The Trend is Your Friend

The tactical strategy also yielded both a much narrower range of outcomes and a lower frequency of negative returns over intermediate holding periods throughout the study.  The data below summarize these two metrics for the tactical strategy versus buy-and-hold over 463 overlapping three-year holding periods (measured monthly) between 1971 and 2011.

Hypothetical back-test study
 Range of outcomes and frequency of losses
463 overlapping three-year periods
1971 - 2011

* Countries marked with an asterisk indicate that the best three-year period for the tactical strategy was higher than the best three-year period for buy-and-hold.  In these instances, the spread between the best-case and worst-case outcomes is wide for the tactical strategy for a good reason – i.e. better outcomes on the best-case and worst-case metrics compared to buy-and-hold.
           
The tactical strategy delivered substantial diversification benefits during periods when the buy-and-hold strategy delivered negative returns.  The table below shows the three-year return for the tactical strategy during whichever period represented the single-worst three-year outcome for buy-and-hold for each country included in the study.
 
Hypothetical back-test study
Relative return during the worst 3-year period for buy-and-hold
463 overlapping three-year periods
1971 - 2011

Despite the potential benefits of the tactical strategy presented above, it did little better than a coin-toss at outperforming buy-and-hold over shorter time periods.  The frequency of outperforming buy-and-hold improved modestly as the holding period increased, but the win-loss ratio was balanced throughout the study period. 

Investors seeking a “magic” strategy that captures the upside of the equity markets without downside risk will not find it in a moving-average crossover approach.  The table below shows the relative returns of the tactical strategy versus buy-and-hold during overlapping one-year, three-year and five-year holding periods included in the study.

Hypothetical back-test study
Percentage of periods when tactical outperformed buy-and-hold
1971 - 2011

At times, tracking error was dramatic for the tactical strategy.  The following table shows the maximum outperformance and underperformance of the tactical strategy relative to buy-and-hold over every rolling three-year holding period included in the study (measured monthly).  Most countries in the study include a period when the tactical strategy under-performed buy-and-hold by more than 100% during a 36-month period.  If the study period were extended through August, 2012, many countries, including the United States, would show dramatic underperformance for the tactical strategy relative to buy-and-hold over the most recent three-year period.  The data below suggest that such episodes should be expected from time to time.

Hypothetical back-test study
Maximum tracking error
463 overlapping three-year periods
Tactical vs. buy-and-hold 1971 - 2011

A final table below shows the cumulative annualized return and standard deviation for both strategies over the entire 41-year period of the study.  This comparison is extremely favorable to the tactical strategy, despite frequent periods of under-performance relative to buy-and-hold, including the multiple three-year periods we have seen for most countries in the study when the cumulative underperformance exceeded 100%. 

It bears noting that it’s not possible to invest directly in these strategies. Transaction costs, taxes, and expense ratios would all eat into the advantage of the tactical strategy presented here.  Nonetheless, our findings demonstrate the way asset markets work and that there were no exceptions among any of the markets to our finding that the tactical strategy offered benefits across 18 geographically diverse countries, cultures and geopolitical systems.

Hypothetical back-test study
Long-term growth and volatility
1971 - 2011

Conclusions

According to the experience of 18 countries across 41 years of market history, a simple tactical investment strategy offers substantial diversification benefits relative to buy-and-hold.  The tactical strategy narrowed the range of outcomes over intermediate holding periods, and it delivered much shallower drawdowns during periods when a buy-and-hold strategy had negative returns in each country.  By reducing the frequency and magnitude of large drawdowns, the tactical strategy delivered a higher cumulative return with less volatility compared to buy-and-hold over the entire 41-year period for every country.

The primary drawbacks to the tactical approach included whipsaw risk, frequent underperformance versus buy-and-hold over shorter periods of one to five years, and, at times, considerable tracking error in both directions.  These hazards of trend-following strategies appear to be unavoidable.

From a total portfolio perspective, however, investors can combine tactical strategies similar to the approach examined in this study with buy-and-hold positions to add a new dimension of diversification and risk management to their portfolios.  In addition to traditional diversification through asset class selection, a complement of tactical exposure helps investors to reduce drawdown risk and narrow the range of expected outcomes from their investments over three-to-five year forecast horizons. And moving-average strategies like the one presented here have shown promise in their tendency to deliver valuable diversification benefits when they are needed most – during bear markets.

It’s an approach, at the very least, that you’d be remiss never to even consider.

Keith Goddard is the chief investment officer of Capital Advisors, Inc., a Tulsa, Oklahom- based asset manager with offices in Dallas, Houston and Oklahoma City.  As of June 30, 2012, Capital Advisors served as manager and advisor to approximately $1.1 billion in client assets.  He can be reached at .

Hannah Newman and Will Wright contributed materially to the research studies presented.

Disclosures

Introduction

The investment return and principal value of an investment will fluctuate so that an investor’s portfolio may be worth more or less than its original cost at any given time. Due to differences in portfolio timing and position weightings, the returns for any individual portfolio managed by Capital Advisors may be lower or higher than the performance quoted.

Security Recommendations

The investments presented are examples of the securities held, bought and/or sold in the Capital Advisors’ strategies during the periods presented. These investments may not be representative of the current or future investments of the strategies. You should not assume that investments in the securities identified in this Market Comment were or will be profitable. We will furnish, upon your request, a list of all securities purchased, sold or held in the strategy during the 12 months preceding the date of this presentation. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of securities identified in this Market Comment. Other Disclosures: Commentary is published by: Capital Advisors, Inc. This commentary does not purport to be a statement of all material facts relating to the securities mentioned. The information contained herein, while not guaranteed as to accuracy or completeness, has been obtained from sources believed to be reliable. The securities mentioned do not represent all securities bought, sold, or recommended to clients of Capital Advisors, Inc. Due to differences in timing, objectives, or portfolio size, issues discussed in this note may not apply to all clients. Opinions expressed herein are subject to change without notice. Capital Advisors, Inc., or one or more of its officers or employees, may have a position in the securities discussed herein, and may purchase or sell such securities from time to time. Specific information regarding topics covered in this report is available upon request.

A complete list of Capital Advisor’s portfolio models and performance results is available upon request. Additional information including management fees and expenses is provided on Capital Advisors’ Form ADV Part 2. The actual return and value of an account fluctuate and, at any time, the account may be worth more or less than the amount invested.

Description of the Back-Test Studies

The following indices were utilized in the back-test studies described in this paper:

MSCI Country Indices are designed to measure the performance of the equity markets of single countries globally. The indices assume the reinvestment of dividends. Returns for these indices were utilized throughout the study period for each country included in the hypothetical back-test studies.

Barclays Capital Aggregate Bond Index is an unmanaged index made up of U.S. Government, corporate, mortgage backed and asset-backed securities rated investment grade or higher. The index is designed to measure the performance of the domestic investment-grade bond market. It is not possible to invest directly in the index. This index was formerly known as the “Lehman Aggregate Bond Index” prior to Lehman’s sale of assets to Barclays in 2008. Returns for this index were utilized in all of the back-test studies for periods beginning in January 1976 and thereafter.

Intermediate Government Bond Index is an unmanaged benchmark for 5-Year U.S. Treasury Notes maintained by Ibbotson Associates since 1926. Monthly returns for this index were utilized in each back-test study for the period from January 1971 through December 1975.

Past performance results are not indicative of future results. TacticalShares® is a registered trademark of Capital Advisors, Inc. Presentation is prepared by: Capital Advisors, Inc.

Copyright © 2012, by Capital Advisors, Inc. All rights reserved.

Read more articles by Keith C. Goddard, CFA