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Simple Pair – Switching Bond Strategy Using Mutual Funds

Summary This strategy switches between a high yield corporate bond fund and a high yield municipal bond fund based on 3-month returns. A 3-month simple moving average filter is also used. The strategy is very low risk (i.e. low standard deviation and low maximum drawdown) while maintaining reasonable growth (~10% CAGR). Backtesting from 1986 using FAGIX and MMHYX produces CAGR = 11.3%, standard deviation = 5.5%, and maximum drawdown (based on monthly returns) = -5.5%. There are essentially no losing years. No load/no fee mutual funds must be selected for practical application. They are platform-dependent; for Schwab, I selected JAHYX and NHMAX as the best available no load/no fee mutual funds. Using JAHYX and NMHAX and backtesting to 2000, the strategy produces CAGR = 9.7%, standard deviation = 4.8%, and maximum drawdown = -3.5%. There are no losing years. This article explains a rather simple strategy that tactically switches between a high-yield corporate bond mutual fund and a high-yield municipal bond mutual fund, with money market being a safety net. The goal was to develop a low risk, capital-preservation strategy with reasonable growth (CAGR ~ 10%). I also desired to use mutual funds rather than ETFs to reduce volatility. This necessitated that the strategy be updated on a quarterly basis rather than a monthly basis (my usual preference). The reason these two bond asset classes were chosen was because they are not well-correlated; typically, their correlation is about 0.15. To show the feasibility of the strategy, I used two representative mutual funds that could be backtested to 1986 in Portfolio Visualizer (PV): Fidelity Capital and Income Fund (MUTF: FAGIX ) and MFS Municipal High Yield Bond Fund (MUTF: MMHYX ). Some might object to the usage of FAGIX as the high-yield corporate bond mutual fund because a small percentage of the fund is invested in equities rather than bonds. Fidelity Advisor High Income Advantage Class A (MUTF: FAHDX ) is actually a better representative of this class, but its history starts in 1987 in PV. I wanted to include 1987 in the analysis, so I used FAGIX instead of FAHDX. But I will show results using both FAGIX and FAHDX later in this article. The strategy uses 3-month relative strength momentum ranking to determine which asset to pick each quarter. In addition, the top-ranked asset must pass a 3-month simple moving average, MA, filter in order to be selected. If the asset does not pass this filter, then the money goes to the money market. This is a pretty simple set of parameters, and others have shown that a 3-month lookback period for bonds is most satisfactory. The backtesting was performed using the free Portfolio Visualizer (PV) software. Any investor can run these calculations and trade this strategy. The backtest results are shown below for FAGIX and MMHYX. CASHX (PV’s ticker for money market) is the cash filter asset. The timeframe is 1986 – present. It can be seen that the CAGR = 11.3%, the standard deviation, SD = 5.5%, the maximum drawdown based on monthly returns (MaxDD) = -5.5%, and the worst year = -0.3%. Risk adjustment return-on-investment can be seen using CAGR/SD and/or CAGR/MaxDD. In this strategy, CAGR/SD = 2.04, and CAGR/MaxDD = 2.02. Summary Table for FAGIX – MMHYX: 1986 – present (click to enlarge) Total Return for FAGIX – MMHYX: 1986 – present (click to enlarge) Annual Returns for FAGIX – MMHYX: 1986 – present (click to enlarge) It should be noted that results are also shown for an equal-weight portfolio, i.e. both assets are held continually and rebalanced annually. This is commonly referred to as a buy & hold strategy. The equal-weight strategy has a CAGR of 7.7%, but it has a MaxDD of -27.6% and a worst year return of -25.9%. The benefit of the tactical strategy I am proposing can readily be seen: almost 50% higher growth compared to the passive buy & hold strategy (CAGR of 11.3% versus 7.7%) and much less drawdown (-5.5% versus -27.6%). If FAHDX is substituted for FAGIX, the backtest timeframe becomes 1988 – present. The results are shown below. It can be seen that CAGR = 10.5%, SD = 5.6%, MaxDD = 6.5%, and worst year = +0.2%. The CAGR/SD = 1.89, and CAGR/MaxDD = 1.62. Summary Table for FAHDX – MMHYX: 1988 – present (click to enlarge) Total Return for FAHDX – MMHYX: 1988 – present (click to enlarge) Now comes the difficult task of picking mutual funds for a real application of the strategy. I needed to find mutual funds with no loads and no redemption fees, and operating expenses (including 12b-1 fees) that are kept to a minimum. Of course, every platform has different funds that meet these requirements. I use the Schwab platform, and they provide a lot of no load/no fee options. After extensive searching, I selected Janus High-Yield T Shs Fund (MUTF: JAHYX ) as the best high yield corporate bond mutual fund, and Nuveen High Yield Municipal Bond Fund Class A (MUTF: NHMAX ) as the best high yield municipal bond mutual fund. These funds only permit backtesting to 2000. So the results shown below have a timeframe from 2000 – present. It can be seen that CAGR = 9.7%, SD = 4.8%, MaxDD = -3.4%, and the worst year = +1.6%. The CAGR/SD = 2.03, and the CAGR/MaxDD = 2.66 (a very good number). Summary Table for JAHYX – NHMAX: 2000 – Present (click to enlarge) Total Return for JAHYX – NHMAX: 2000 – Present (click to enlarge) Annual Returns for JAHYX – NHMAX: 2000 – Present (click to enlarge) The robustness of the strategy is seen in the table below. The MA has been varied between 2 months and 4 months, and the lookback timing period (TP) was changed between 3 months and 4 months. The overall results do not change appreciably. Robustness of Strategy (click to enlarge) In summary, this article presents a very conservative tactical strategy that produces reasonable growth with very low risk. It is a quarterly updating strategy that uses less volatile mutual funds rather than ETFs. The basic strategy can be implemented on any platform, but care must be exercised in finding the best no load/no fee mutual funds for any given platform. For the Schwab platform, I believe the best mutual funds for this strategy are JAHYX and NHMAX. The pick for last quarter (July – September, 2015) was CASHX. The selection for this quarter (October – December, 2015) is NHMAX.

Momentum Model Of ‘Swensen Six’ Portfolio Recommends 100% In Cash

Momentum Model called for move to cash back on August 10th. A three metric model is used to drive the momentum model. The “Swensen Six” portfolio covers six asset classes, depending on how asset class is defined. Example ETFs are provided to populate the recommended asset classes. David Swensen, in his book, Unconventional Success: A Fundamental Approach to Personal Investment , lays out what he calls “The Science of Portfolio Structure.” The following bullet points lay out the basic points of Swensen’s logic for constructing what I call the “Swensen Six” portfolio. Basic financial principles require the portfolio exhibit diversification and equity orientation. The “Swensen Six” is well diversified in that it covers the globe by using U.S. Equities (NYSEARCA: VTI ), Developed International Equities (NYSEARCA: VEA ), and Emerging Market Equities (NYSEARCA: VWO ). By equity orientation Swensen skews a portfolio toward stocks instead of bonds. The equity Exchange Traded Funds (ETFs) in the “Swensen Six” are: VTI, VEA, VWO, and VNQ . High expected return types of securities dominate the portfolio as 70% is allocated to equity investments. The specific percentages are listed below. Use six asset classes to provide portfolio diversification. Domestic equities comprise 30% of the portfolio or invest 30% in VTI. Swensen is not specific about the individual securities so I am recommending particular ETFs for each asset class. The percentages are Swensen recommendations. Determining what percentage to invest in what asset class is one of the most difficult decisions individual investors face when it comes to portfolio construction so Swensen’s percentage recommendations are most helpful. Developed international equities carry a recommendation of 10% so invest 10% in VEA. Originally, Swensen recommended 15% be allocated to developed international equities, but in a more recent paper lowered the percentage to 10%. One could stay with the original 15% recommendation. Emerging markets make up 10% of the portfolio so invest 10% in VWO. Originally, Swensen recommended 5% be assigned to emerging markets, but he later shifted 5% from developed international equities to emerging markets. One could stay with the original 5% recommendation. Domestic Real Estate makes up 20% of the total portfolio so invest 20% in VNQ. Another option is to invest 15% in VNQ and 5% in RWX , an international REIT ETF. This is my preference as it adds more diversification by adding a seventh asset class, International Real Estate. Investors wishing to keep life simple will stick to the “Swensen Six” rather than expand to include RWX. U.S. Treasury Bonds make up another 15% of the portfolio so invest 15% of the total in TLT . U.S. Treasury Inflation-Protected Securities is the last asset class and we invest 15% in TIP . In my Dashboards worksheet, I classify both TLT and TIP in the Bonds and Income asset class, but for purposes of following Swensen, I’ll break the two into separate asset classes. With only six ETFs, Swensen covers the globe so diversification is accomplished. The equity orientation is in place as 70% of the portfolio is tilted in that direction. Swensen provides interesting logic behind his recommendations. Two paragraphs from page 83 of his book state it very well so I quote below: “Investors achieve equity orientation by investing a preponderance of assets in the high-expected-return asset classes of domestic equity, foreign developed equity, emerging market equity, and real estate. The return-generating power of equity positions drives the results of long-term investment portfolios. Investors give up expected return to defend portfolios against unanticipated inflationary or deflationary economic conditions. U.S. Treasury Inflation-Protected Securities protect against inflation with certainty, while real estate holding guard against inflation with reasonable assurance. In the long run domestic equities add to the inflation-hedging characteristics of a portfolio, but in the short run domestic equities prove notoriously unreliable as inflation hedges.” This six ETF portfolio has an equity emphasis, provides some protection against inflation and is broadly diversified. By keeping these six assets in balance, the passive investor is well served. If you are a momentum style investor, what does the “Swensen Six” look like in the current market environment? Below is the ranking for these six ETFs and as readers can see, all monies are investing in SHY or cash. None of the critical ETFs are ranked above SHY. ETF Rankings of “Swensen Six”: The following ranking is built upon three metrics. Fifty percent (50%) of the weight is allocated to the performance of each ETF over the past 91 calendar days. Thirty percent (30%) of the weight is assigned to the performance over the most recent 182 calendar days and the final 20% is a volatility measurement where low volatility is highly valued. SHY is the cutoff or “circuit breaker” ETF. When the ETFs rank below SHY, as is currently the case, 100% of the portfolio is invested in SHY or cash. The portfolio is reviewed every 33 days as the ETFs are ranked again to see if any show up for potential investment. This portfolio has been in cash for nearly two months. (click to enlarge)

Consolidated Edison’s Place In A Dividend Growth Portfolio

Consolidated Edison is known as a slow growing utility. Yet this alone has not precluded the security from providing reasonable returns. This article illustrates what an investor ought to require in order for the company to have a place in your dividend growth portfolio. Tracing its roots back over 180 years, Consolidated Edison (NYSE: ED ) provides electricity for 3.3 million customers and gas to 1.1 million customers in and around New York City. You might imagine that this business is fairly stable. Indeed, the company has not only paid but also increased its dividend for 41 consecutive years . That’s an investing lifetime for many, each and every year waking up to more and more Consolidated Edison dividends. The way the company operates is a slightly different from your typical dividend growth firm. That’s to be expected: it’s a regulated utility. Yet this alone does not preclude it from providing reasonable returns. I’ll demonstrate both points below. Here’s a look at both the business and investment growth of Consolidated Edison during the 2005 through 2014 period: ED Revenue Growth 1.1% Start Profit Margin 6.2% End Profit Margin 8.3% Earnings Growth 4.5% Yearly Share Count 2.0% EPS Growth 2.1% Start P/E 15 End P/E 18 Share Price Growth 4.0% % Of Divs Collected 46% Start Payout % 76% End Payout % 70% Dividend Growth 1.1% Total Return 7.3% The top line growth certainly isn’t impressive. As a point of comparison, companies like Coca-Cola (NYSE: KO ), Boeing (NYSE: BA ) and Procter & Gamble (NYSE: PG ) were able to grow revenues by 8%, 6% and 4% respectively over the same time period. Of course this is easily anticipated: utilities by their nature tend to be slow growing. The demand for their product is fairly consistent and doesn’t suddenly accelerate with the advent of a new higher efficiency light bulb. So 1% annual revenue growth sets the stage. From there the company has been able to increase its net profit margin, resulting in total earnings growth that outpaces total revenue growth. If the number of common shares outstanding remains the same, total earnings growth will be equal to earnings-per-share growth. Yet this situation rarely holds. With you typical dividend growth company you see shares being retired over the years due to share repurchases. As a point of reference, about three-fourths of the current Dow Jones (NYSEARCA: DIA ) components have reduced their share count in the last decade. Utilities tend to do the opposite – selling shares to raise capital. Consolidated Edison has been no exception, increasing its share count from about 245 million in 2005 to 293 million by 2014, or an average compound increase of about 2% per year. As such, EPS growth trailed overall company profitability, coming in at just over 2% per year. If the earnings multiple remains the same at the beginning and end of the observation period, the share price appreciation will be equal to EPS growth. In this case, investors were willing to pay about 15 times earnings at the start as compared to roughly 18 times at the end of 2014. As such, the share price increased by 4% per year. If you were to look at a stock chart, this is all that you would see. Yet an even larger component to the overall return was dividends received. Remember, investors were able to collect a rising stream of income over time. The magnitude of these increases has not been impressive in any sense: coming in at just over 1% annually. Yet the beginning payout ratio was above 75%. When coupled with a reasonable valuation, this equates to starting dividend yield of about 5%. So investors were able to collect nearly half of their beginning investment in this slow grower. All told capital appreciation would have accounted for about $20 worth of additional value while you would have also received about $21.50 in dividend payments. Your total return would have been roughly 7.3% per year. Now surely this isn’t overly impressive – it’s more or less in line with what I would deem “reasonable” returns. Yet it should be noted that the slow growth didn’t prevent you from increasing your wealth. Moreover, the annual return is in-line with or better than what Procter & Gamble, Caterpillar (NYSE: CAT ), UnitedHealth (NYSE: UNH ) or Intel (NASDAQ: INTC ) provided during the same time period. Its not always about the growth, the interaction of the value components also makes a difference. The reason that Consolidated Edison provided reasonable returns was related to two factors: investors were willing to pay a higher of a valuation and the dividend yield started near 5%. Moving forward, you likely want to think about the repeatability of those components. More than likely Consolidated Edison isn’t going to “wow” you with its upcoming growth. Analysts are presently expecting intermediate-term growth in the 2% to 3% range , much like the past decade. As such, the valuation that you require to invest should be paramount. You can pay a bit more for a company that grows by 8% or 10% and “grow out of” a slight premium paid. When you have a much lower growth rate, your margin of error is much lower. As a for instance, imagine company that grows earnings-per-share by 2% annually over the next five years. If you paid say 17 times earnings and it later trades at 15 times earnings, this results in negative capital appreciation. On the other hand, if you pay 17 times earnings for a company that grows by 8% per year and it later trades at 15 times earnings, this equates to 5.3% annual price appreciation. The penalty of “overpaying” is far less severe for faster growing companies. Thus in contemplating an investment in Consolidated Edison you should be especially mindful of the price paid. (Naturally this holds for any company, but even more so with slower expected growth.) Over the past decade shares have routinely traded in the 12 to 18 P/E range. While its possible to see a valuation outside of this range, you’d likely want to demand something on the lower end of the spectrum in order for the security to look comparatively compelling. The second important thing to note is that the dividend payment is apt to play a much larger role than your typical investment. You know the rate of dividend increases likely isn’t going to be substantial, so once more the focus is on demanding a reasonable starting yield. It’s the high starting yield that allows an investment in Consolidated Edison to rival that of the Procter & Gamble’s of the world. Without a reasonable yield premium the investment doesn’t have many more levers at its disposable. An investment in Consolidated Edison is an investment in the dividend, with the occasional revision in valuation. Alternatively, with a reasonable dividend yield and reinvestment, it’s a reliable way to see your income increase by 5% or 6% annually. In short, just because Consolidated Edison hasn’t grown very fast doesn’t mean that it can’t be a reasonable investment. As illustrated above, just 1% annual revenue growth turned into 7%+ yearly returns. Moving forward, the same drivers – valuation and dividends received – will continue to play an outsized role in future returns. As such, focusing on these components from a slow growing utility becomes central to a successful investing process.