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Quarterly Tactical Strategy Using Fidelity Fixed-Income Mutual Funds

Summary This strategy consists of ranking four fixed-income mutual funds based on 3-month returns, and then selecting the top-ranked fund at the end of each quarter. The top-ranked fund must pass a 3-month simple moving average filter in order to be purchased. Otherwise, the money goes into a money market asset. Backtested to 1986, the CAGR is 11.1%, the MaxDD is 5.5%, the worst year is +0.73%, and the return-to-risk ratio [CAGR/MaxDD] is 2.03. The monthly win rate is 79%. The strategy appears to be very robust in terms of relative momentum look-back period length and moving average duration. The strategy can be traded between the end of quarter [EOQ] and the next four trade days without any significant detrimental effect on performance or risk. I have recently been developing monthly tactical strategies that employ mutual funds instead of ETFs (see here and here ). There are a number of benefits in trading mutual funds instead of ETFs. First, mutual funds of a certain class tend to have much less volatility than ETFs in the same class. This permits the use of shorter duration look-back periods and moving averages in a tactical strategy without as much whipsaw. Second, there is the benefit of trading at one closing price, thus avoiding slippage losses (bid/ask losses) associated with trading ETFs. Third, mutual funds tend to have higher liquidity than ETFs. This avoids sudden price changes caused by lack of asset liquidity. Fourth, there are no fees/loads at all if Vanguard funds are traded in a Vanguard account, or Fidelity funds in a Fidelity account. And fifth, using mutual funds with long histories enables backtesting of almost 30 years, back to the mid-1980s. This is in contrast to ETFs that have very short histories, especially bond ETFs, that limit the timeframe of backtests. One of the negatives against mutual funds is the higher management expenses, but in some cases mutual funds actually have similar expenses as ETFs (e.g. Vanguard Admiral funds versus corresponding ETFs). And then there are the practical issues of trading mutual funds. These practical issues are challenging, but can be solved. Until recently, mutual funds did not permit monthly trading; severe short-term redemption penalties were charged or frequent-trading restrictions were imposed. But these penalties/restrictions have been lifted so that monthly trading is now permissible on some platforms, most notably Vanguard and Fidelity. This is the case as long as trades are made at least 30 calendar days apart. So a strict trading schedule must be followed that I have discussed previously (see here ). However, most of the trading issues are eliminated if a quarterly strategy is implemented. In past articles, I have presented monthly strategies using Vanguard mutual funds. But in this article, I am proposing a fixed-income asset allocation strategy that uses Fidelity mutual funds and trades on a quarterly basis. So the trading issues are greatly reduced. Four asset classes are used in the strategy: High yield corporate bonds: Fidelity Capital and Income Fund (MUTF: FAGIX ) High yield municipal bonds: Fidelity California Municipal Income Fund (MUTF: FCTFX ) Mortgaged-backed bonds: Fidelity Mortgage Securities Fund (MUTF: FMSFX ) Money market: CASHX (in Portfolio Visualizer). The overall objectives of this moderate growth/low risk strategy are: To attain a 10% compounded annualized growth rate [CAGR]; To achieve a maximum drawdown [MaxDD] of -5.0% (based on monthly returns); To produce a return-to-risk MAR [CAGR/MaxDD] of 2 or greater; To have positive returns every year in backtesting; and To attain a monthly win rate over 75%. The correlations between these funds are shown below, taken from Portfolio Visualizer [PV]. It can be seen that the funds have low correlation to each other, as desired. (click to enlarge) The strategy consists of ranking the 3-month total returns of each fund, and selecting the top-ranked fund at the end-of-the-quarter [EOQ]. The top-ranked fund must then pass a 3-month simple moving average [SMA] screen in order to be purchased. Otherwise, the money goes to the money market fund. It’s a pretty simple set of rules. What seems to make this strategy work is the relatively high return of FAGIX and its low correlation to FCTFX and FMSFX that have moderate return. CASHX is included as an absolute momentum filter to control risk. Backtest Results Using Portfolio Visualizer The strategy was first backtested using the PV software. All of the funds have histories that date back to at least 1985, so the backtesting went from Jan 1986 to Nov 2015. By using only Fidelity funds and trading on a quarterly basis, there are no trading costs, loads or restrictions if a Fidelity platform is used. The backtest results are shown below. Trading is done at the EOQ. (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) The tactical strategy is compared with a buy & hold strategy in which the four funds are held continuously and rebalanced annually. The thing that jumps out at you is the large annual returns in 2003 and 2009; the rest of the time the tactical strategy has more modest returns as expected. The overall results show that the tactical strategy has a much higher CAGR (11.1% to 6.5%) and much lower MaxDD (-5.5% to -10.0%) than the buy & hold strategy. The worst year for the tactical strategy is a positive 0.7% (in 2008), while the buy and hold strategy has a worst year of negative 8.6%. It can be seen that the tactical strategy matches the buy & hold strategy over much of the timeframe, but in times of market stress, the tactical strategy performs much better than buy & hold. Backtest Results Using the Haynes’ Backtester The next step in backtesting was to assess the effects of look-back period length, SMA length, number of assets held, and trade day on the performance and risk of the tactical strategy. These calculations were performed using Herbert Haynes’ backtester. We first made sure that the Haynes’ backtester matched PV’s results for EOQ calculations. The comparative results are: PV’s Summary Results, CAGR = 11.1%, MaxDD = 5.5% (monthly basis); Haynes’ Summary Results, CAGR = 11.2%, MaxDD = 5.5% (monthly basis). Overall, we see very good agreement. All of the quarterly selections were exactly the same. The very small difference between CAGRs is probably caused by small variations in the adjusted price data between the two calculations. We proceeded to look at the effects of SMA duration. Rather than looking at calendar months, the SMA duration was switched to trade days. Twenty-one trade days corresponds to one calendar month, forty-two trade days corresponds to two calendar months, etc. The SMA duration was varied from 20 trade days to 70 trade days, and it was seen that SMA length had little impact on the results. CAGR varied from 11.2% to 11.3%, and MaxDD remained fixed at 5.5% Next, we studied the effect of the relative momentum lookback period. The lookback period was varied between 20 trade days and 84 trade days while the SMA screen was varied between 20 trade days and 50 trade days. As long as the SMA duration was 40 trade days or greater, the lookback period could be 2-months (42 trade days), 3-months (63 trade days) or 4-months (84 trade days) without any significant difference in CAGR or MaxDD. A final matrix was run in which the number of assets (1 to 3) and trade day (EOQ-20 to EOQ+20) were independently varied. For this matrix, the lookback period was fixed at 3 calendar months and the SMA screen duration was maintained at 63 days. The tabulated values and heatmaps are shown below for CAGR, MaxDD, and MAR. The tabulated values have the trade day on the top line (EOQ-20, EOQ-18, etc.) and the number of assets (1 to 3) in the first column. CAGR Results: Range = 6.1% [red] to 11.2 [blue] (click to enlarge) (click to enlarge) MaxDD Results: Range = -16.7% [red] to -4.0% [blue] (click to enlarge) (click to enlarge) MAR Results: Range = 0.5 [red] to 2.0 [blue] (click to enlarge) (click to enlarge) As expected, increasing the number of assets results in lower performance and lower risk. In terms of the return-to-risk metric [MAR], the optimal number of assets is one. One asset also produces the highest CAGR. The optimal trade days for one asset is seen to be EOQ to EOQ+4. It should be noted that this is not the equivalent of making a selection using EOQ data and waiting up to four days before making the trade. The way the program assessed the effect of trade day was to determine the fund selection and make the trade on the same day. Conclusions from Backtesting The tactical strategy is very robust in terms of the lookback duration length and SMA duration length. Significant variation of these parameters does not seem to greatly affect the backtest results. The selection of one asset each quarter (versus two or three assets) produces the best overall performance and risk adjusted returns. When only one fund is selected each quarter, the optimal trade day is EOQ to EOQ+4. Other trade days produce inferior results based on backtesting. 30-years of backtest results (1986 – 2015) show a CAGR of 11.1%, a MaxDD of 5.5%, and a MAR of 2.03. There are no losing years, and the monthly win rate is 79%. Some Practical Considerations These funds distribute their dividends on a monthly basis at the end of the month [EOM]. The dividend distribution does not make its way into the daily data until a number of days later. Thus, the selection that PV makes at EOQ may be in error until the correct data is available. The problem is that we don’t know exactly when the latest distribution information has been added to the adjusted data in PV’s selections. So a quarterly fund selection made by PV at the latest EOQ might change a few days later. Thus, each investor cannot just blindly use PV’s selection at the EOQ. Rather, each investor needs to look at the 3-month returns of the funds based on data that include the latest dividend distribution. There are two ways to determine the correct 3-month returns. One way is to take adjusted data from Yahoo and correct it for the latest dividend distribution. A second way is to use stockcharts.com (after the dividend distribution has been added to their data). Either way will work. There is an added benefit that can be achieved from this strategy that I want to discuss. It turns out that high yield mutual funds have a unique characteristic that I do not totally understand: when distributions occur on ex-div day, the price of the fund doesn’t drop by the amount of the distribution. For most funds, ETFs and stocks, whenever a dividend distribution occurs on ex-div day, the price of the asset drops by that amount. However, this does not occur for high yield mutual funds. I’m not exactly sure why the actual price does not drop on ex-div day, but it doesn’t. We can use this aspect of high yield mutual funds to our benefit. Thus, it will be better to always move from money market to FAGIX or FCTFX on EOQ-1 rather than on EOQ or later. In this way, you will receive the dividend without any accompanying loss in price. It’s like getting a free dividend payment. Likewise, if you are moving from FAGIX or FCTFX to money market, it will always be better to sell on EOQ or later (after the distribution is given). Because FMSFX has a relatively small distribution, the same rules apply to it too, i.e. selling FMSFX and buying FAGIX or FCTFX should be done on EOQ-1, and selling FAGIX or FCTFX and buying FMSFX should be done on EOQ or later. An Alternate Basket of Funds for Schwab Accounts For those investors who have Schwab accounts, an alternative basket of funds is recommended. Although there will be small costs for trading some of these funds, the costs will not be excessive because only one fund is traded each quarter. The basket of funds I recommend for use on the Schwab platform are the following: FAGIX, the Nuveen High Yield Municipal Fund (MUTF: NHMAX ), the Vanguard GNMA Fund (MUTF: VFIIX ), and a Schwab money market fund [CASHX in PV]. These funds can only be backtested from 2000 – 2015, and the results using PV are shown below, compared to the Fidelity version over the same years. Schwab Version (2000 – 2015) (click to enlarge) Fidelity Version (2000 – 2015) (click to enlarge) It can be seen that the Schwab version gives superior results in terms of CAGR (13.2% to 12.0%) while maintaining the same MaxDD (-5.5%). This is mainly caused by the superior returns of NHMAX compared to FCTFX.

The FlexShares Global Quality Real Estate ETF Is As Much Domestic As Global

Summary GQRE has a fairly high expense ratio for half of the holdings being domestic equity. I don’t see a benefit to using one global REIT ETF when investors can combine a lower expense ratio domestic fund with an international REIT ETF. The ETF has more concentration to individual company weights than I would want to see. Investors should be seeking to improve their risk-adjusted returns. I’m a big fan of using ETFs to achieve the risk-adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. One of the funds I am researching is the FlexShares Global Quality Real Estate Index ETF (NYSEARCA: GQRE ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio GQRE sports an expense ratio of .45%. In any event, that falls short of being “excellent”. When we consider that around half of the positions are domestic equity, it looks even less appealing. I would favor getting a pure domestic equity REIT ETF for any diversified domestic exposure that is desired. There are several options with dramatically lower expense ratios for the domestic equity position. International equity REITs are a very small niche, and the sector generally has higher expense ratios, but there is no need to pay it on the domestic assets. Country Allocations I grabbed the following chart from the FlexShares website: If we look past the enormous domestic allocation, the next major weights are Hong Kong, Japan, United Kingdom and Japan. Those four are usually the top 4 countries for international REIT ETFs. I’ve looked at enough of them to simply know that off the top of my head. The interesting thing here is that they weighted Hong Kong at the top and Japan in the second place. Most international REIT ETFs, in my experience, are prone to overweighting Japan. If the fund were designed to have a heavier weight on the other countries that are traditionally underweighted, it would provide a nice bright spot in the portfolio. Holdings I grabbed the following chart to represent the top 10 holdings. (click to enlarge) Unlike most international REIT ETFs, the top holdings here should be recognizable to many investors. The top 10 holdings include 6 that are from the United States and fall under “large cap”. There is a benefit to large-cap REITs, because larger-capitalization companies tend to have more coverage, which results in more efficient pricing, and thus, a lower level of volatility. A Bright Spot in the Holdings While I’d like to see lower weights for individual holdings, I can still appreciate the sector exposure. The top holding is Public Storage (NYSE: PSA ). If you don’t remember them off the top of your head, I bet you will when you look at the photo below. I retrieved it from a piece by Michael Hooper on PSA : If you want some diversification in your exposures, then PSA makes great sense, since it operates in the storage sector of the REIT market. I have no problem with this being a major holding for any domestic equity REIT, and it frequently is one of the top holdings in domestic REIT ETFs. Moving down the list, we see that Simon Property Group (NYSE: SPG ) is another major holding. The downside here is that SPG is literally the #1 holding of most domestic equity REIT ETFs. If you are holding domestic equity REIT ETFs, you already have SPG in your portfolio. Seriously, check the holdings for your ETF and you’ll probably see SPG near the top. I have nothing against investors holding SPG. I hold domestic equity REIT ETFs, and the top position is Simon Property Group. However, my domestic REIT ETFs have expense ratios of .07% and .12%. As a sector, commercial REITs are being given a very heavy weighting. Because the fund is holding so many commercial REITs, I’m glad to see a storage REIT and two residential REITs near the top. However, I do wonder why they aren’t including established champions like Realty Income Corp. (NYSE: O ) if the goal is to establish a portfolio of REITs that are efficiently operating large operations. If the focus is on the “quality” of the underlying holdings, it is hard to argue against a triple net lease REIT with over 80 dividend raises to-date and a focus on only renting to customers with high credit quality and business that are likely to survive any moderate depressions. They do have National Retail Properties (NYSE: NNN ), which is a triple net lease REIT that I find very attractive. I like it enough that I bought shares of NNN for my portfolio to complement my position in REIT ETFs. Unfortunately, the position is only about 1% of the total portfolio. Liquidity The liquidity is bad. If investors want to take a position, only use limit orders to trade the ETF. Conclusion The fund offers heavy weightings to domestic equity that could be more efficiently purchased through domestic equity REIT funds. The fund appears to have a large bias towards buying large-cap REITs and their exclusion of one very high-quality net lease REIT leaves questions about how “quality” is the factor influencing selections. To be thorough, I downloaded the entire list of holdings to ensure that O was not simply positioned outside of the top 10. I didn’t see it anywhere in the fund. Overall, I’m not impressed with the fund. It could be an interesting play if the shares were deviating from NAV, but that would really put the investor in the place of trying to play as a market maker rather than an investor. If the expense ratio was low enough, I could see investors using this as a way to get global REIT exposure. In that case, I would want the domestic allocations to be even higher. Since international REITs move with international stocks, I don’t see the point of combining international REITs with domestic REITs. Yes, they are both REITs. That does not mean they need to be in the same fund.

Comparing 3 Small Capitalization ETFs Tracking The Russell 2000 Indexes

Summary The highest dividend yield comes from IWN, but the lowest expense ratio comes from IWM. The sector allocations for IWN and IWO add up to the same allocations as IWM. Between IWN and IWO, I don’t see IWO as being substantially more aggressive despite being based on a growth index. There is a rare situation where an investor could benefit from combining the value and growth funds rather than using the main fund. One of the areas I frequently cover is ETFs. I’ve been a large proponent of investors holding the core of their portfolio in high quality ETFs with very low expense ratios. The same argument can be made for passive mutual funds with very low expense ratios, though there are fewer of those. In this argument I’m doing a quick comparison of several of the ETFs I have covered. Ticker Name Index IWM iShares Russell 2000 ETF Russell 2000 Index IWN iShares Russell 2000 Value ETF Russell 2000 Value Index IWO iShares Russell 2000 Growth ETF Russell 2000 Growth Index By covering a few of these ETFs in the same article I hope to provide some clarity on the relative attractiveness of the ETFs. One reason investors may struggle to reconcile positions is that investments must be compared on a relative basis and the market is constantly changing which will increase and decrease the relative attractiveness. Dividend Yields I charted the dividend yields from Yahoo Finance for each portfolio. All else equal, I consider higher dividend yields to be more favorable even if the expectation for total returns is the same. The preference for higher yielding ETFs comes from behavioral finance rather than modern portfolio theory. Under behavioral finance the human elements of investing are considered. A higher yield can encourage investors to stay invested when the market is done and to recognize lower prices as an opportunity to acquire shares that are “on sale” rather than a reason to panic and sell their portfolio at low prices only to repurchase the securities at higher prices. Expense Ratios I want diversification, I want stability, and I don’t want to pay for them. My general guideline for expense ratios is that I want to see the ratios below .15% on domestic equity ETFs and below .30% on international equity ETFs. However, there are times where it is reasonable to make an exception. Funds that must regularly rebalance their portfolio have a better case for having a high expense ratio than funds that simply follow a market capitalization approach. Sector I built a fairly nice table for comparing the sector allocations across each ETF to make it substantially easier to get a quick feel for the risk factors: (click to enlarge) For an investor with an emphasis on certain sectors there could be an incentive to take either the growth or value side. I find the health care sector to be a fairly defensive allocation, but it is heavily over weight in the growth fund and underweighted in the value fund. The other major defensive allocations are consumer defensive, which is similarly weighted, utilities, which is heavier in value, and real estate which is heavier in value. All things considered, I don’t find the growth ETF to be substantially more aggressive than the value ETF despite the growth ETF being characterized by funds with higher expected earnings growth rates and higher price to book ratios. Would You Ever Want to Combine IWO and IWN? IWM represents the entire Russell 2000 index and the weightings for IWM are consistently within a very small rounding error of the weightings for the other two funds because of the way the value and growth indexes are constructed. Because of the way the funds are constructed, I would expect IWM to consistently outperform a position of IWN and IWO since the investor would save on the expense ratios by paying .20% on their position rather than paying .25% on each of the other funds. On the other hand, theoretically if the funds were trading at a small discount or premium to NAV there could be a reason to take the two smaller funds. Returns I thought it would be interesting to run the returns on all 3 ETFs and see how similar or different the performance was across the ETFs. The results surprised me. Over the last 15 years or so the value side of the index performed dramatically better. Given the dot com crash early in the century, the results may be heavily biased. (click to enlarge) I entered the ETFs with the growth ETF first, the blended ETF second, and the value ETF third. It is interesting to note that the beta and annualized volatility moves down as we shift from growth towards value. That fits what I would expect, but it is interesting to see that the lower risk position (using beta) materially outperformed. However, when we restrict the performance to the last five years, the picture for returns changes: (click to enlarge) Despite the growth ETF offering superior returns over the last 5 years, it has still demonstrated a higher beta and higher volatility. Therefore, I would expect the higher level of volatility and beta on IWO to remain as a simple function of investing in small capitalization growth companies. Conclusion Over the last 15 years there was a strong outperformance by the value side of the index. Despite the strong performance of the value side through a period that saw two market crashes, the value side of the index does not look dramatically safer. The beta values indicate that the risk level on the growth side of the index is around 8% to 10% higher than the value side. In my opinion, the most attractive option for long term investments would be IWM for the lower expense ratio of IWN for the lower beta since I hold a substantial position in larger capitalization domestic equity.