Tag Archives: fahdx

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.

Lower Risk Versions Of A Dual Momentum Fixed Income Strategy

Summary This article presents the performance and risk of Lower Risk Versions (LRVs) of a dual momentum fixed income strategy as compared to a High Risk Version (HRV) presented previously. The difference between the LRVs and HRV is the number of assets per month; the HRV selects one asset per month, while the LRVs select multiple assets per month. The LRV-3 (3 assets per month), backtested to 1994 using mutual fund proxies, has a CAGR of 10.2%, a standard deviation of 6.3%, and a maximum drawdown of -6.1%. The minimum annual return of LRV-3 is -2.4% in 1994. All other annual returns are positive. The LRVs are more robust than the HRV, and should be used by more conservative investors, who desire reasonable growth with less volatility and drawdown. In a recent article on Seeking Alpha, I discussed a simple tactical bond ETF strategy employing relative strength momentum. This strategy is explained in detail here . I will call the original strategy the High Risk Version (HRV) of the fixed income strategy, since only one ETF is selected each month (out of a basket of five ETFs). This article presents Lower Risk Versions (LRVs) of the same momentum strategy. For LRVs, a multiple number of ETFs are selected each month in order to reduce volatility and drawdown compared to the HRV, while still maintaining a CAGR greater than an equalweight portfolio holding all five assets. My basic objectives of the LRVs are: 1. A CAGR > 10%; 2. A standard deviation (SD) that is less than the SD of an equalweight portfolio of all assets; 3. No negative years of return; and 4. A maximum drawdown based on monthly returns of less than 7%. I started out by making a slight modification to the original HRV strategy in order to turn the strategy into a dual momentum strategy. The original methodology only used relative strength (no absolute momentum) to determine what asset to select. But, in a way, the original HRV that selected only one asset each month was really a dual momentum strategy, because a short-term treasury was included in the basket of assets. In order to determine the effect of selecting multiple assets each month rather than just one asset, I needed to use a true dual momentum approach instead of a relative strength strategy. So I have switched to the dual momentum technique in this study. Dual momentum strategies have been popularized by Gary Antonacci and are well-known to many investors. Dual momentum means relative strength momentum is first used to select the top-ranked asset(s) each month, and then the top-ranked asset(s) have to pass an additional absolute momentum test (must have positive momentum) in order to be selected in any given month. I selected a basket of five fixed income assets that have relatively low correlation to each other. A major challenge in developing fixed income strategies is the short history of fixed income ETFs. This results in rather limited backtesting for the ETFs. To extend the backtesting, mutual fund proxies are used that have longer histories; this permits backtesting of the strategy to the 1990s. Shown below are the assets in the basket, both the ETF and the mutual fund proxy. Convertible Bonds: SPDR Barclays Capital Convertible Bond ETF (NYSEARCA: CWB ) – Vanguard Convertible Securities Fund (MUTF: VCVSX ) High Yield Bonds: SPDR Barclays Capital High Yield Bond ETF (NYSEARCA: JNK ) – Fidelity Advisor High Income Advantage Fund (MUTF: FAHDX ) Long Term Treasury: iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) – Vanguard Long Term Treasury Fund (MUTF: VUSTX ) Short Term Treasury: iShares 1-3 Year Treasury Bond ETF (NYSEARCA: SHY ) – Vanguard Short Term Treasury Fund (MUTF: VFISX ) Emerging Market Bonds: PowerShares Emerging Markets Sovereign Debt Portfolio ETF (NYSEARCA: PCY ) – Fidelity New Markets Income Fund (MUTF: FNMIX ) In the original article, I used CNSAX as proxy for CWB and PREMX as proxy for PCY. But based on comments by EquityCurve in the original article, in order to get backtesting to 1994 instead of 1998, I changed to VCVSX instead of CNSAX and FNMIX instead of PREMX. So backtesting of the mutual funds now goes back to 1994. 1994 turns out to be a difficult year for bonds and I’m glad I could include it in the analysis. (All of this work was performed using the free Portfolio Visualizer software. Any investor can go online and trade the strategies in this article without any cost.) It turns out that the dual momentum strategy using this basket of assets is very robust, and good results are seen if one, two, three, four or all five ETFs are selected each month. There is the usual tradeoff between growth and drawdown depending on the number of assets selected each month. The greater the number of assets selected, the less the risk and growth. I will now present the results of the HRV that selects only one asset each month. These results are similar to the results presented in the original article, and are presented here just to be consistent with the results of the LRVs shown later in this article. The basket of mutual funds is used, and the backtesting timeframe is 1994-present. Two relative strength timing periods are employed to rank the funds: 4-months and 2-months. A 51% weighting on the 4-month ranking and a 49% weighting on the 2-month ranking is used. The 51%/49% weighting split is a good way to ensure that the 4-month timing period determines the better-ranking asset if there is a tie. The total return curves of the HRV, the equalweight portfolio (buy and hold all five assets, rebalanced annually), and the S&P 500 are shown below, together with a table of their relevant parameters and annual returns. Total Return Curve of HRV: (click to enlarge) Tabular Summary of HRV Results: (click to enlarge) Annual Returns: (click to enlarge) It can be seen that the HRV has a CAGR of 15.0%, an SD of 10.4%, and a maximum drawdown (based on monthly returns) of -13.0%. In terms of a risk-adjusted return on investment, the CAGR/SD is 1.44. This compares with holding an equalweight portfolio that has a CAGR of 7.8%, an SD of 7.0%, a maximum drawdown of -17.6%, and a CAGR/SD of 1.11. It can be seen that the HRV substantially increases growth at the expense of volatility (standard deviation). Yet the maximum drawdown is actually better for the HRV than the equalweight portfolio holding all five assets. For the LRVs, I systematically looked at various combinations of timing periods and number of assets selected each month. Overall, when two or more assets are selected each month, the strategy tends to be very robust in terms of what timing periods are used for relative strength ranking. This means the strategy works well for various sets of timing periods and results do not change dramatically when timing periods are varied slightly. With some flexibility in what timing periods to choose, I decided to use the same timing periods that I employed for the HRV in my previous article, namely 4-months and 2-months. I first show graphical results when one, two, three, four and five assets are selected each month. A logarithmic scale of total return is employed. One asset (HRV): (click to enlarge) Two assets (LRV-2): (click to enlarge) Three assets (LRV-3): (click to enlarge) Four assets (LRV-4): (click to enlarge) Five assets (LRV-5): (click to enlarge) The results of LRV-5, compared to the equalweight portfolio, identify the effect of absolute momentum. It can be seen that absolute momentum mainly plays a role in reducing drawdown, and does not significantly affect growth in the years when drawdown does not occur. The beneficial effect of absolute momentum continues to be seen as the number of assets is reduced using relative strength. When the number of assets is reduced using relative strength, higher portfolio growth is seen as expected. The highest growth, of course, comes when only one asset is selected each month corresponding to the HRV. The tabular form of the overall results is shown below: (click to enlarge) The tradeoff between performance and risk is seen in the table above. Based on the objectives stated previously, the best LRV is LRV-3 (three assets each month). LRV-3 has a CAGR of 10.2%, an SD of 6.3%, a maximum drawdown of 6.1%, and CAGR/SD of 1.62. This compares well against the equalweight portfolio that has a CAGR of 7.8%, an SD of 7.0%, a maximum drawdown of -17.6%, and a CAGR/SD of 1.11. Thus, the LRV-3 has significantly higher CAGR, lower SD, and substantially lower drawdown and higher risk-adjusted return on investment than the equalweight portfolio. The equalweight portfolio also has three negative years: 1994 (-6.4%), 1998 (-0.3%), and 2008 (-11.6%), while the LRV-3 only has one year with negative returns: 1994 (-2.4%). In comparison to the HRV, the LRV-3 has lower growth (CAGR of 10.2% versus 15.0%), but the SD (6.3% versus 10.4%) and maximum drawdown (-6.1% versus -14.5%) are greatly improved. And the risk-adjusted return on investment of LRV-3 is significantly better (CAGR/SD of 1.62 versus 1.44). And for 1994, the LRV-3 has a -2.4% return, while the HRV has a -5.4% return. One negative aspect of the LRV-3 is that more trades are required each year compared to the HRV. However, the costs will still be minimal for an account value over $100K. Based on backtest results, the average number of annual trades (buys and sells) is approximately 20 for LRV-3. In a Schwab account, this amounts to a cost of 20 x $9 = $180 per year. So, the cost is about 0.18% for a $100K account. In addition, PCY and CWB are commission-free ETFs on Schwab (and the commission-free SCHO is a good substitute for VFISX). So, the commission costs of trading LRV-3 (neglecting any other costs) are quite minimal. A final step in this study is to ensure the ETF version of the strategy gives similar results as the mutual fund version. The ETF version can only be backtested to 2010, so the 2010-present timeframe is used for comparison. The backtest results for the ETFs and the mutual funds for LRV-3 are shown below. LRV-3 Results Using ETFs (2010 – Present) (click to enlarge) LRV-3 Results Using Mutual Funds (2010 – Present) (click to enlarge) Good agreement is seen between using ETFs and mutual funds. Using ETFs, the CAGR is 7.9%, the SD is 6.2%, and the maximum drawdown is -4.5%. Using mutual funds, the CAGR is 8.3%, the SD is 5.3%, and the maximum drawdown is -4.2%. It should be noted that the performance of the mutual funds from 2010-present is less than the performance between 1994-present. This is probably caused by the Federal Reserve holding short-term rates near zero from 2009-present. When short-term rates are increased, performance should eventually increase (after, perhaps, a short time of reduced performance). Also to be noted is that LRV-3 has gone to all cash (money market) since July 2015. So, for July, August and September, the top three assets based on relative strength have not passed the absolute momentum test. In summary, the LRV-3 should be used by more conservative investors, who desire solid growth (10%) with lower risk, while HRV should be used if more growth is desired (15%) at the expense of higher risk. For those investors, who desire even lower risk than LRV-3 as well as higher risk-adjusted return on investment, LRV-5 might be a better choice. For 1994-present, LRV-5 has a CAGR of 9.0%, a maximum drawdown of only -4.4%, and a CAGR/SD of 1.80. It should be mentioned that this strategy using fixed income ETFs is best employed in non taxable retirement accounts that avoid tax issues. I would also like to thank Terry Doherty for reading over this article and making a number of excellent suggestions.