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Timing Luck with Tactical Asset Allocation

Tactical asset allocation (TAA) is most often based on the investor trading once-per-month and that once occurs on the last trading day of each month. There may be an inherent problem in the selection of the same day each month on which to rebalance the portfolio and this is referred to as timing luck.

Fortunately, Walter at Allocate Smartly and Corey Hoffstein at Newfound Research wrote about timing luck as it pertains to TAA so there is no need for me to reinvent the wheel.

The Allocate Smartly post is here and the Newfound Research post is here.  If you are a TAA investor, I strongly suggest you read both articles and consider the timing luck issue if you are making allocation adjustments only at month end.

The take away from both articles is that trading on the same day each month, be it the last trading day, the eleventh trading day, etc, introduces the risk that the performance results are due, in part, to the day selected to trade. To remove timing luck from a TAA, both articles present the solution that the investor divide their TAA portfolio into equal weights and rebalance each segment on a different day of the month. The assumption is that the rebalancing days are equally spaced apart.

I have decided to take the advice of Water, Corey and other professionals that I have spoken to. I divided my portfolio into four equal segments and, going forward, will adjust the weights of the ETF’s on a weekly basis. Segment 1 which is 25% of my portfolio will be adjusted on the last trading day of week 1 (which was last week in my case). Segment 2 which is 25% of my portfolio will be adjusted on the last trading day of Week 2. Repeat for segments 3 and 4. On the fifth week, the process repeats starting with segment 1.

As for my portfolio, it slipped by 2.54% in March resulting in a year-to-date loss of 3.34%.

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Process Versus Outcomes in Investing

Outcomes. When you are a long-only investor and the markets behave like they did in 2017 it is easy to focus on outcomes and tend to allow your mind to diminish the importance of process. When your equity chart increases every month for twelve months straight you have full confidence in your process because the outcomes are so darn favorable.

Then February 2018 hits you. The outcomes that your brain has become accustomed to change dramatically and your focus switches to process. Every day the financial media reminds you that volatility has returned with a vengeance like you haven’t experienced in so long that you forgot what it feels like. This is very unpleasant. Gut-wrenching even. Suddenly there is a voice in your mind screaming that there must be something wildly amiss with your process.

Process. It is far more important than outcome and it is what we, as investors, should be focusing on but why would we when we produced positive returns every single month in 2017. Our investing process must have been sound given how smooth and upward sloping our equity curve was last year.

Doubts. If you have them about your process there is nothing quite like a spike in volatility and a swift drawdown to make you question whether your investing strategy is in dire need of an update. New rules perhaps. Tighter stop losses would have worked so well this month. Buying cheaply priced puts in January now seems like such an obvious move that you should have made.

Relax. If you have a sound strategy that has proven itself over time then now should be no different and you must ignore the alarms from the financial media and relax. Now is not a time to jump ship and abandon your strategy. Surely you have read about the gains you would have enjoyed had you bought stocks in Berkshire Hathaway and Apple decades ago and just held. I suspect you also understand that you would have had to endure many drawdowns in excess of 40% between then and now. What we are experiencing lately is child’s play compared to those drawdowns.

My advice is to stay the course (assuming that your course is a systematic investing strategy that suits you and will provide you with returns and drawdowns that are acceptable), don’t pay attention to the alarmist headlines in the media, and if you are in the accumulation phase of your investing plan continue to contribute each month.

Fred

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January, 2018 Update. Firing on All Cylinders

Last month felt like one for the record books. Broad equity indices rose without resistance throughout the month as if all was well with the world. The markets fell a little at the very end of January but even with that decline, my tactical asset allocation strategy which uses ETF’s rose 6.69%.

Volatility remains on the low side but did increase and is pushing the limit for me to be prepared to reduce leverage. Currently, I am using 30% leverage and have been doing so for some time. Interest rates are low and volatility, until now, has been low so it has been an opportune occasion to use margin.

It is at times like this when my equity chart moves ever so continuously higher that I remind myself to not confuse a bull market with brains. Conditions have been exceptional for a tactical asset allocation strategy such as mine and I used margin responsibly and it paid off. Let’s keep in mind that we, as investors, should focus on process over outcome. Every month I report the outcome but it is the underlying investing process that is truly important.

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2017 Was a Great Year for My Style of Investing

By now you know that the US equity markets, in particular, had a solid 2017. My ETF investment strategy selects five or six ETFs at the end of each month and holds them until the end of the following month when selections are made again.It should be no surprise that my tactical asset allocation style of investing had me hold SPY every month throughout 2017.

Volatility was historically low last year. On average, I used 30% leverage in 2017 but the annualized volatility of my ETF portfolio was almost always below 10%.

I have been asked about my expectations regarding which markets will be the 2018 winners. My style of investing is based, in part, on an understanding that I as an investor do not make predictions. Yes, I can tell you which asset classes are represented in my holdings right now but I can’t tell you how long I will have them. Nor can I make any sort of educated guess regarding how my portfolio will fare overall in 2018. As I alluded to in earlier posts, I consider monthly returns analogous to picking green and red marbles from a bag while blindfolded. My strategy determines if there are more green marbles (positive monthly returns) than red marbles (negative monthly returns) but I have no say in the order the marbles will be picked.

December’s performance was yet another green marble as my portfolio grew by 2.29% giving an overall gain for 2017 of 22.4%. The amazing characteristic of 2017 was the low volatility. If you look at my equity chart below you will see how incredibly smooth it was last year.

My Gain to Pain Ratio is an absurdly high 4.96 due to it being measured over just under two years when the markets have provided solid returns. In the long run, I expect this ratio to lower to between 1.5 and 2.0.

My five ETF holdings for January cover US equities, Asian equities, and energy.

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My ETF Momentum Strategy Performance for November

Another month, another great performance. My strategy produced a 3.0% return in November and again volatility remains exceptionally low. Nobody knows how long this regime of low volatility will remain but strong gains with minimal draw down can make investors very comfortable if not overconfident and we must be aware that higher volatility will return some day and monthly losses will be more prevalent than they have been for the past two years.

The low volatility combined with consistently positive monthly returns has resulted in a Gain To Pain ratio of 4.52 which is beyond exceptional and which I expect to be lower in the future.

You never know what path your monthly returns will follow. My strategy has now provided 13 months of returns without a loss. I couldn’t have predicted that. Yes it feels good but one must never confuse a bull market with brains. As per the chart below, anyone following a global passive ETF strategy has done almost as well as my strategy. The true test will come when the markets become bearish and every investor’s willingness to stick to their strategy (if they even have one) is tested.

My holdings remain unchanged from November to December with my largest holding being EPP (iShares MSCI Pacific ex-Japan).

I track the performance of my ETF strategy on Collective2.

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