Tactical Allocator (Introduction)

Introduction:
Because of my profession, I am often asked for investment advice in casual circumstances.  This is difficult for me because the advice I give today (what I think are good investments today) may change quite a bit within a few months.  So while my advice may be good today, it may not be a great long term strategy.

If you are looking for a buy and hold strategy in which to put your money and forget about it, I would suggest buying something that is very diversified by asset class and rebalancing once every couple of years.  My "equal weighted" portfolio would be one such option.

But, if you believe, as I do, that it makes sense to take on more risk in certain environments and less risk in others then this blog may be helpful to you.  Below I highlight my investment philosophy and in the dated blogs I share the trades and ideas for three different portfolio strategies as well as how they have performed since the beginning of my blog.

To be completely transparent, The information I am showing is not for an actual account but rather a hypothetical account that trades on these ideas, however these ideas and theme's are very prevalent in my personal portfolios.  Where they differ, it is because much of my money is in a retirement account with limited fund options (I follow the Enhanced portfolio as close as I can in that account) or because I do some trading of individual companies.  Either way, the asset class exposures are the same. I am just using other instruments in addition to the ones presented in the blog.

I hope the information in this blog will be as beneficial to you as it has been for me.

Asset Allocation:
Asset Allocation is the process of deciding where to invest your money. There are many investment options ranging from very conservative investments (and typically low returning) like cash and short term bonds, to very risky investments (which are often high returning, but also at times have large negative returns) like small cap equity or currencies. You can be either strategic or tactical about your allocations. Strategic means that you pick an allocation and stick with it, never changing it. Strategic allocations typically hold many or all the asset classes to one degree or another. Tactical means you change your allocation base on market conditions, at one point you may have a lot of equity (lots of risk) and at another time you may have lots of debt (lower risk). By the name of my blog I bet you can guess which one I prefer.

From a very high level, I view the world as offering three investment worthy asset class's 1) Equity - ownership of a company (common stock) which gives you the rights to the cash flows the company generates 2) Debt - lending money to a person or company with the expectation of getting your money back plus some interest, usually (bonds, cash) 3) Assets - Buying a thing that you expect will increase in value (commodities, real estate, art).

There are sub asset classes within these. For example you can own US equities (all US based companies) or International equities (all non-US based companies) or Global equities (all companies). Within debt you have the same regional segregations as well as quality segregations. Investment Grade debt is high quality while High Yield debt is more likely to default (but pays higher interest rates to compensate). Within assets you have commodities (oil, metals, agriculture), real estate (commercial and residential), and infrastructure. It can all get a bit confusing so I like to stay focused on the top three. For retail investors, it is difficult to invest in assets directly so I actually focus on equity and debt in my investment models. If you own a home, you have a pretty good amount of asset exposure there.

When it comes to investment returns, asset allocation is the single most important investment decision. Unfortunately most people are horrible at it. Fear and greed are two difficult emotions that push us, as people, into making very poor allocation timing decisions. If you get it wrong it can be devastating to your portfolio. Many have therefore decided to strategically allocate and focus on adding value through security selection.

My experience tells me that this is leaving a huge amount of potential returns on the table. Below is a return quilt looking at the four asset classes I will allocate between:

1. Large Cap Equity (The largest 1000 US companies)
2. Small Cap Equity (2000 small US companies)
3. High Yield Debt (Low quality, US dollar based debt that pays high interest)
4. Investment Grade Debt (High quality, US dollar based debt that pays low interest) 

Each has a different color and they are ordered with the top performing asset class for each year at the top and the bottom performing at the bottom. The point of the quilt is to show that the best performing asset class varies widely from year to year and the difference in returns is also very large (51% difference between top and bottom in 2009, 43% difference in 2008, 39% difference in 2013).

2006	2007	2008	2009	2010	2011	2012	2013	2014	2015	2016
17% SC Equity	6.98% Inv Grd	4.53% Inv Grd	57.51% High Yield	25.31% SC Equity	7.81% Inv Grd	15.59% High Yield	37.01% SC Equity	10.45% LC Equity	0.6% Inv Grd	19.49% SC Equity
13.65% LC Equity	3.29% LC Equity	-26.39% High Yield	25.44% LC Equity	15.21% High Yield	4.39% High Yield	14.65% SC Equity	30.95% LC Equity	6.29% Inv Grd	-1.47% LC Equity	17.51% High Yield
11.79% High Yield	2.17% High Yield	-34.79% SC Equity	25.22% SC Equity	14.75% LC Equity	-0.92% LC Equity	13.98% LC Equity	7.43% High Yield	3.54% SC Equity	-4.64% High Yield	10.42% LC Equity
4.38% Inv Grd	-2.76% SC Equity	-38.7% LC Equity	6.14% Inv Grd	6.82% Inv Grd	-5.45% SC Equity	4.53% Inv Grd	-2.25% Inv Grd	2.5% High Yield	-5.73% SC Equity	2.61% Inv Grd

The Model:
I seek to take advantage of these different returns by focusing on market dynamics (economic indicators) that have historically given good information as to which asset class (on average) will perform the best over the next 12 months. I then put 1/12th of my portfolio into that asset class. Each month I roll over the bet made one year previous into a new bet, thus creating a monthly ladder of one year investments.

This process has generated impressive returns over the last twelve years that I have been using it, and has worked in a similar manner in my backtests (which go back 30 years).  The movie (below) shows how the allocations have changed over time (for the past 30 years). You will notice that the allocation is very aggressive, often being 100% in only one of the four asset classes.

I do not include assets in my mix because I own a home and view that as a large part of my investment portfolio, it is very illiquid and is highly levered.  I do not often want to take additional exposure in that asset class.

In Addition:  
On top of allocating to the best asset class, I will give occasional thoughts on things you might do within an asset class to improve your average returns relative to the benchmark.

I will show three portfolios in the blog, an "Equal Weighted Portfolio" that is static and equal weighted (my view of the best buy-and-hold option for those of you not wanting to do something with your portfolio every month), a "Tactical Allocation (TA) Porfolio" that only invests in the same securities as the Equal Weighted Portfolio but with very different and monthly changing exposures and an "Enhanced Portfolio" that will follow the allocation of the TA Portfolio but include my insights with ways to enhance the returns using securities different from those in the Equal Weighted Portfolio.

I will monitor and compare the performance of each portfolio over time and will take into account transactions costs (assume $7 per trade). My simulated portfolio's will use $100,000 as a beginning value.

History:
Looking back, my strategy has performed very well.  I went back to September 1986 because that is the furthest I could go back and have all the necessary indicators. I personally started using this model in 2004 so there is more than 10 years of actual use. The rest is back filled as though I had been using it.

The results have been fairly consistent and very strong. The strategy on average has outperformed in 2 out of 3 months and has outperformed by 0.4% per month.  In looking at annual returns the tactical allocation has underperformed in 4 years while it has outperformed in 26.  If you had invested $100 in this strategy, with no trading costs, from September 1986 to April 2017 you would now have $3886.  Investing in the best performing asset class over that time frame (High Yield Debt) would have given you $1221. An equal mix of the asset classes would have given you $1046.

This is a huge improvement but it is nowhere close to perfect (so do not expect perfection). A perfect foresight model (investing 100% in the best asset class each month) would have given you $12,569,561.  I tell you that so you will be patient in bad periods and to help highlight the huge potential of tactical allocation, even if you can only improve upon a static allocation by a small amount.

Beginning Allocation:
The beginning allocation will have 50% in Large Cap Equity (I use a Russell 1000 ETF, ticker VONE, to get this cheaply) and 50% in Small Cap Equity (I use a Russell 2000 ETF, ticker VTWO, to get this cheaply).

My personal enhancements will be to substitute active international equity (ticker DSEUX) for large cap and emerging market equity (ticker IEMG) for small cap equity. From a valuation standpoint international equity markets seem to be a better value to me at this point, however the model just looks at US equities.

Please follow me and watch as the strategy unfolds.

For More Details:

For a deeper look check out Diversification: Myths and Mastery blog, for ideas on how to implement (trade) the strategy see the Technical Stuff blog and for a statistical analysis of the past results (some actual and some backtested) see the Into The Weeds blog.

Other than that I post what I am going to do at month end and the following business day I post what my trades actually were and give a performance update.

Past performance is not a guarantee of future performance.  This strategy is presented for informational purposes only and is not a solicitation to buy or sell any securities. October is one of the peculiarly dangerous months to speculate in stocks in.  The others are July, January, September, April, November, May , March, June, December, August and February. ~ Mark Twain