with whatever strategy you have chosen. There is a great deal of research which proves that strategy switching by investors is the biggest mistake they make. Investors all too often give up on a strategy when it begins to under-perform only to jump into a strategy which has long been out-performing and is due for a slip.

The Contenders

We will compare performance across seven investment strategies (all of which include dividends) beginning with 2007; the year in which the last big bear market began:

  • Buy and hold the S&P 500 aka "The Market"
  • Buy and hold the Vanguard Balanced Index Fund (60% equities, 40% fixed income) widely considered to be a conservative core investment strategy
  • Buy and hold the Best Active Managers(1)
  • Enhanced Best Active Managers(1) using Tactical Asset Allocation
  • TAAS Tactical Adaptive Global Strategy
  • TAAS Tactical Adaptive Income Strategy
  • TAAS Tactical Adaptive Innovation Strategy (data is limited)

(1) In a previous blog, "TAA versus Active Fund Management", the Best Active Managers strategy bought and held the funds managed by the top Active Manager in each of Morningstar's five categories. The TAA Enhanced Best Active Managers strategy used basic Tactical Asset Allocation to select the three top performing Best Active Manager funds each month or went to cash if all were performing negatively.

Investment Risk

"my personal investment screening process begins with finding investments with acceptable drawdowns before ever looking at returns"

Each year is ranked visually from dark red to dark green. The S&P 500 captures 11 dark reds while TAA Enhanced Best Active Managers captures 2. Notably, the dark red percentages in TAA Enhanced Best Active Managers, Adaptive Global and Adaptive Income are relatively small.

The large drawdowns in the S&P 500 (2008-2011 and 2018) are all large enough to visually mask 10%+- losses in the Vanguard Balanced and both Best Active Managers strategies.

Stomach-churning declines of 20%+ in the S&P 500, Vanguard Balanced, and Best Active Managers (all buy and hold strategies) were actually compounded by continuing from one year into the next. For many investors, stomach-churning returns lead to selling out when the decline is well advanced followed by fear of getting back in as the recovery advanced.

Adaptive Income captures 9 dark green, while Adaptive Global captures 3 and TAA Enhanced Best Managers captures 2.

Results for Adaptive Innovation are shown but not included in ranking due to short history.

This is why, again and again, I try to drive home the point that investors should know the drawdowns before investing based on seemingly attractive returns. 

Investment Returns

The 22.4% gains shown for Adaptive Global for both 2007 and 2008 is a coincidence, not an error.

Each year is ranked visually from dark red to dark green. A quick visual check reveals 7 dark green for Adaptive Global and 3 dark greens each for the S&P 500 and Adaptive Income. (Adaptive Income's exceptional performance in 2009 is attributable to switching into high yield bonds after they were smashed during the bear market.)

While both versions of Best Active Managers look spotty, the TAA Enhanced version handily outperforms the buy and hold version (see the Summary below).

Results for Adaptive Innovation are shown but not included in ranking due to short history.

Summarizing The Full Market Cycle

Our final table summarizes investment risk and return across the full market cycle:

Again, we apply color ranking to quickly visualize the results across all 12 years.

The Ulcer Index is calculated using daily results to measure downside losses in both depth and duration against the strategy's gains. It is an excellent measure of risk adjusted return as well as the persistence of losses. 5% is generally considered a useful threshold with higher percentages to be avoided.

The Ulcer index runs the gamut from 1.3% to 15.3%. Adaptive Income and Adaptive Global are comfortably below the 5% threshold. TAA Enhanced Best Active Managers is just above at 5.2%. The three buy and hold strategies lie well above the threshold with the S&P 500 coming in at a stomach churning 15.3%.

The Compound Annual Growth Rate pretty well summarizes the results seen in the annual Compound Annual Growth Rate table above.

Maximum Monthly Drawdown, requires an explanation. This is quite simply the maximum percentage by which monthly statements show the account value has declined from the peak statement. During a Bear Market, this will persist across months and even years. If a statement shows a peak value of $100,000 in Month 1 and a value of $50,000 in Month 13, the drawdown is 50%.

In this case, Maximum Monthly Drawdown not only summarizes the results seen in the Maximum Monthly Drawdown table above, but shows the effects when the drawdowns persist across calendar years. Tactical Global's Maximum Monthly Drawdown of 8.7% lasted from April through October of 2010. In comparison, the S&P 500's 50.8% MMD lasted from October 2007 through March 2012.

Large drawdowns dig large holes. Setting aside the psychological issues, a portfolio which has declined by 50% must double in value just to get back to its peak. That takes time and burns through gains which would otherwise be creating new value in the portfolio.

Interestingly, the allegedly conservative strategy of buying and holding the Vanguard Balanced Index Fund does not look so conservative. So much for market timing not working!

Markets Do Cycle

Earlier, I referred to the effect of "recency bias" in viewing our investment results as we look at our monthly statements. Every Bull Market in history has been followed by a Bear Market (and vice-versa). This makes it imperative that we deal with "recency bias" by holding onto our long term objectives. For those who are not market timers and dedicated asset allocations, this means following an investment strategy which is designed to adapt to market conditions during a full market cycle.

"The hurrier I go, the behinder I get.”

You can retain personal control and custody of your investments without having it occupy your every waking hour. Tactical Asset Allocation will not catch exact tops in Bull Markets or exact bottoms in Bear Markets but it will stick with persistent positive trends and get out of the way of persistent negative trends. Tactical Asset Allocation will pick and choose among the best performing assets and get out of the way when there are none.

The TAAS Tactical Adaptive Strategies do this better than any Tactical Asset Allocation strategies I have found. That is why a substantial portion of my family's assets are invested in the Strategies.

Earl Adamy

 

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I will be rolling out upgrades to the Tactical Model and Adaptive Strategies beginning with the November 29 rebalance for the month of December. In each case, the focus has been on improving control over the upper bounds of portfolio volatility, improving the consistency of annual returns, and on reducing fund turnover.

In order to provide the fullest possible disclosure, the Chart and Table displays on the website will include tables for both the original (labeled “Repl Dec 2019)” and upgraded Strategy beginning with the next update in early December.

The primary benefit of minor changes to Adaptive Global is reduction in both Standard Deviation of Monthly Returns and the Ulcer Index:.

  • Fund basket and condition eligibility: no change was made to fund baskets or condition eligibility
  • Fund selection: no change to fund selection method (Adaptive Dynamic Momentum)
  • Weighting of selected funds: Volatility Weighting was replaced with Limited Portfolio Volatility Weighting which is employed to cap the expected total portfolio volatility when high volatility funds (especially equities) are used. This slightly reduces both risk and return.
  • Position Optimization: Upgraded which slightly improves holding periods and performance.

Full cycle: CAGR decreased slightly from 15.0% to 14.6%;  Max Monthly Drawdown declined from 8.7% to 7.9%; and the Up/Down Ratio decreased slightly from 228.7% to 228.4%. The Ulcer Index declined from 3.7% to 3.6% and Standard Deviation of Monthly Returns declined from 9.5% to 9.1% reflecting improved consistency of 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.

I will be rolling out upgrades to the Tactical Model and Adaptive Strategies beginning with the November 29 rebalance for the month of December. In each case, the focus has been on improving control over the upper bounds of portfolio volatility, improving the consistency of annual returns, and on reducing fund turnover.

In order to provide the fullest possible disclosure, the Chart and Table displays on the website will include tables for both the original (labeled “Repl Dec 2019)” and upgraded Strategy beginning with the next update in early December.

The primary benefit of changes to Adaptive Income is a broadening of the fund basket and reduction in both Standard Deviation of Monthly Returns and the Ulcer Index:

  • Fund basket and condition eligibility: the number of fixed income ETFs was increased from 5 to 6 to broaden the basket to include an investment grade ETF.
  • Fund selection: no change to fund selection method (Adaptive Dynamic Momentum)
  • Weighting of selected funds: Adaptive Income employed a single selection, 100% weighting to the best performing fund. Limited Portfolio Volatility Weighting is employed to cap the expected total portfolio volatility when higher volatility funds (especially high yield) are used. This forces the allocation across a second, lower volatility fund when the cap is exceeded.
  • Position Optimization: Upgraded which slightly improves holding periods and performance.
  • Full Cycle: CAGR increased slightly from 10.6% to 11.1%; Max Monthly Drawdown increased from 2.9% to 3.8% however Max Daily Drawdown remains unchanged at 7.1%; and the Up/Down Ratio rose from 503.0% to 556.9%. The Ulcer Index declined from 1.3% to 1.2% and Standard Deviation of Monthly Returns declined from 5.6% to 5.1% reflecting improved consistency of 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.

 

I will be rolling out upgrades to the Tactical Model and Adaptive Strategies beginning with the November 29 rebalance for the month of December. In each case, the focus has been on improving control over the upper bounds of portfolio volatility, improving the consistency of annual returns, and on reducing fund turnover.

In order to provide the fullest possible disclosure, the Chart and Table displays on the website will include tables for both the original (labeled “Repl Dec 2019)” and upgraded Strategy beginning with the next update in early December.

This upgrade to Adaptive Innovation improves performance while significantly reducing volatility.

  • Fund basket and condition eligibility: The existing long duration Treasury ETF was added to the eligible funds for Balanced conditions. This allows strongly performing Treasuries to complete effectively with the Innovation equities for selection. A short duration Treasury ETF was added to provide a higher yielding alternative to cash.
  • Fund selection: no change to fund selection method (Adaptive Dynamic Momentum)
  • Weighting of selected funds: Volatility Weighting was replaced with Limited Portfolio Volatility Weighting which is employed to cap the expected total portfolio volatility when the higher volatility Innovation funds are used. This forces the allocation across a second or third fund when the volatility of the primary fund(s) exceeds the cap.
  • Position Optimization: Upgraded which made no change in holding periods and performance.
  • Partial cycle: CAGR increased slightly from 26.3% to 28.4%,  Max Monthly Drawdown and Maximum Daily Drawdown remained unchanged at 12.2% and 19.2% respectively; and the Up/Down Ratio increased from 280.2% to 336.9%. The Ulcer Index declined from 5.6% to 5.1% and Standard Deviation of Monthly Returns declined from 15.7% to 14.9% reflecting improved consistency of 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.