One approach to a simple rules-based, mechanical system to manage opportunity and potentially minimize maximum drawdown in Bear markets is to use relative momentum between each strategic asset and a risk-free asset (T-Bills) as an alternative — all-in or all-out of each strategic asset based on its return versus the return of T-Bills.Bear market.

The shorter the evaluation period, the smaller the maximum drawdown exposure — but the greater the trade frequency which is not tax efficient in a regular taxable account, and the more frequent the whipsaw (sort of a head-fake by the market requiring reversal of the position with positive loss or opportunity cost).

The longer the evaluation period, the larger the maximum drawdown exposure — but the lower the trade frequency, which is more tax efficient in regular taxable account, and the less frequent and potentially less costly the whipsaw.

Ways to attempt the avoid the worst of each evaluation period length while attempting to capture some of the best of the each evaluation period may be to use an average of shorter and longer periods, or to step into and out of strategic positions in phases by using more than one evaluation period length.

Relative Performance Rotation With the Swensen Portfolio:

Let’s look at an example, using the Swensen Reference Portolio as a base case with 2018-08-23 data.

Swensen is the CIO of the Yale Endowment, who proposed his “Reference Portfolio” as something from which to depart for a personally suitable portfolio in his book, “Unconventional Successs: a Fundamental Approach to Personal Investment”. He did not recommend momentum rotation in that book.

The Swensen portfolio is 70% OWN, 30% LOAN and 0% RESERVE.

This table shows the Swensen portolio as the default allocation, and to the right of that are four alternative allocations based on whether the strategic risk asset has outperformed risk-free cash over a 3, 6, or 12 months rating period, or the average of those periods. Where the risk asset did not outperform, cash is held in lieu of the asset.

(click images to enlarge)

Pink shaded cells indicate that the strategic risk asset is not held and instead the money for that slot is held in Reserve in risk-free T-Bills.

The tables on the left show the total return of each asset over each evaluation period and the excess return. The excess return is the total return minus the return of the risk-free asset (T-Bills) for the same period.

For equities (OWN), the relative momentum method suggests not owning the emerging markets fund at this time, and only owning the non-US developed markets fund if using the 12-month evaluation period.Total US stocks and US REITs have positive excess return for all periods and would be held at the full strategic allocation level.

For debt (LOAN), the relative momentum method suggests intermediate-term Treasuries should not be owned if using the 12-month evaluation period.Short-term TIPS are OK for all the periods.

You can operate portfolios, with any chosen set of risk assets using relative momentum as illustrated here. Such portfolios can be rebalanced at intervals ranging from monthly, quarterly, semi-annually to annually.

The longer rating periods may lag too much, and the shorter periods may be prone to whipsaw losses or opportunity cost. The method is intended to capture the bulk of major up trends and to avoid the bulk of major down trends.

This is not a panacea approach, and may or may not improve returns, but probably can limit maximum drawdowns associated with Bear markets without relying on the variable quality of judgement (assuming as is typically the case that market tops are a process of rolling over; not a steep, sudden drop).

Staged In-and-Out Approach:

Let’s say, you were using a staged in-and-out approach to each strategic asset based on three steps governed by the 3-month, 6-month and 12-month relative returns.

• VTI would be 30% (all-in)
• VEA would be 10% (1/3 out)
• VWO would be 0% (all-out)
• VNQ would be 15% (all-in)
• VGIT would be 10% (1/3 out)
• VTIP would be 15% (all-in)
• CASH would be 20% (residual not in strategic assets).

Critical Note:

This simple relative momentum investing does not include consideration of the fundamental condition, fundamental prospects for or valuation of the assets used and being rotated. That is a key weakness and risk factor associated with this approach unless the assets are pre-selected based on fundamentals and/or valuation. Presumably, the strategic assets and their allocation weights would have been chosen for a good long-term fundamental, non-technical reasons.This method is meant merely to modulate exposure to each strategic asset based on performance relative to a risk-free asset (T-Bills).

Building More Complexity:

The approach can become progressively more complex and granular. For example, a portfolio may have a tactical sleeve that involves less diversified assets, that may be higher opportunity/risk or that are expected to exhibit particularly favorable momentum over shorter periods of time.

Such a sleeve might be for the top momentum sector funds, or top country funds, or top ETFs of any type, or top momentum individual stocks, or the top security from a custom list.

In the example below, we created a tactical sleeve that would invest in the top 2 momentum sectors among the 10 Vanguard US large-cap/mid-cap sector funds, and also invest in the top momentum stock among the 5 FAANG stocks [Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), Google (GOOG)].

In addition, just to make it yet more complex, the default strategic assets are considered for substitution with a related alternative. In this case we use these alternatives:

• default S&P 500 (SPY), alternatives S&P 500 pure growth (RPG) and S&P 500 pure value RPV)
• default total US stocks (VTI), alternatives S&P 100 (OEF) and Russell 2000 (IWM)
• default total international stocks (VXUS), alternatives DM markets (VEA) and EM markets (VWO)
• default US REITs (VNQ), alternativeinternational real estate (VNQI)
• default US high dividend (VYM), alternative international high yield (VYMI)
• default short-term Treasuries (VGSH), alternatives short-term investment-grade corporate bonds (VCSH), ultra-short-term, investment-grade, floating-rate debt (FLOT)
• default intermediate-term Treasuries (VGIT), alternative intermediate-term corporate investment-grade corporate bonds (VCIT)
• default long-term Treasuries (VGLT), alternative long-term investment-grade corporate bonds (VCLT)
• default short-term TIPS (VTIP), alternative long-term TIPS (TIP).

Note: This is not a recommendation for a portfolio, merely an illustration of how complexity can be increased.

It is probably obvious that as the number of portfolio slots increases, and the number of securities considered for each slot increases, the decision process moves from one of paper and pencil to one requiring a database return download source and some coding in an Excel spreadsheet – unless you want to drive yourself a little bit crazy.