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Tactical Asset Allocation: Beware Of Geeks Bearing Formulas

By Wesley R. Gray, Ph.D. How Should I Tactically Allocate my Assets? A lot of investors ask this question as their wealth grows and the number of financial products grows exponentially. In order to generate a response, investors pay money to professional finance geeks who often present complex formulas as a solution to the asset allocation problem. Last year, when I was asked to present a seminar on the subject at the Morningstar ETF conference , I developed a tongue-in-cheek title for it: ” Beware of Geeks Bearing Formulas .” In this short research piece, we explore this seminar in detail. Our goal as evidence-based investors, and not story-based investors, is to set the record straight on the value of complexity in the context of asset allocation. Bottom line: simple seems to be better. Defining Tactical Asset Allocation (TAA) What exactly is tactical asset allocation? I like to work backward to forward, since it helps to build the concept. Allocation (A) : Our baseline, or static allocation to assets in our universe. E.g., 50% stocks, 50% bonds, rebalanced annually. Asset (A) : Financial assets that can be traded with reasonable liquidity. A key component of being “tactical” is being liquid, which implies that hedge funds, private equity, and other asset classes with limited liquidity rights should be avoided in the context of “tactical” asset allocation. E.g. Stocks, bonds, commodities, alternatives (if liquid). Tactical (T) : Changing our baseline allocation based on some tactical rules. E.g., 50% stocks, 50% bonds -> 30% stocks, 70% bonds based on a market valuation signal . So there you have it, tactical asset allocation is tactically investing in liquid assets in order to beat a static benchmark allocation. Basic Asset Classes: There is an old investor adage that you shouldn’t put all of your eggs in one basket. For my classes, I dive into correlation mathematics to prove this point (see below), but the conceptual benefit of diversification is grounded in common sense. (click to enlarge) But how do we identify the eggs that go into our diversification basket? Meb Faber highlights in his Ivy Portfolio book, and reemphasizes in his new book Global Asset Allocation , that you don’t need to get fancy when it comes to asset class selection. One can capture the big muscle movements of the world by simply allocating across 5 asset classes: Domestic Equity = S&P 500 Total Return Index International Equity = MSCI EAFE Total Return Index Real Estate = FTSE NAREIT All Equity REITS Total Return Index Commodities = GSCI Index Fixed Income = Merrill Lynch 7-10 year Government Bond Index (click to enlarge) We label the return series as follows throughout the analysis: S&P 500 = S&P 500 Total Return Index EAFE = MSCI EAFE Total Return Index REIT = FTSE NAREIT All Equity REITS Total Return Index GSCI = GSCI Index LTR = Merrill Lynch 7-10 year Government Bond Index Common Asset Allocation Techniques We discuss five common asset allocation techniques that are commonly utilized in one form or the other by academics and/or practitioners. 1. Tangency Portfolio/ Max Sharpe Portfolio Modern portfolio theory, inspired by Markowitz ‘s work on mean-variance-analysis in the early 1950s, identified the optimal trade-off between risk and reward for a portfolio. Of course, the underlying assumptions serving as the foundation for this so-called “optimal” algorithm stretch the imagination, but the intellectual construct and concepts are rock solid. The punchline from modern portfolio theory is the so-called “tangency portfolio.” This portfolio is identified by the “x” with a vertical line through it and sits on the CAL (capital allocation line). For those of you who haven’t taken an investment management course in a while, the CAL represents all combinations of risk-free rate and the tangency portfolio. These are “optimal” portfolios because there is no possible way to achieve a higher risk/reward. The optimal allocation weights for a 100% risk investor (i.e., no allocation to risk-free bonds) are the tangency portfolio weights. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. 2. Minimum Variance Portfolio Many readers are probably familiar with minimum variance portfolios. As the name implies, minimum variance portfolio weights are identified such that the portfolio’s expected variance is minimized. We can’t get too excited over the minimum variance portfolio – being low variance doesn’t necessarily mean something is a good investment. We need to consider expected return. In a modern portfolio theory context, the minimum variance portfolio (represented by the diamond below) is actually sub-optimal and should never be used. Instead, an investor can simply hold a small portion in risk-free bonds and the tangency portfolio to achieve a result with the same risk, but higher return. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Interestingly, even though there is no theoretical basis for its use, the minimum variance algorithm is often used in practice… 3. Risk Parity Portfolio Risk parity has been widely advocated recently, partly due to the success of the strategy’s largest proponent – Bridgewater Associates, LP. The basic concept behind risk parity is to equalize risk allocations across asset classes. For example, consider a traditional 60/40 stock/bond portfolio allocation. The “problem” with this allocation is that a large portion of the portfolio’s risk is driven by the stock allocation. Let’s say 90 percent of the risk is driven by the 60 percent allocation to stocks, and only 10 percent of portfolio’s risk is driven by the 40 percent allocation to bonds. Risk parity argues that we should allocate to stocks and bonds such that 50 percent of the portfolio’s risk is driven by the stock allocation and 50 percent is driven by the bond allocation. For example purposes, let’s say that a 50/50 risk contribution implies an 80 percent allocation to bonds and a 20 percent allocation to stocks. The figures below attempt to explain this via illustrations. Also, here’s a post that explains risk parity logistics. 4. Momentum Portfolio Momentum strategies overweight assets that have relative strength over the mid-term (e.g., 1 year) and underweight assets that have performed relatively poorly over the mid-term. This basic concept has been applied across asset classes, asset sectors, and on individual securities. As an example, the chart below shows the invested growth of high momentum portfolios and low momentum portfolios back to 1927. The data is from the French library . The historical performance of momentum strategies speaks for itself. In an asset allocation context, a momentum strategy will allocate more to relatively strong performing assets and relatively less to poor performing assets. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. 5. Simple Trend-Following Portfolios Simple moving averages represent a classic trend following strategy. The rule is simple: If the market is above the 200-day moving average rule, hold, otherwise go to cash. Wharton Professor Jeremy Siegel found that this simple technical rule outperforms a buy-and-hold approach, both in absolute terms and on a risk-adjusted basis. In general, while efforts to time the market should be viewed with skepticism, certain systematic timing strategies that have been explored in academia appear to reduce risk, without significantly impacting long-run returns. In particular, the application of simple moving average rules has been demonstrated to protect investors from large market drawdowns, which is defined as the peak-to-trough decline experienced by an investor. Siegel, in his book, “Stocks for the Long Run,” explores the effect on performance on the Dow Jones Industrial Average from 1886 to 2006, when applying a 200-day moving average rule. (click to enlarge) Red circles highlight episodes where the current market price breaks the 12-month moving average. The results are applied on the S&P 500. The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Performance of Common Techniques Let’s run a horse race on the various asset allocation strategies described above. The back test period is from 1/1979 to 12/2013. Our core 5 assets are: S&P 500 = S&P 500 Total Return Index EAFE = MSCI EAFE Total Return Index REIT = FTSE NAREIT All Equity REITS Total Return Index GSCI = GSCI Index LTR = Merrill Lynch 7-10 year Government Bond Index (prior to 6/1982, Amit Goyal Data) Our back test asset allocation strategies are: RISK_PARITY = Risk parity on core 5 asset classes, 3-year rolling windows MOM_TAA = Relative momentum on core 5 asset classes, calculated using 12-month momentum MAX_SHARPE = Tangency portfolio weights on core 5 asset classes, 3-year rolling windows (weights constrained [-1,1]) MIN_VAR = Minimum variance portfolio weights on core 5 asset classes, 3-year rolling windows EW_INDEX = Equal-weight, monthly rebalanced across core 5 asset classes EW_INDEX_MA = Equal-weight, monthly rebalanced across core 5 asset classes, with 12-month moving average rule RANDOM = ¼ random chance of moving to risk-free rate, monthly rebalanced across core 5 asset classes Results are gross of management fee and transaction costs and for illustrative purposes only. These are simulated performance results and do not reflect the returns an investor would actually achieve. All returns are total returns and include the reinvestment of distributions (e.g., dividends). Max Sharpe weights are constrained between -1 and 1. Data is from Bloomberg and publicly available sources. Summary Statistics: Benchmarks (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Over the time period, the S&P 500 and 10-Year bond exposures perform the best. It is no wonder that a 60/40 portfolio is so popular these days-the strategy cherry picks the best performing assets over the past 30+ years. Summary Statistics: Asset Allocation with Core 5 The EW_INDEX strategy and the RANDOM strategies serve as benchmarks for the tactical asset allocation models (their construction is outlined above). The results can be summarized as follows: The tangency portfolio, or “max-sharpe” method perform the worst and cannot even compete with the benchmarks. Minimum variance beats the tangency portfolio, which is ironic, given the theoretical underpinnings for the tangency portfolio. Nonetheless, the strategy, while risk-managed, does poorly on upside returns, underperforming the simply 10-Year bond CAGR. The risk parity methodology performs admirably, with strong risk-adjusted statistics and strong drawdown containment. Momentum also performs admirably, with the highest CAGR, however, the strategy has to contend with large drawdowns. The EW index with trend-following performs the best, capturing much of the upside, but preventing large drawdowns. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Overall, risk parity, momentum and EW w/ MA look like the top performers. Summary Statistics: Asset Allocation with Core 4 As a robustness test, we run all our tests for all tactical asset allocation models with and without 10-Year Treasury Bond exposure. We do these tests because the 10-Year has been on an epic tear over the past 30 years, which makes it challenging to ascertain whether a tactical strategy is lucky or good when a system chooses a large position in Treasury Bonds. If a tactical system is robust it should work on 2 assets, 4 assets, 5 assets, or 50 assets. Again, similar to the last table, we present the summary statistics for the EW_INDEX and RANDOM, which serve as benchmark performance guidelines when fixed-income is not included as an asset class. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. The results can be summarized as follows: Risk parity completely blows up and no longer works. Clearly, the results associated with risk parity are dependent on 10-Year Treasury exposure. Minimum variance and tangency portfolios do not beat the benchmarks. Momentum squeaks out a small gain on a risk-adjusted basis relative to the benchmarks, but the edge is much lower. The EW index with trend-following performs the best, capturing much of the upside, but preventing large drawdowns. We highlight the drawdowns associated with the top-performing asset allocation systems, but exclude 10 years as an allocation choice. The only system that provides robust drawdown protection is the trend-following system. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. So Trend-Following looks to be the winner – Time To Go All-In? Based on the results over the past 30+ years, trend-following looks to be the most effective and the most robust form of tactical asset allocation… But how has the trend-following system performed since the 2008 financial crisis? Well, in a word, terribly. The chart below highlights the performance path of the EW buy & hold strategy versus the EW w/ trend-following index. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Conclusion There is no panacea when it comes to tactical asset allocation. The evidence seems to suggest that trend-following rules are the most effective and the most robust, but as the recent 5-year run highlights, NOTHING WORKS ALL THE TIME. Original Post

Dividend Growth Stock Overview: WGL Holdings, Inc.

Summary WGL Holdings provides over 1 million customers in the mid-Atlantic region with energy services. The company has paid dividends for over 160 years and raised them for nearly 40 years. The company sees gains in earnings of 8-16% in 2015; long-term objectives are to increase earnings by 5-7% a year. WGL Holdings has grown dividends by an average of 4% annually over the last 5 years and 2.5% over the last two decades. About WGL Holdings, Inc. WGL Holdings, Inc. (NYSE: WGL ) is a utility holding company with multiple subsidiaries serving Washington, D.C. and the surrounding areas. The company operates multiple subsidiaries, but its largest subsidiary is Washington Gas, which provides natural gas service to more than 1.1 million customers in D.C., Maryland and Virginia. WGL Holdings has more than 1400 employees and is headquartered in Washington, D.C. WGL Holdings’ operations include: Distribution/Regulated Utility: This operation distributes natural gas to Washington Gas customers and other regulated energy markets. Distributed Generation: This operation is responsible for designing, building and operating on-site energy systems. Included in this is the WGL Energy Systems subsidiary, which is responsible for WGL’s green energy solutions. Retail Supply/Energy: This operation markets and distributes energy to competitive and unregulated markets. Midstream: The midstream operation is run by the WGL Midstream subsidiary, which invests in and owns natural gas pipelines and storage facilities in the Midwest and Eastern U.S. and is responsible for supplying the wholesale market customers – including Washington Gas – with natural gas. In the 2014 fiscal year, which ended September 30, 2014, WGL Holdings reported net income of $105.9 million, up 31.9% from $80.3 million in the prior year (all figures are GAAP numbers). Earnings per share in 2014 were $2.05, up 32.3% from $1.55 per share in the prior year. The year-over-year growth can be attributed to an increase in earnings in the regulated utility and midstream energy services operating segments. Regulated Utility earnings increased 36% to $1.89 per share while Midstream Energy services earnings swung to a gain of 12 cents per share from a loss of 36 cents per share in 2013. This more than offset the 75% drop in earnings from Retail Energy operations. The WGL board expects that the 2015 fiscal year will see earnings grow by 8-16%, which exceeds the company’s long-term earnings growth objectives of 5-7%. The company is a member of the S&P Mid Cap 400 index and S&P’s High Yield Dividend Aristocrats index, and trades under the ticker symbol WGL. WGL Holdings’ Dividend and Stock Split History (click to enlarge) WGL Holdings has paid dividends for over 160 years and increased them since 1977. The company usually announces dividend increases at the beginning of February, with the stock going ex-dividend in April. In February 2015, WGL Holdings announced a 5.1% increase in its dividend to an annualized rate of $1.85. I expect WGL to announce its 40th annual dividend increase in February 2016. Like most mature utility companies, WGL Holdings has a record of very slow dividend growth. The recent dividend increase of 5.1% is the largest in over 25 years. The company has a 5-year compounded annual dividend growth rate (CADGR) of 4.03%, and a 10-year CADGR of 3.29%. Longer term, the dividend growth rates are even lower, with 20-year and 25-year CADGRs of 2.49% and 2.40%. WGL Holdings has split its stock twice 2-for-1 since beginning its record of dividend growth in 1977. The most recent split was in May 1995. Prior to that, the company split the stock in November 1984. For each share of WGL stock that you owned in the early 1980s, you would now have 4 shares of stock. Over the 5 years ending on December 31, 2014, WGL Holdings stock appreciated at an annualized rate of 14.84%, from a split adjusted $27.12 to $54.17. This outperformed the 13.0% annualized return of the S&P 500 and roughly matched the 14.9% annualized return of the S&P Mid Cap 400 index during this time. WGL Holdings’ Direct Purchase and Dividend Reinvestment Plans WGL Holdings, Inc. has both direct purchase and dividend reinvestment plans. The plans’ fees are not too onerous. You do not need to be an existing shareholder to participate. As a new investor, you’ll pay a one-time enrollment fee of $15. There are no fees associated with purchasing shares, either directly or through dividend reinvestment. For new investors, the minimum purchase amount is $250. Once you begin participating in the plan, the minimum purchase amount is $50. When you sell your shares in the plan, you’ll pay a fee of either $15 or $25 plus a transaction fee of 12 cents per share sold. You’ll also be charged an additional $15 if you request help from a customer service representative in placing a sales order. All the fees will be deducted from the sales proceeds. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

February 2015: Funds In Registration

By David Alphacentric Bond Rotation Fund Alphacentric Bond Rotation Fund will pursue “long-term capital appreciation and total return through various economic or interest rate environments.” They’ll rotate through two to four global bond ETFs based on their judgment of the relative strengths of various bond sectors. The fund will be managed by Gordon Nelson, Chief Investment Strategist, and Tyler Vanderbeek, both of Keystone Wealth Advisors. The expense ratio will be 1.39% and the minimum initial investment for the no-load “I” class shares is $2,500, reduced to $100 for accounts set up with an automatic investing plan. Alphacentric Enhanced Yield Fund Alphacentric Enhanced Yield Fund will seek current income by investing in asset-backed fixed income securities. While it expects to invest over 25% in residential mortgage-backed securities, it can also pursue “securities backed by credit card receivables, automobiles, aircraft, [and] student loans.” It might also invest in Treasuries or hedge the portfolio by shorting. The fund will be managed by a team from Garrison Point Capital, led by Tom Miner. Expenses are 1.74%. The minimum investment for the no-load “I” class shares is $2,500, reduced to $100 for accounts set up with an automatic investing plan. AMG Trilogy Emerging Wealth Equity Fund AMG Trilogy Emerging Wealth Equity Fund will seek long-term capital appreciation by investing in firms whose earnings are driven by their exposure to emerging markets. That might include firms domiciled in developed countries, as well as emerging ones. They can invest in both equities and derivatives and they anticipate building an all-cap portfolio of 60-100 securities. The fund will be managed by a team from Trilogy Global Advisors. The initial expense ratio is 1.45% after waivers and the minimum investment will be $2,000. Columbia Multi-Asset Income Fund Columbia Multi-Asset Income Fund will primarily seek high current income and secondarily, total return. They can invest in pretty much anything that generates income, there’s no set asset allocation and the portfolio doesn’t exactly explain what they’re looking for in an investment. If you have reason to trust Jeffrey Knight, the lead manager, and Toby Nangle, go for it! The expenses are not yet set. The minimum investment for “A” shares will be $2,000. Though the “A” shares carry a load, most Columbia funds are no-load/NTF at Schwab and, likely, other supermarkets. DoubleLine Strategic Commodity Fund DoubleLine Strategic Commodity Fund will seek long-term total return by having (leveraged) long exposure to commodity indexes with selective long or short exposure to individual commodities, indexes or ETFs. Then, too, it might turn market neutral. The disclosure of potential risks runs to 13 pages, single-spaced. It will be managed by Jeffrey J. Sherman of DoubleLine Commodity Advisors. Expenses are not yet set. The minimum investment is $2,000. Frontier MFG Global Plus Fund Frontier MFG Global Plus Fund will pursue capital appreciation by investing in 20-40 high-quality companies purchased at attractive prices, both in the US and elsewhere. There will be a macro-level risk overlay. The fund will be managed by Hamish Douglass, of the Australian firm Magellan Asset Management. Mr. Douglass has managed a perfectly respectable global fund for Frontier since 2011. The expense ratio for “Y” shares will be 1.20% and the minimum investment will be $1,000. Sit Small Cap Dividend Growth Fund Sit Small Cap Dividend Growth Fund mostly seeks income that’s greater than its benchmarks (the Russell 2000) and that is growing; it’s willing to accept some capital appreciation if that comes along, too. The Russell 2000 currently yields 1.29%. The plan, not surprisingly given the name, is to invest in “dividend paying growth-oriented companies [the manager] believes exhibit the potential for growth and growing dividend payments.” The portfolio will be mostly domestic. The lead manager will be Roger Sit. Expenses for the “S” class will be 1.50% and the minimum initial investment will be $5,000. Vanguard Tax-Exempt Bond Index Fund Vanguard Tax-Exempt Bond Index Fund will track the Standard & Poor’s National AMT-Free Municipal Bond Index. Adam Ferguson will manage the fund. The expense ratio will be 0.20% and the minimum investment will be $3,000. The Admiral share class will drop expenses to 0.12% with a $10,000 minimum. Virtus Long/Short Equity Fund Virtus Long/Short Equity Fund will seek total return by investing, long and short, in various sorts of equities including MLPs and REITs. The fund will be managed by John F. Brennan, Managing Director at, and cofounder of, Sirios Capital Management. The minimum initial investment will be $2,500. The expense ratio has not yet been announced. Though the “A” shares carry a load, most Virtus funds are no-load/NTF at Schwab and, likely, other supermarkets.