According to a 2013 study in The Journal of Financial Therapy, a whopping 93% of advisors suffered from post-traumatic stress disorder after the market crash of 2008. That should come as no surprise to the many RIAs who scrambled night and day to keep investors fully informed and invested during the global financial crisis. In spite of the best efforts of many professionals, there was a definite shift from equities to fixed income in the years that followed, based on International Monetary Fund data.
Some advisors managed to sidestep the enormous pullback in equity markets and were in cash for most of the crisis. They delivered the added benefit of big returns in 2009. This group uses a tactical approach, and in some cases, these managers are willing to go to cash in severe bear markets. The strategy is also known as market timing.
I must admit some personal skepticism on this subject. Investors have heard for ages that tactical strategies are a fool’s errand. But after interviewing a number of high-caliber timers, my skepticism has waned: The results speak for themselves.
Porter Landreth, an associated person with broker-dealer Girard Securities and a partner at Asset One LLC in Greenwood Village, Colorado, has been successfully navigating bond market trends for more than 30 years. He calls his methodology “slow motion fixed income sector rotation,” and primarily looks for high-quality price trends to develop before making an allocation. “But the trends must make sense fundamentally,” he said. “If we can’t figure out why a move is occurring, we’ll take a pass.”
Landreth didn’t always restrict the bulk of his activities to the bond market. “I actually started on the equity side, but discovered that the high volatility of stocks makes timing decisions difficult. More importantly, as the equity markets evolve, a given set of indicators goes from very accurate to ineffective in short order.”
According to Landreth, the fixed income markets—especially high-yield bonds—can add an important predictive element to asset allocation. “The high-yield sector typically peaks before stocks, and this tendency can be very valuable in determining a portfolio’s risk budget. For example, prior to the bursting of the tech bubble in 1999, high yield gave us a sell signal. This enabled us to sidestep a pretty ferocious bear market.”
The same type of signal occurred in 2007, Landreth recalled. “We were early in missing the 2008 crash, but thankfully high-yield bonds gave us a buy signal in early 2009. As a result, we were able to miss the big equity losses in ’08 and outpace the S&P 500 Index by about 500 basis points in 2009.”
The ability to avoid difficult periods can make a particularly big difference to investors nearing retirement. “Sustainable withdrawal rates are very sensitive to volatility and to the sequence of returns,” Landreth said. To the extent timing can address these issues, he said, “the strategy is well-suited to those nearing the end of their [working] careers.” Landreth’s emphasis on price trends to make investment decisions is typical for tactical advisors.
A simple price chart of the Merrill Lynch High Yield Master II index, which tracks the performance of below-investment-grade U.S. dollar-denominated corporate bonds, underscores the logic behind his approach (see Figure 1, above). During favorable economic periods, money flows into high-yield funds for the attractive income. Investors tend to exit such funds in volatile times in favor of more stable options. The money flows from this behavior can be captured graphically in this simple price chart. When overlaid with a simple moving average, clear buy and sell signals emerge.
These signals potentially enable portfolio managers to avoid troubling bear markets while capturing the bulk of bull markets.
Figure 1 shows a price chart for the Bank of America Merrill Lynch High Yield Master II Index versus a 100-day simple moving average. The S&P 500 Index is plotted for comparison.
When the price of the index crosses over the moving average, a “buy” signal is produced, and when the price dips below the average, a “sell” is generated.
If the trader were to follow this system, a return of 22.8% would be generated versus a 4.8% loss if one were to buy and hold the high-yield index. If a trader were to use the buy and sell signals to trade the S&P 500 Index, the loss would have been 7.9% versus a 35% buy-and hold loss.
From an execution standpoint, it is not possible to trade the Merrill index. As a result, advisors have traditionally used high-yield exchange-traded funds or open-ended mutual funds to express their views. But with high-yield bonds so much over par, Landreth has moved to other instruments. “Convertible bonds and Treasuries make up more of our core holdings now, but that could change if junk bonds come back to earth.”
Consistency Is Crucial
For Ralph Doudera, CEO of Virginia Beach-based Spectrum Financial Inc., market timing is a skill he has honed since he started trading for himself in the 1970s. He originally started trading proprietary capital using the Dick Fabian Telephone Switch Newsletter. At the time, Doudera was working for Connecticut General Life Insurance Company as an estate planner. His research led him to begin a money management career in 1983, and he became a fee-only advisor in 1988.
But it was the stock market crash of 1987 that really colored his view on active management. “I was using a strategy at the time that got us out of the market a few days before the October crash, but I had one client who insisted on a buy-and-hold approach. To see him lose so much money in such a short period of time was devastating to me.” After that experience, Doudera became more focused on identifying clients with more realistic objectives emphasizing risk management.
The roughly $190 million in assets controlled by Doudera are split fairly evenly among Spectrum’s separately managed accounts, the sub-advised Spectrum Low Volatility Fund, and Hundredfold Advisor’s two actively managed funds, including Hundredfold Select Alternatives (SFHYX), which is composed of 60% high-yield timing and 40% liquid alternatives. The fund boasts a 10-year track record and a four-star rating from Morningstar. True to form, based on Morningstar analytics, the fund has less than 60% of the volatility of other funds in its category, but with similar returns.
Doudera’s favorite Scripture citation from Proverbs—“Steady plodding brings prosperity, [while] hasty speculation brings poverty”—encapsulates his market views. “Based on my experience, the pain of losing money in the markets outpaces the pleasure of winning.” For an advisor who is as well-known for his significant philanthropic efforts as his eye-catching returns, that’s a good lesson to learn.
The Academic Approach
Some tactical managers do not restrict their activities to the fixed income markets. Jerry Wagner, president of Flexible Plan Investments, a $2 billion-plus advisor based in Bloomfield Hills, Michigan, has utilized a diverse set of assets during the firm’s 34-year history.
Wagner’s first taste of asset management occurred during his law school days at the University of Michigan, where he and two classmates started a hedge fund. “I had just read Ed Thorp’s ‘Beat the Market,’ which at the time was a seminal work. Thorp’s strategy of hedging with warrants (bonds were often issued with detachable warrants in those days) was a great arbitrage strategy, which worked well for years.” But after law school, Wagner decided on a career in tax and securities law, and the fund went by the wayside.
But the markets proved to be irresistible to Wagner and he continued with his personal research. “At the time, my wife and I would record stock prices and input them into programs using punch cards, and I started Flexible Plan in 1981.” Eventually the advisory firm grew to the point where Wagner gave up his law practice.
Flexible Plan’s business is as diverse as the assets managed. About half of the firm’s AUM lies in its Strategic Solutions wrap fee program, which was formed in 1998 so that independent advisors and reps could diversify client accounts by active strategies held in a single account, as opposed to a more traditional asset allocation approach. “One of the potential benefits of the platform is the avoidance of converging correlations in asset classes, since there are more opportunities for diversification across a spectrum of active strategy buckets.”
The other half of the firm’s assets are on differing platforms. Wagner employs wholesalers nationwide to market to the independent BD channel, offering Flexible Plan management in variable annuities and retirement plans such as 401(k) and 403(b) plans. Flexible Plan is also an independent sub-advisor to the Quantified family of mutual funds and The Gold Bullion Strategy Fund, the only mutual fund seeking to track the daily percentage change in the price of gold bullion, an asset class Wagner believes can offer significant diversification benefits.
Wagner’s academic bent is apparent when he discusses the markets, as is his emphasis on creating robust investment strategies. He has published several articles on the subject of tactical management, and created the NAAIM Wagner Award Competition, which offers $10,000 for the best original paper on the subject. Separately from Flexible Plan, he is the publisher of “Proactive Advisor Magazine,” a weekly e-zine devoted to advisors who use active management.
When asked about competing against the ever-popular passive approach, Wagner is unapologetically optimistic. “This is the golden age of tactical management,” he said. “Investors are much more open to the idea, especially after the bear markets of 2000-2002 and 2007-2008. Now that we are going into a potential rising rate environment, tactical management offers a viable defensive alternative to the passive fixed income asset class.”
Michael Price’s path to success as a tactical manager was hardly direct. During his 30-year career as a Navy pilot, his biggest concern was simply paying the bills. “But after a deployment, I made $30,000 on the sale of our house and for the first time, had money to put in the market,” he said. After a short and very unsuccessful stint trading options, Price was attracted to the Fidelity Select Funds, one of the first families of funds that allowed trading among various sector share classes. Price’s grubstake grew to about $200,000—an amazing feat he humbly said “occurred in a very friendly environment for stocks”—which gave him enough money to start his firm after retiring from the military in 1994.
Price originally created an investment newsletter with his buy and sell recommendations, which led to managing separate accounts. His first three clients were himself, his mother and his brother. “My willingness to put family money on the line really resonated with people,” said Price. He eventually created an RIA to keep up with the rising demand for his services. Price soon realized the challenge of trading similarly across a number of investment platforms, eventually deciding to pool capital into four in-house hedge funds in 2000. He also runs the OnTrack Core mutual fund (OTRFX). Today, Price manages about $510 million at Gulf Breeze, Florida-based Price Capital Management.
For such a charismatic personality, even his research efforts led to new money under management. “My initial foray in technical analysis utilized a program named FastTrack, which is still being used extensively by active investors. The owner of that company asked me to speak at product seminars from the perspective of the end user. I did 11 presentations throughout the U.S. in the mid-1990s, and many of the folks that attended eventually became clients of the firm.”
His methodology is mostly homegrown and best described as classic chart reading. Price is very eclectic in his asset selection, having gone from a value tilt in 2002 to small-cap growth-oriented during the bull market that followed. Like most active managers, his mandate is to cap losses as much as possible. “We were mostly flat during the 1999-2002 bear market and in 2008. Today, we have an increasingly large equity position, but we use futures as a hedge. We also own some municipal bonds, but we’re not huge fans of high yield due to lofty valuations.”
Price is cautiously optimistic about the market currently. “Conditions don’t seem tremendously favorable at present, mainly due to valuations. We’ve seen an increase in volatility over the last seven or eight months and think that will continue. The bull market is not over in our opinion, but it will roll over eventually. The key is to be ready when that occurs.”
Successful tactical managers have a few differences. While Spectrum’s Doudera prefers to traffic in high-yield bonds due to the asset class’ tendency to call market turns, Flex Plan’s Wagner and Price Capital’s Price tend to run a more diverse portfolio. Asset One’s Landreth, on the other hand, likes to concentrate on the most promising asset classes and uses a fundamental filter to ensure that technically based signals that don’t make sense are rejected. But it is the common elements of timers that are especially noteworthy.
The near-universal acceptance of momentum-based strategies among this group is an important point of agreement. The tendency of securities to perform better after periods of outperformance has been noted in numerous academic studies, including the more recent factor models of Eugene Fama and Ken French. Trend-based strategies have also been more widely researched recently, and it has been shown in some work that timing models using such inputs are more effective than fundamentally based methodologies.
Another significant common element of these managers is their insistence on avoiding tough market periods. The mathematics of drawdown supports this view (see Figure 2, above).
The equities markets generate positive returns on average, over long periods of time, but in the short run, a severe bear market can have a devastating impact on those nearing (or already in) retirement. In 2008, even the most diversified portfolios suffered as correlations converged and markets sank. After all, the most important element of asset management is matching client needs to the amount of risk taken. If a client doesn’t need the return of the S&P 500 Index, an indexed approach may not be ideal.
Of course, there are downsides to tactical approaches. Most buy-and-hold portfolios will over time outpace the returns of a timer, albeit with higher volatility. There are also tax considerations in a tactical portfolio, and fees for such an account are usually higher than for a more traditional portfolio. But tactical managers are quick to point out that most clients who favor this approach would be more heavily invested in income-oriented portfolios that are taxed at ordinary income tax rates.
With so many differences separating a traditional portfolio with a more active approach, all of the advisors agreed that an important factor for success was choosing the right clients. “Our firm is perfectly suited for investors with modest and realistic return expectations,” said Spectrum’s Doudera. “We have averaged double digit returns over the past 25 years. That means we have doubled clients’ money every seven years on average, and outperformed the stock market with much lower risk. We want to get rich slowly without subjecting our clients to large drawdowns, which will happen by investing in stocks in a buy-and-hold tradition. If they want volatility and the possibility of large short-term gains, they should go elsewhere.”
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