August 18, 2014: Consistency, The Most Important Edge In Investing: Tactical Case

Consistency, The Most Important Edge In Investing: Tactical Case

In our previous newsletter May 19, 2014: Consistency, The Most Important Edge In Investing: Strategic Case, we made a strong case that consistent buy and hold and rebalance is the most important factor to succeed in a strategic portfolio management. In this newsletter, we discuss the consistency in a tactical portfolio management.

One of our users said this best:

I agree that consistency or disciplined execution is very critical to a buy and hold portfolio, but I would argue that it is even more important for a tactical portfolio as managing a tactical portfolio entails more activities. If you don’t follow and execute these rebalances rigorously, your investment returns can be affected seriously.

An effective strategy no one would follow consistently?

We were not surprised to see articles like this one 30 Years Ago Warren Buffett Gave Away The Secret To Good Investing And Correctly Predicted No One Would Listen. The ‘open secret’ mentioned in the article is the very basic value investing principle: a stock owner is a business owner and the owner cares most about his/her essential business results such as profits and cash flow. Warren Buffett described this value investing method in the article The Superinvestors of Graham-and-Doddsville (we mentioned this article in our previous newsletter June 16, 2014: There Are Always Lottery Winners) in 1984, 30 years ago.

What is more interesting and amazing is Buffett’s assertion in the article:

“I can only tell you that the secret has been out for 50 years,” Buffett writes, “…yet I have seen no trend toward value investing in the 35 years I’ve practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing over the last 30 years. It’s likely to stay that way. Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.”

An example is the Sequoia Fund (SEQUX (Sequoia)), a fund Buffett recommended to his investors when he dissolved his investment partnership in 1969 before he started Berkshire Hathayway. The fund beats S&P 500 since 1987 by more than 2% annually (the earliest time our system has VFINX (Vanguard 500 Index Investor)‘s number):

as of 8/18/2014:

Ticker/Portfolio Name	1Yr AR	3Yr AR	5Yr AR	10Yr AR	Since 3/30/1987
VFINX (Vanguard 500 Index Investor)	21.3%	20.3%	16.7%	8.5%	9.5%
SEQUX (Sequoia)	9.9%	18.4%	16.5%	9.1%	11.92%

It is arguable whether average individual investors can command strong value analysis skills and become a good value investor. However, it is certainly very feasible for professional investors such as mutual fund managers or asset managers to learn such skills. But if you look at the long term performance of mutual funds, Buffett is certainly correct that most of these pros can not execute this seemingly simple yet better strategy consistently as their funds have lagged behind index funds!

Strong long term performance

Back to our tactical asset allocation case, the trend following Tactical Asset Allocation(TAA) strategy MyPlanIQ uses has a strong historical performance. For example, the portfolio P Relative Strength Trend Following Six Assets that has been back tested since 6/28/1991 (the earliest date our system has fund data) only uses simple six mutual funds, each of which represents a major asset class in the core 6 assets:

U.S. stocks: Vanguard 500 Index (VFINX), inception:3/27/1987
European stocks: Vanguard European (VEURX), inception: 11/1/1990
Pacific stocks: Vanguard Pacific (VPACX), inception: 11/1/1990
US REITs: Vanguard REITs (VGSIX), inception: 6/28/1996
Gold: GLD, inception:1/4/1971. Before ETF GLD’s inception on 11/18/2004, we use London spot gold price (monthly closing).
US Bonds: Vanguard Total Bond Index (VBMFX), inception: 6/4/1990
CASH: calculated using 3 month T-Bill interest.

The only reason using the above funds is that these funds have the longest history and most of them are Vanguard’s index funds. The TAA strategy is as simple as choosing top two funds each month based on their trend scores which are essentially the past total return performance.

Here is the latest performance for this portfolio, compared with other benchmark index funds:

Portfolio Performance Comparison (as of 8/18/2014):

Ticker/Portfolio Name	YTD Return**	1Yr AR	3Yr AR	5Yr AR	10Yr AR	Since 6/28/91
P Relative Strength Trend Following Six Assets	6.3%	17.1%	12.9%	13.6%	12.1%	11.1%
VFINX (Vanguard 500 Index Investor)	7.9%	21.3%	20.3%	16.7%	8.5%	9.6%
VEURX (Vanguard European Stock Index Inv)	0.2%	11.5%	11.8%	9.3%	7.6%	8.8%
VPACX (Vanguard Pacific Stock Index Inv)	4.1%	11.2%	9.2%	7.9%	6.6%	3.16%

See detailed year by year comparison >>

Notice not only the tactical portfolio beats all other indices by some big margin, it does so with much less drawdown. For some more related discussions, please read articles like December 10, 2012: How Asset Allocation Strategies Performed In Secular Market Trends.

We use the European and Asia Pacific funds solely because of their long history. If we use index funds for asset classes International Stocks and Emerging Market Stocks, the portfolio can do even better (see, for example, P Goldman Sachs Global Tactical Include Emerging Market Diversified Bonds on Advanced Strategies page.

These portfolios do not suffer from often cited notorious mutual fund survivability issue. Furthermore, there is no data snooping: in fact the algorithm has been kept intact since 2006.

Well defined simple strategies with strong intuition

So why are there very few successful tactical allocation mutual funds? we believe the very first problem is that many investors have only quasi-defined strategies that are subject to their human emotional response. For example, many funds claim to be tactical as they dynamically change allocations. However, very often, there is no a well defined strategy behind them. Fund managers have vague statements on their strategies> remember those gibberish statements in a fund prospectus? The execution is thus very much dependent on their subjective views and emotion.

As we stated frequently, we believe that it is important to have a simple well defined strategy behind any successful investment. A strategy that is subject to frequent modification or subjective forecast is not a strategy. Furthermore, a strategy that has a overly complicated algorithm or a method or whatever seems to be very complex or ‘advanced’ is usually suspicious at best: as an engineer by training, we understand how such complexity can call for trouble or bugs in programming terminology!

The other important quality we look for is the transparency behind a strategy: to justify high fees and business, many are forced to present a convoluted and opaque strategy. Like Buffett, we believe that the key to be successful is not because one employs top secret methods but instead the consistent implementation with strong attention to details such as how to handle special funds like high yield bonds or dividend funds. The advantage of being open is to align the expectation of the investors/users with the behavior of the underlying strategies.

But it is still hard to follow a well defined strategy

But even for a well defined and relatively simple strategy such as our Tactical Asset Allocation(TAA) strategy, it is still very hard to follow by many people.

Why?

A few reasons we can think of (and observe from our user base):

As we stated elsewhere (see, for example, again December 10, 2012: How Asset Allocation Strategies Performed In Secular Market Trends), various strategies such as Strategic Asset Allocation (SAA) and Tactical Asset Allocation(TAA) can out perform each other in different market cycles. It is very likely that the TAA can under perform in a period that can last as long as 5 years. Many investors don’t have patience to stick to a strategy that is under performing against markets: just imagine you hear people brag about their tech (or internet) stocks in a cocktail party!
Many times, investors try to second guess a strategy: for example, at this moment, for many conservative investors, it is hard to imagine that stock markets can go much higher. It is thus very hard for them to follow a strategy that will not exit from an asset unless there is a weakness. We know for a fact that some users refuse to sell unless exiting from this holding is profitable. The funny thing here is that since 2009, most of times, such a behavior has turned out to be better or at least OK as markets have been going up most of times for the past five years! But imagine if one of these times turns out to be a severe decline that takes years to recover!
Randomly switching between strategies: for example, at this moment, some investors become value investors and refuse to stay in markets. But on the other hand, for these people, they don’t have a clear valuation metrics and plan when markets change. As other times, they might become momentum investors or even a ‘strategic’ or ‘buy and hold’ investor! Remember, if you are randomly switching among strategies, how can you make sure your behavior or ‘strategy’ would work? Is there historical data backing?
Getting emotional: when markets are doing well, become greedy and increase risk exposure (such as invest more into stocks) or become way too timid (fearful) when markets are doing badly. The responses are not well tested and there are no clear rules attached to them.

To summarize, due to various reasons, many people just can not consistently follow a well defined strategy with strong intuition backing. That might answer an often asked question: if this strategy is so great, how come it is not popular. Or at least in your due diligence process, this question does have a reasonable answer: because many people just can not follow it consistently even though its ‘secret’ source is pretty open!

Portfolio Reviews

We compare Six Core Asset ETFs TAA portfolio with other global tactical funds:

Portfolio Performance Comparison (as of 8/18/2014):

Ticker/Portfolio Name	YTD Return**	1Yr AR	3Yr AR	5Yr AR	5Yr Sharpe	10Yr AR	10Yr Sharpe
Six Core Asset ETFs Tactical Asset Allocation Moderate	6.6%	14.0%	8.3%	9.5%	0.98	11.1%	0.99
GTAA (Cambria Global Tactical ETF)	4.4%	7.7%	2.8%
GDAFX (Goldman Sachs Dynamic Allocation A)	2.9%	7.9%	4.5%
DWTFX (Arrow DWA Tactical A)	1.1%	12.3%	6.8%	9.9%	0.63
PASDX (PIMCO All Asset D)	6.5%	9.6%	6.6%	8.6%	1.67	6.5%	0.68
BRAVX (Braver Tactical Opportunity N)	-0.8%	2.6%
VAISX (Virtus Allocator Premium AlphaSector I)	4.3%	10.8%	9.0%

More year by year comparison >>

Market Overview

Markets are recovering and approaching their recent highs. For now, investors seem to be back to good times. For example, it was reported that large institutional investors have tried to take on more junk bonds during their weakness in the last month. However, we note that long term bonds have been exceptional strong, indicating a subdued outlook of long term economic growth. Regardless, markets are over valued and we call for caution and do not encourage risk taking at the moment.

For more detailed asset trend scores, please refer to 360° Market Overview.

We would like to remind our readers that markets are more precarious now than other times in the last 5 years. It is a good time and imperative to adjust to a risk level you are comfortable with right now. However, recognizing our deficiency to predict the markets, we will stay on course.

We again copy our position statements (from previous newsletters):

Our position has not changed: We still maintain our cautious attitude to the recent stock market strength. Again, we have not seen any meaningful or substantial structural change in the U.S., European and emerging market economies. However, we will let markets sort this out and will try to take advantage over its irrational behavior if it is possible.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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