Beating Buy and Hold: A Thinking Man’s Guide to Market Timing

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.”

Demand-Driven Success

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.”

Timer Tendencies

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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