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.