We have explored in our previous papers various methods for tactically adjusting asset allocation. Our macro approach, using the yield curve and credit spreads, was predicated on using market-based indicators to adjust allocation in advance of recession and recovery.
This paper will concentrate on using momentum to adjust asset allocation. In theory, assuming markets discount future events to some degree, bonds should start to outperform stocks before the onset of recession. Rather than try to predict when a recession will arrive, the momentum approach to asset allocation simply allows the market to make the asset allocation decision. Assuming bonds continue to act as a hedge versus stock market losses in recession, this method offers promising results.
The portfolio was constructed using publicly traded ETFs representing various asset classes:
The portfolio was rebalanced on a monthly basis to hold the 4 ETFs with the highest 3-month trailing return. For the period 2003 to 2006, only SPY, EFA, IWM, IYR, SHY, IEF, TLT and LQD were used. For the year 2007 and after, IAU was added as a potential holding. For 2008 and after, RWX, TLH and IEI were added and from 2009 on, HYG, SCZ were added.
The back-test of this tactical portfolio approach confirms our belief that markets anticipate – or indeed may cause – changes in the economy. As the economy approaches recession, bonds start to outperform stocks and other risky assets. The momentum approach, therefore, shifts the asset allocation to bonds ahead of recession and shifts back to risk assets as the economy exits recession.
While the portfolio statistics are benign, we believe this is a fairly aggressive approach to portfolio management as it requires holding just 4 positions, each worth 25% of the portfolio value. If the approach of recession is gradual as it has been in the past, this may not represent a problem. However, if the recession is the result of an unexpected shock, the portfolio might not adjust quickly enough to avoid a large drawdown. For that reason, we generally recommend that the Pathfinder Portfolios be used as a supplement to a more moderate portfolio approach such as our Alhambra Portfolio.