Dynamic Sleeve No Trick Portfolio Play

September 07, 2017

This article is part of a regular series on thought leadership from some of the more influential ETF strategists in the money management industry. Today's article is by Andrew Gogerty, vice president of investment strategies at Boston-based Newfound Research.

With the start of another football season underway, I am reminded of a classic mantra: “Offense wins games, defense wins championships.” You can’t argue with the logic: To win over time, you have to be proficient in both aspects of the game.

Adding a tactical sleeve into a core portfolio allows for participation (offense) in rising markets and a risk mitigation (defense) when things become less certain than they appear today.

But just like practicing more plays than will actually be used in a game, successful portfolios have these allocations included before they are needed.

U.S. investors use a core portfolio of domestic stocks and core bonds. Within this context, even small dynamic allocations can have a material impact.

A Look At Some Strategies
As an example, for this article, we have constructed simple, backtested strategies (note these are not investment strategies that are currently managed by Newfound, and the trades and allocations mentioned below are not actual, live trades, but hypothetical only).

For each Morningstar allocation category below, we constructed a simple momentum portfolio using the underlying indices for the SPDR S&P 500 ETF Trust (SPY), the iShares Core US Aggregate Bond ETF (AGG) and the iShares 20+ Year Treasury Bond ETF (TLT).

When the S&P 500 Index’s price is above its 200-day moving average, we hold the top equity allocation (the rest in AGG), and when it is below, we hold the bottom equity level and add a TLT allocation (20-year Treasuries have historically been a valuable hedge for U.S. equities and have exhibited low total return correlation). The portfolios are updated monthly.

 

Category Price > 200 Day MA Price < 200 Day MA
US allocation 15%-30% equity  30% SPY / 70% AGG 15% SPY / 15% TLT / 70% AGG
US allocation 50%-70% equity 70% SPY / 30% AGG 50% SPY / 20% TLT / 30% AGG
US allocation 85%+ equity 100% SPY 85% SPY / 15% TLT 

 

The portfolios improved the max drawdown impact (defense), as well as kept pace (offense) in recent years. There are five total allocation categories; for simplicity, we highlighted the low-, middle- and high-equity allocations.

Over the past 20 years, only 18 trades would have been made to adjust the allocation, and with only a small portion of the portfolio being traded, the strategy is also efficient from a tax and implementation perspective.

 

US Allocation 15%-30% Equity YTD 1Yr 3Yr 5yr 10yr 15yr 20yr Max DD
Tactical portfolio 5.32 4.25 4.55 5.40 6.21 6.48 6.53 -6.99
Category 25th percentile 5.17 5.04 5.04 4.75 4.88 5.64 5.95 -15.66
Category 50th percentile 4.74 4.28 4.28 4.00 4.20 4.95 5.43 -17.99
Category 75th percentile 4.00 3.39 3.39 2.96 3.45 4.08 5.19 -34.05
                 
US Allocation 50%-70% Equity YTD 1Yr 3Yr 5yr 10yr 15yr 20yr Max DD
Tactical portfolio 8.87 10.87 7.59 10.37 7.86 8.63 7.56 -26.91
Category 25th percentile 8.98 10.83 6.26 9.29 5.94 7.61 6.61 -33.31
Category 50th percentile 7.96 9.46 5.42 8.31 5.22 6.84 5.88 -37.15
Category 75th percentile 6.90 8.07 4.45 7.28 4.49 6.19 5.15 -39.82
                 
US Allocation 85%+ Equity YTD 1Yr 3Yr 5yr 10yr 15yr 20yr Max DD
Tactical portfolio 11.59 16.04 10.20 14.36 8.48 9.72 7.66 -44.49
Category 25th percentile 12.99 16.09 7.29 11.79 5.56 8.18 7.38 -47.38
Category 50th percentile 11.72 15.18 6.65 11.30 5.00 7.70 6.83 -49.90
Category 75th percentile 10.48 13.36 5.92 10.66 4.50 7.35 6.33 -51.39

Sources: Morningstar, Newfound Research; through 7/31/17

 

Current Implications
Core stocks and bonds have performed well in 2017, and even safe-haven assets such as 20-year Treasuries have joined the rally. As a result, a core domestic portfolio such as 60% SPY/40% AGG is enjoying historically high risk-adjusted returns. Below is a chart of the rolling one-year Sharpe ratio and historical quartiles.

 

 

The chart also shows that things have changed quickly and dramatically at times. As a result, having a robust plan in place can help mitigate risks and also tilt a portfolio toward stronger-trending assets during rallies.

Looking at the graph above and the aforementioned strategies is like watching a game tape of an upcoming opponent. You have an idea of what is likely to happen, but that doesn’t mean you can forgo thinking, “Well, what else could they throw at us?” Having a plan for the expected and a strategy for dealing with the unexpected is key to success.

A dynamic sleeve works the same way. If things continue, the portfolio would likely stay tilted toward the top end of its equity allocation. Should conditions change, it already has a built-in lever to begin de-risking the equity exposure.

For advisors wanting a complete portfolio that uses both core and satellite exposures with a comprehensive risk management framework, Newfound’s QuBe Model Portfolios offer an outsourced multimanager, yet customized solution with a zero overlay fee.

At the time of writing, Newfound held positions in the securities mentioned. Newfound is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research, call 617-531-9773, visit www.thinknewfound.com or email [email protected]. For a list of relevant disclosures, click here.
 

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