Not buy-and-hold, but buy-and-sell rarely(ZT)

By Robert Powell, MarketWatch

BOSTON (MarketWatch) — As investment strategies go, it’s pretty simple one. Even better, it’s one that will improve, according to the authors of a newly published paper, the risk-adjusted return of your portfolio without much fuss.

No, it’s not a buy-and-hold strategy. Rather, call it a market-valuation-based-tactical asset allocation strategy. Or, if you prefer, and with apologies to the authors of the paper, call it the buy-and-sell-twice-a-decade strategy, when market valuations — as measured by the PE 5 (a version of Yale University Professor Robert Shiller’s PE 10 ratio) — are either very high or very low.

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Here’s how it works according to Michael Kitces, chief investment officer of Pinnacle Advisor Group, publisher of The Kitces Report, and one of the co-authors of the paper, which was published in December issue of the Journal of Financial Planning.

You start with a portfolio that is allocated 50% to stocks and 50% to bonds.

And when the stock market is undervalued, when the PE5 is 10½ or lower, you would increase the percent invested in stocks to 60% and decrease the percent invested in bonds to 40%.

And when the stock market is overvalued, when the PE5 is 22 or above, you decrease the percent invested in stocks to 40% and increase the percent invested in bonds to 60%.

All other times, you would maintain a 50% stocks, 50% bonds portfolio, a neutral portfolio.

In practice, Kitces said this approach has resulted in but a couple of trades a decade. “We trade in the 10% most overvalued environments, and the 10% most undervalued environments,” he said. “That means we trade 20% of the time in total. That would be two out of every 10 years.”

So, what would this strategy get you in terms of return and risk? In the paper, the authors noted that a 50% stocks/50% bond portfolio would have an expected return of 8.21% with a Sharpe Ratio of 0.352. (The Sharpe Ratio is used to measure risk-adjusted performance, the greater a portfolio’s Sharpe Ratio, the better its risk-adjusted performance.)

By contrast, the tactical portfolios of 60% stocks/40% bonds or 40% stocks/60% bonds portfolios had an expected return of 8.40% and a Sharpe Ratio of 0.369.

And if you were even more aggressive, allocating not just 60% to stocks when the market was undervalued, but 70% or 30% when it was overvalued, the portfolio had an expected return of 8.58% with a Sharpe Ratio of 0.379.

Read the study in the Journal of Financial Planning, here.

Now all that might seem like a small difference, but according to Kitces adding one-quarter to one-half of 1% in return per year can add up over time. “It’s not a huge effect,” he said. “We’re talking about 25 to 50 basis points of increased long-term average returns. But compound that over a lifetime and you’ll have a material increase in long-term wealth.”

What’s more, this tactical asset allocation strategy is not just about absolute returns, but risk-adjusted returns, he said. With this strategy, Kitces said, investors will avoid what he describes as bad volatility and reap the benefits of good volatility. “When you are tactical, you get rid of the bad volatility of losing money and keep the good volatility associated with making money,” he said.

For the record, plenty of financial advisers are now using tactical asset allocation strategies to manage money these days. According to a Cerulli Associates survey, the percent of financial advisers using either a pure tactical allocation or strategic allocation with a tactical overlay is now at 61%, up 8.3% from 2010, according to a Registered Rep report.

What’s more, a Jefferson National survey from September 2011 found that 75.5% of advisers believe that active portfolio managers can outperform an index over the long term. In Jefferson National’s 2010 survey, 66% of advisors said clients were more confident with a tactical asset management strategy, while only 34% said clients were more confident with a traditional buy-and-hold strategy.

Now at first blush, Kitces’ approach might seem like nothing more than a buy-low-and sell-high strategy. And in some ways it is. The big difference, however, is this. Kitces is applying rules to the buying and selling. Plus, Kitces is able to execute his strategy with other asset classes.

At least one investment professional is supportive of the strategy. “I generally agree that tactical asset allocation can in fact add value to portfolio management,” said W. Bradford McMillan, a vice president and chief investment officer at Commonwealth Financial Network. “The results seem reasonable.” McMillan noted, for instance, that he too has done research in related areas and that others, notably Ed Easterling of Crestmont Research, have done research so as well.

But not all investment professionals are enamored with the tactical asset allocation approach to investing. Kitces’ paper outlines an approach that suggests that you can get higher returns vs. a static asset allocation if you increase exposure to equities when P/E is low and reduce exposure to equities when P/E is high, said Geoff Considine, founder of Quantext.

“This is logical enough,” Considine said. “There is a wide array of research that shows that buying stocks when P/Es are low is likely to yield higher returns than when P/Es are high.”

But the overall returns from this historical analysis are very modest in Kitces’ paper, said Considine. “The Sharpe ratios are lower for the portfolios using the tactical strategy, though the authors give a fair explanation. The tactical overlay strategy with the highest Sortino ratio adds only 0.3% per year. Given all of the uncertainties associated with back-testing a strategy, this apparent benefit is slim.”

What’s more, Considine said the relative gain of 0.3% per year is much smaller than projections of the value of simply adding commodities to your asset allocation. For example, he cited an Ibbotson study commissioned by PIMCO in which portfolios boosted returns by adding commodities.

See the relevant portion of the Ibbotson study commissioned by P IMCO, page 44.

In general, the use of fundamental information such a P/E or dividend yields to determine the relative attractiveness of bonds vs. stocks makes sense, said Considine. But the results in Kitces’ study suggest that this “type of tactical overlay may not be worth the additional complexity as compared with alternatives to boosting the risk-adjusted return such as by including alternative asset classes.”

It’s unlike that Kitces would agree with that assessment. Two trades a decade is hardly complex. True, it’s more complex than buy-and-hold. But it’s not nearly as complex as market timing, and that might make it a sound strategy for those who like to tinker but not all that much or often.

Robert Powell is editor of Retirement Weekly, published by MarketWatch. Learn more about Retirement Weekly here. Follow his tweets here. 

Robert Powell has been a journalist covering personal finance issues for more than 20 years, writing and editing for publications such as The Wall Street Journal, the Financial Times, and Mutual Fund Market News.