Lowering volatility with market-timing strategies is no free lunch, Swedroe cautions.
Market-timing strategies attempt to outperform a buy-and-hold strategy by anticipating the future direction of a market. They can work, but mostly they don’t.
First, such strategies are based on the belief that future security prices are predictable, typically through the use of technical indicators, such as trend following or momentum, that are computed from the past prices.
There are numerous papers that confirm the superior performance of momentum strategies across markets and around the globe. Studies have also found that trend-following strategies have enhanced risk-adjusted returns, producing higher Sharpe ratios.
Also, since some trend-following trading rules would have helped investors avoid some of the massive losses experienced during the two severe bear markets that occurred during the first decade of 2000s, the popularity of such strategies has increased.
Valeriy Zakamulin, author of the November 2013 study “The Real-Life Performance of Market Timing with Moving Average and Time-Series Momentum Rules,” examined the performance of these strategies, with particular concern for the potential for data mining.
To address the issue of “data snooping,” he used a bootstrapping method to examine out-of-sample data. A bootstrap is a computer-intensive method of estimation of the sampling distribution of a test statistics by resampling—that is, randomizing—the historical data. His study also accounted for trading costs, though he didn’t examine taxes.
Using the S&P 500 Composite Stock Price Index, the Dow Jones industrial average, and both a long-term and intermediate-term U.S government bond index, Zakamulin examined two technical trading rules: the simple moving average rule; and the momentum rule. Every technical trading rule invests in stocks/bonds when a “buy” signal is generated, and then moves to the risk-free asset when a “sell” signal is generated.
Perhaps the most interesting of Zakamulin’s findings was that these strategies failed most of the time. He defined failure as a period in which the riskless investment, Treasury bills, failed to deliver a higher return than did stocks during a “sell” period. He found that the average failure rate was about 80 percent.
This result demonstrates that, when the passive benchmark is a stock price index, the superior performance of the market-timing strategy is confined to some relatively short particular episodes. Thus, compared to a buy-and-hold strategy, market-timing investors frequently have to wait a very long time and experience painful emotions—referred to as tracking-error regret—because their active portfolios consistently lag the benchmark.