Tactical Asset Allocation Backtest Part 3: Short-Term Vs Long-Term

Published: July 12, 2018 at 9:26 am

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In the third part on the series on tactical asset allocation techniques based on market timing, we evaluate the Market PE and Ten-month moving average methods over five-year vs ten-year periods and also change the equity allocation in the portfolio from 30% to 50% to 70%. In addition, we also use the method followed by Franklin Dynamic PE fund of funds.  This time we also use Franklin India Blue Chip Fund for the Equity component and Franklin India Dynamic Accrual Fund (Templeton India Income Fund) for the debt component.

Warning and Disclaimer

The following is to be treated as investment research based on past data unrepresentative of practical implementation and is not investment advice. They do not factor in behavioural/emotional aspects associated with investing. If you do not know how to understand a backtest result, evaluate its disadvantages, then please, please DO NOT play with your money using market timing.  Please watch this video before proceeding further.

What is meant by tactical asset allocation (TAA)?

Asset allocation is the ratio of much equity, fixed income, gold, cash etc. is present in a portfolio. We will only consider equity and fixed income in this study. Tactical asset allocation (TAA) refers to changing these allocations based on certain factors or indicators.

What is market timing?

It is a technique to reduce portfolio risk and/or enhance portfolio returns by changing asset allocation based on our reading of where the market will head in the near future. This can be the stock market, bond market, gold market etc.

Is tactical asset allocation necessary?

Yes, as the risk associated with a portfolio must be systematically reduced or contained to ensure we have enough money for our future needs.

Is market timing necessary?

No. Tactical asset allocation is necessary and one need not resort to market timing to do this. TAA is possible based on a target corpus associated with a financial goal. See:

Part 1 How to reduce risk in an investment portfolio

Part 2 Do we need to time the market?

Part 3 Why we need to gradually pull out of equity investments well before we need the money!

Can we time the market?

Yes. However, realistic and reproducible market timing methods have often primarily reduced risk with or without return enhancement. See results here: Want to time the market with Nifty PE? Learn from Franklin Dynamic PE Fund and here: Is it possible to time the market?

To summarise, Can we time the market? Yes, we can. Do we need to time the market, No, there is no need to. If you do not understand this difference, please do not proceed further.

Rules of Market Timing with Index PE Ratio

Please refer to: Market Timing with Index PE Ratio: Tactical Asset Allocation Backtest Part 1

Rules of Market Timing with Ten-month Moving average

Kindly note that for you to understand these results, you will have to read the above two parts

We will compare two portfolios over a 5-year and 10-year investment period.

1: systematic investing into a portfolio of

(a) 30% equity and 70% fixed income -> 30:70 (over 5Y only)

(c) 50% equity and 50% fixed income -> 50:50 (5Y,10Y)

(a) 70% equity and 30% fixed income -> 70:50 (5Y,10Y)

Equity here refers to Franklin India Blue Chip Fund

Debt here refers to Franklin India Dynamic Accrual Fund.

A total amount of Rs. 1000 will be invested into the portfolio in the above-mentioned asset allocation. The portfolio will be rebalanced once a year. To account for exit loads and tax associated with this, the final portfolio amount will be reduced by 4%.

2: Tactical investing with the rules detailed in parts 1 and 2.  The final tactical portfolio is reduced by 20% (this is 5 times the amount assumed for the systematic portfolio as the average no of trades in 10Y is about 5). This 20% accounts for exit loads of equity and fixed income and tax associated with equity. Remember equity was taxed like a debt fund before 2004 and will be again taxed from the current FY.

1 PE-Timing: 5-years and 50% Equity and 50% debt

Top Left: The XIRR or returns are compared. Higher the better!

Top Right: The maximum fall of the portfolio from a peak is compared. The vertical axis is negative. So lower the value, the more the fall, the more the risk.

Bottom left: Standard deviation or how much the monthly returns fluctuate is compared. Higher the value, the higher the fluctuation, the higher the risk.

Bottom right: The no of months, the portfolio was continuously lower than a previous peak (underwater) is compared. Higher the no of months, higher the risk.

Notice PE method has done better in terms of returns only for about half the no of times (196 5Y periods were considered)

2 PE-Timing: 10-years and 50% Equity and 50% debt

Over the long-term, the PE-based portfolio remains underwater for shorter periods of time, but the reward is not high often. A total of 136 10Y periods were considered.

3 PE-Timing: 5-years and 70% Equity and 30% debt

This is a comparison of the PE-timing strategy vs a high-risk systematic strategy over 5Y.  I am surprised that the PE method still has higher risk and not always a higher reward

4 PE-Timing: 10-years and 70% Equity and 30% debt

A 70% equity strategy over 10Y has a risk comparable to the PE model. The main advantage of the PE model seems to be the recovery time. The portfolio falls but does not stay lower than the peak for long (compared to the systematic method).

I have said it before and I say it again: Time the market because you desire lower risk and not because you desire a higher return. The former is much more probable than the latter.

5 PE-Timing: 5-years and 30% Equity and 70% debt

This is a comparison between a conservative systematic approach (only 30% equity) and the PE-method. It is clear that the systematic approach is better.

Overall impression: There seems to be no great benefit in adopting the PE-timing model over 5 years. Over 10Y, the no of months the portfolio is “down” is lower with timing but this does not guarantee higher returns. Now let us move on to the ten moth moving average.

6 Ten-month moving average: 5-years and 50% Equity and 50% debt

7 Ten-month moving average: 10-years and 50% Equity and 50% debt

The 10MMA model appears to be riskier than the PE-model. The no of months the 10mma model is “underwater” is higher.

8 Ten-month moving average: 5-years and 70% Equity and 30% debt

9 Ten-month moving average: 10-years and 70% Equity and 30% debt

Again the 10MMA does not seem as impressive as the systematic approach.

10 Ten-month moving average: 5-years and 30% Equity and 70% debt

Over 5 years, if you simply held lower (30%) equity, you could have got the job done instead of timing!

We then consider a method identical to the one used by Franklin Dynamic PE Fund of Funds. This is the PE model used:

Franklin Dynamic PE Fund of Fund Investment stategy

For more details see: Want to time the market with Nifty PE? Learn from Franklin Dynamic PE FundQuite clearly this is a lot of work and involves about 4-5 buy/sell transactions (of the existing holding) per year.

11 Franklin Dynamic PE: 5-years and 50% Equity and 50% debt

12 Franklin Dynamic PE: 10-years and 50% Equity and 50% debt

13 Franklin Dynamic PE: 5-years and 70% Equity and 30% debt

14 Franklin Dynamic PE:10-years and 70% Equity and 30% debt

15 Franklin Dynamic PE: 5-years and 30% Equity and 70% debt

Overall impression: The Franklin Dynamic PE model does lower risk (months underwater) but the returns are more uniformly subdued. This is actually better in terms of investor expectations. It appears to fall in the lower-risk and lower return category, while the others are clearly, higher-risk with potential higher-reward.

If you actually bothered to look at all the graphs and have come up to this point, then I thank you. Reactions from readers to this series have been on expected lines. Many of them prefer to “buy more” based on market timing and not sell existing holdings. That is what we will be backtesting in the next segment.

I think this attitude stems from the impression that buying and selling involve more effort. Actually one of the most important results for me is that over a period of 10Y, the no of buy/sell transactions for the 10MMA and PE-method are only 5-6, which is fantastic. Over 5Y, the number is only about 2-3. The taxes and loads would be minimised. The FT Dynamic PE is an exception but that is as expected.

A higher-risk, higher-reward option with less than 1 transaction per year on average is simply fantastic! Yet readers seem to think it is too much work and prefer only to “buy on dips”! Hmm, plenty of behavioural insights there!

That is the next step in the series: (1) test a buying only model then move on (2) quarterly check on PE and 10MMA instead of monthly, then (3) use yield gap for timing (4) double moving averages and more as we search for the holy grail: Can we consistently lower risk and consistently (to within reason) enhance return?  If you have any suggestions for the backtest, let me know.

Let me end with a question: If you are someone who thinks buying and selling existing holdings is a pain and thinks “buying on dips” is better, how many times have you rebalanced your portfolio? My answer: I rebalance (without timing) 1-2 times a year – this is a lot more then the timing backtest!!

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About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
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