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Static vs. Tactical Allocation

What makes sense and for whom.

Our first post discussed one of the biggest risk that investors face: sequence-of-returns risk. One way to mitigate this is through asset allocation. You can just put half your investments in equities and half in bonds to reduce your over-all risk. An alternative is tactical allocation. In tactical allocation, you use a signal, like an SMA (Simple Moving Average) or equity valuations to switch between equities and bonds. Here, at any given point in time, you are fully invested in one asset class.

So, which one is “better?”

The answer is, “it depends!”

It depends on the investor’s tax slab and whether it is going to be a lump-sum investment or a SIP. For lump-sums, investors are better off with a tactical approach (bonus if you are in a lower tax slab.) For SIP investors, static allocation makes more sense because you can maintain proportions without selling the over-allocated asset. And, surprisingly, the frequency of re-balance did not matter for static allocation.

Re-balance Frequency for Static Allocation

Our back-test shows that there is no difference to overall returns between monthly and annual re-balance frequencies. Focus on the black line on the following charts.

Monthly re-balance:

Annual re-balance:

Static vs. Tactical – Rolling 10-year Returns

Static allocation returns have been converging with those of the tactical strategy.

Green: static 50/50 allocation, monthly re-balance

Red dot: static 50/50 allocation, annual re-balance

Brown: 50-day SMA, weekly sampling

The above chart reinforces a couple of points we made earlier:

  1. Sequence-of-returns risk is real.

  2. Large impact of when you start and stop your investments (“luck” factor,) is real.

  3. Excess returns in a back-test could be because of high transaction costs or lack of liquidity. In such cases, expect excess returns to diminish as those factors improve.

  4. Barring a couple of instances, annually re-balanced returns were within the range of those that were re-balanced monthly.

Tax impact

If you do a worst-case tax impact analysis on both static vs tactical (SMA) strategies, over the long-arch of time, tactical wins. In the chart below, static allocation is the ALLOC.NET-ST (green) line and tactical is the SMA.NET-ST (red) line.

However, if you are a SIP investor, then you don’t need to sell the over-allocated asset under a static-allocation setup – you could just buy the under-allocated one till it falls back in line. So, if you plot the after-tax returns of tactical allocation with pre-tax returns of static allocation by year:

Years 2011 through now, there is hardly any difference between them. They both turn in annualized gains in the low 7% range – adding about 1.25% over an all equity portfolio.

Summary

  1. For lump-sums, choose tactical. For SIP choose static allocation.

  2. Don’t ignore bonds. There are periods where a bulk of the returns are driven them.

  3. Don’t ignore the role of taxes in DIY. For example, a mutual fund that wraps the SMA strategy would enjoy a 2+ % boost in annualized returns.

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Tactical Allocation, An Introduction, Part II

We introduced tactical allocation in our Free Float newsletter last week. We saw how, by using a simple moving average to toggle between equities and bonds, one can reduce drawdowns in their portfolios. In the ensuing discussion, we mentioned how excess-returns found during back-tests could be an artifact of illiquidity and high transaction costs of the markets in the past. It is not like people who traded markets before us were dumb (or somehow, we suddenly added 50 IQ points in the last 20 years.) There has to be a reason why the money was left on the table.

Indian markets have seen significant changes over time. It has got more deeper and wider with better liquidity, lower transaction costs and higher levels of automation. One way to gauge the efficacy of strategies is to use a metric like Sharpe or Information Ratio over rolling-windows through time. Also, the drivers of total returns in allocation strategies will be different across different time-horizons leading to different tax liabilities. It is useful to decompose returns to handicap them from a tax angle.

200-day Tactical Strategy
50-day Tactical Strategy
  • There are quite a few time-periods where tactical allocations will under-perform buy-and-hold equities.
  • Over a 10-year horizon, on an annualized basis, bonds have contributed about 1-4% to over-all returns.
  • Sharpes have been falling through time. One should expect this strategy to attenuate further.
  • Bonds have a bigger say in determining over-all returns in low equity return environments. So, use both assets!
  • Bond returns have been less volatile that those of equities’. However, that doesn’t mean that have been constant through time.
With and without bonds

In high equity-returns environments, bonds are usually an after-thought. However, running these strategies “equities-only” is ill-advised. In the chart above, returns in the recent 10-year periods have been palatable only because of the returns contributed by bonds.

Our personal experience has been that when equities drawdown, investors switch over to tactical strategies, only to abandon them once stocks recover. Thus, leaving their downsides exposed during the next drawdown; ensuring that they end up with the worst of both worlds.

Excess returns aside, SMA strategies are also useful in managing risk. With lower risk, one can employ a bit of leverage to boost returns. We have done deep-dives into variations of these strategies in the past. Interested readers can have a look at our SMA Collection.

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Allocating a Four-Asset Portfolio

Our previous posts showed how various allocation decisions impact optimized and equal-weighted three-asset portfolios. Here, we add a fourth asset – gold – and run it through the same scenarios.

Picking the Assets and Allocation

The assets we selected previously – MIDCAP, 0-5yr bond and NASDAQ-100 – were based on low observed historical pair-wise correlations. Most investors tend to add a fourth asset – gold – to their portfolios. Not only is gold not correlated with the other three, it has the added benefit of being priced internationally but traded locally. This allows it to benefit from rupee depreciation even if international gold prices remain flat. Observe how, at times, gold has a negative correlation to other assets:
correlations between gold, SPY, QQQ, MIDCAP and BONDs

The results

In the cumulative return and drawdown chart below, A1 is the MIDCAP index, A2 is the 0-5yr bond index, A3 is the QQQ and A4 is gold. A tax drag of 10% and an STT of 0.1% is applied at every rebalance. The rebalance threshold is set at 20%. The light-blue lines are the resulting portfolio returns. In the case of optimized portfolios, assets are allowed to have a weighting between 10% and 40% during the optimization process.

Equal Weighted

after tax cumulative returns of 4-asset equal weighted portfolio

Variance optimized

after tax cumulative returns of 4-asset variance optimized portfolio

Expected Tail Loss optimized

after tax cumulative returns of 4-asset ETL optimzied portfolio

Pre- and Post-tax returns

before and after tax cumulative returns of 4-asset equal weighted portfolio
before and after tax cumulative returns of 4-asset variance optimized portfolio
before and after tax cumulative returns of 4-asset ETL optimized portfolio

Rebalance

The rebalance threshold ends up determining the frequency of rebalance events. For a variance optimized portfolio, contrast the difference between a 20% threshold and an 80% threshold:

4-asset portfolio at a 20% rebalance threshold
4-asset portfolio at a 80% rebalance threshold

Take-away

  1. Every time there is a rebalance, the tax-man cometh and taketh away. Trying to minimize taxes is equivalent to minimizing the number of rebalancing events.
  2. To minimize reblancing events, one could set the threshold of rebalance higher. But there is a point of inflection with regards to after-tax returns.
  3. Allowing a single asset to balloon in weight risks larger portfolio drawdowns if that asset deflates.
  4. A four-asset equal weight portfolio under-performs a 3-asset equal weight portfolio. Gold maybe a good diversifier, but it doesn’t appear to do any favors to the portfolio on the performance front.
  5. Equal-weight 4-asset portfolio containing gold (above) drew-down less than the equal-weight 3-asset portfolio during the 2008 carnage (~30% vs. ~40%, respectively.)

Adding gold to a portfolio does not look like a good idea when looked through the lens of asset allocation schemes discussed here. However, there is a strong case for owning gold and the Sovereign Gold Bond (SGB) Scheme makes a lot of sense. See our previous post regarding the case for owning gold in India here.

Code, charts and the complete result dataset are available on github.

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Allocating a Three-Asset Portfolio, Optimized

Our previous post showed how various allocation decisions impact an equal-weighted three-asset portfolio. However, equal-weights are not the only way to go. Every time a rebalance occurs, we can use that opportunity to re-weight the assets to minimize expected risk while maximizing expected returns. In this post, we look at two ways in which risk and returns can be optimized.

Portfolio optimization and the efficient frontier

The intuition behind what we are going to do is quite simple: for a given set of assets, there is an ideal mix of them that perfectly balances risk with reward. Imagine a plot of risk and returns of each asset under consideration. Harry Markowitz showed back in the 1950’s that they form a parabola and at a particular tangent of the parabola lies the ideal mix. The goal of portfolio optimization is to find that point. Here are some links that explain this concept further:

For the purpose of this post, we will assume risk to either mean variance (var) or expected tail loss (ETL.) We will use portfolio optimization methods to minimize one of these risk metric and maximize expected mean returns below.

Optimized portfolios

Like before, to keep things simple, we will go with the MIDCAP 100 index (A1), the 0-5yr TRI (A2) and the QQQ ETF (prices converted to INR, A3) as the three assets that form our portfolio.

Here is how the optimized minimum-variance portfolio performs after-tax:
min-var 3-asset portfolio (NIFTY MIDCAP, 0-5yr bond, NASDAQ-100)

Asset weights after rebalance:
min-var 3-asset portfolio (NIFTY MIDCAP, 0-5yr bond, NASDAQ-100) asset weights

And here is how the optimized minimum-ETL portfolio performs after-tax:
min-etl 3-asset portfolio (NIFTY MIDCAP, 0-5yr bond, NASDAQ-100)

Asset weights after rebalance:
min-etl 3-asset portfolio (NIFTY MIDCAP, 0-5yr bond, NASDAQ-100) asset weights

Min-var portfolio returns

min-var 3-asset portfolio (NIFTY MIDCAP, 0-5yr bond, NASDAQ-100) returns

Min-ETL portfolio returns

min-var 3-asset portfolio (NIFTY MIDCAP, 0-5yr bond, NASDAQ-100) returns

Take-away

  1. All things equal, the optimized portfolios under-perform the equal-weight portfolio in terms of absolute returns.
  2. Optimized portfolios show lesser risk than the equal-weight portfolio. During the 2008 carnage, for example, equal-weight drew-down ~40% whereas optimized portfolios drew-down ~20%.
  3. Optimized portfolios over-weigh bonds. Hard limits were set on the maximum and minimum weights the assets can have in optimized portfolios. Toggling these will have a significant impact on portfolio risk and returns.

Code, charts and the complete result dataset are available on github.

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Allocating a Three-Asset Portfolio, Equal Weighted

Our previous post showed how various allocation decisions impact a two-asset portfolio. We started with two assets – equities and bonds – because it forms the foundation on which most allocation plans are built. However, the true impact of diversification is felt when you have uncorrelated assets in the portfolio. Here, we expand on the post by adding a third asset.

Picking the Assets and Allocation

As much as we would like equities and bonds to be uncorrelated, it is not always true. Indian equities and bonds are buffeted by the same storms at about the same time. However, what has historically shown to be a true diversifier are international equities. If you run the pair-wise correlations between the S&P 500, Nasdaq 100, the USD adjusted MIDCAP 100 and 0-5yr TRI, you see this:
correlations between SPY, QQQ, Indian MIDCAP and bonds

Given how strongly the S&P 500 (the SPY ETF) and the Nasdaq 100 (the QQQ ETF) are correlated, there is no point in adding both. We’ll go with the QQQ because it has an Indian analogue in the N100 ETF. Also, note how the SPY and QQQ are uncorrelated to the dollar adjusted MIDCAP and 0-5yr TRI indices. And finally, observe the light correlation between the MIDCAP and 0-5yr TRI indices.

So, to keep things simple, we will go with the MIDCAP 100 index, the 0-5yr TRI and the QQQ ETF (prices converted to INR) as the three assets that form our portfolio. And to get things started, we’ll keep an equal weight on all these three assets in the portfolio. The toggles that remain are the rebalance thresholds and tax impact. Here, we will use the same iterations that we employed in our two-asset portfolio example.

The results

In the cumulative return and drawdown chart below, A1 is the MIDCAP index, A2 is the 0-5yr bond index and A3 is the QQQ. A tax drag of 10% and an STT of 0.1% is applied at every rebalance. The rebalance threshold is set at 20%. The blue line is the resulting equal weight 3-asset portfolio returns.
NIFTY MIDCAP 100, 0-5yr bond and NASDAQ 100 equal weight portfolio

Take-away

  1. Lower risk: The equal-weight portfolio draws-down less than the MIDCAP index.
  2. Lower returns: The MIDCAP index out-performs the equal-weight portfolio (but with far greater volatility.)
  3. Needs discipline: The difference in returns between the MIDCAP index and the equal-weight portfolio can often be very large. Keeping still is a virtue.
  4. Tax-impact: The equal-weight portfolio has a tax and transaction cost angle that a MIDCAP buy-and-hold strategy doesn’t. Capital gains on international equities, bonds and domestic equities are all treated differently.
  5. Asset allocation is about delivering better risk-adjusted returns through diversification.
equal weight portfolio returns
Side note: setting the rebalance threshold is a trade-off between holding onto trending assets (potentially more profits) vs. booking profits and buying a lower-return asset (FOMO and tax incidence.) There is a wide range of theories on this topic. For now, we will restrict ourselves to just running through different scenarios.

Code, charts and the complete result dataset are available on github.

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