As we approach the 1 year anniversary of publishing our first post on credit-informed tactical asset allocation (Are You There Stocks? It’s Me Credit), we thought now would be a good time to take a look back and see how the strategy performed in real-time and to extend the strategy as well. Following our credit-informed tactical asset allocation strategy provided superior absolute and risk-adjusted returns over the past year.
Our original paper paired the Russell 2000 stock index with the Merrill Lynch HY/B corporate credit index. More recently, we developed the Capital Context Corporate Index (C3I) as a proprietary credit index with high sensitivity to the S&P 500. The strategy is straightforward. Based on a 6 month time horizon, if equities appear cheap relative to their empirical relationship to the credit index, we stay long equities. If equities appear expensive, we are market neutral. The strategy is thus a long-flat exercise rather than long-short. Over our 15 year back-test, the strategy tends to be neutral more often than long.
Starting in the spring of 2011, our stock indicator pointed to equities trading expensive. Thus, we missed the massive swoon in July/August of last year. We were not completely immune to losses given that the indicator switched from rich to cheap a day too early. However, the strategy avoided most of the summer’s losses. As the market recovered, the strategy missed out on much of the gains. This is a feature of the credit-informed model. It tends to outperform in volatile, down markets by getting out early and often lags in up markets. For this reason, we believe it makes sense to combine the credit-informed TAA strategy with other, non-correlated strategies.
Overall, the strategy was market neutral a whopping 90% of the past year. This led to a painful period from last fall through the winter when the equity market was on an express elevator upwards and we were stuck in neutral. With the recent market sell-off, equities are trading much closer to their year-ago levels. In contrast, the TAA strategy made healthy gains with relatively low volatility. All gains reported are based on market open to market open returns as the signal is calculated after market close. From June 3, 2011 through May 31, 2012, the strategy returned 7.6% with volatility of 9.5% compared to the S&P 500 which returned 3.3% on 21.7% volatility. To keep things simple throughout our analysis, we assume that cash returns 0%. This understates our TAA performance (of course, over the past year the difference is negligible).
Moving Beyond Equities – Switching Between SPY & AGG
Of course, a common investor aim is to maintain a mix of asset classes in one’s portfolio. The credit-informed TAA strategy can help raise expected returns and lower portfolio volatility within the broader context of a portfolio’s strategic asset allocation. As an example, we choose a 60/40 ETF portfolio of the S&P 500 (SPY) and the Barclays Aggregate Bond index (AGG). For simplicity, we rebalance daily but monthly rebalancing provides similar results. We use a beta of 0.57 as our hedge ratio based on SPY & AGG’s relative daily performance from Jan 2010 through May 2011. As is evident in the chart, the equity hedge boosts returns to the 60/40 portfolio. It also lowers portfolio volatility.
AGG has a negative correlation to SPY. A straightforward extension of our long/flat strategy is to be long stocks when they are cheap and long AGG when stocks are expensive. Rather than going market neutral or shorting the market when stocks appear expensive, we invest in a negative beta, yield-producing asset. In back-test, this long/long switching strategy provides stellar returns. Since AGG’s inception in September 1993, the strategy would have produced annualized returns of 14.5% on volatility of 16.0%. This compares favorably with the 60/40 strategy’s 5.2% annualized return with vol of 12.5%. While the strategy calls for switching from 100% long SPY to 100% long AGG, a more tax-efficient and scalable way to implement the strategy is to stay 100% long AGG and buy S&P futures when stocks appear cheap. Regardless of how the strategy is implemented, we believe it is worth consideration.
In keeping with recent history, the past year brought a great deal of tumult to the markets. Credit-informed TAA proved its worth this past summer and continues to do so. Whether used on its own or in conjunction with other TAA strategies, equity investors would do well to keep an eye on developments in the credit markets when making tactical asset allocation decisions.