By Richard Morey
January 2022
2021Tactical Allocation Retrospective
Last year we had a difficult beginning, due to the worst first quarter in 40 years for government bonds. In the first quarter last year our bonds dropped 2.97%. Gold had a much worse beginning, pulling back 11.35% in Q1 2020. (The bond market did rebound some as the year progressed, though the entire U.S. bond market index ended the year down 1.1%.) 
In fact, four out of the five defensive funds we owned as 2021 began dropped in the first quarter. When we combined those five funds, our portfolios invested according to “pure” tactical allocation lost 2.4% in the first quarter of the year.
We began the year on heightened alert to avoid risk, so by the end of the quarter we had begun to sell the offenders: first our intermediate Treasury bonds and gold shortly thereafter. This money was then invested relatively slowly over the next few weeks and months in the attempt to hit a target of approximately 6% average annual return* between now and the time the markets change direction.
Since the changes were made at the beginning of the 2nd quarter, 2021, our portfolio rebounded and showed profits each of the last 3 quarters of 2021 for a total of a positive 3.8% over the last 3 quarters.
Here are the returns from our six core funds since the changes were made, i.e. over the last 9 months of 2021. They are listed with the oldest holding first and the most recent purchase last. The first five funds were either owned all year or purchased from April through August, while the last fund was purchased in late December:
Hussman Strategic Total Return 4.17%
PIMCO Trends Managed Futures 10.34%
AlphaCentric Premium Opportunity 4.33%
Rational Tactical Total Return 1.62%
PIMCO 25+ Year Zero Coupon US Treasury Bonds .45% **
* Note this is our minimum targeted, expected average annual return. It obviously isn’t a guarantee we’ll always make that exact amount or more. Guarantees such as that don’t exist when we’re dealing with investments whose prices move each day based on a wide variety of factors. We believe this expected return is achievable – at a mathematically defined, relatively low level of risk – with the likelihood of success rising over time.
** This fund (Pimco 25+ Zero Coupon US Treasury Bonds) was sold on 1/7/21. It went down 3.9% the first four days of this year. While not a large drop, this market looks suspiciously like both 2018 and 2021– years which began with a short but severe bond market rout, bringing down the stock market. In other words, everything went down in those markets, as they have begun to do this week at time of writing. We therefore decided to sell our long treasury bond fund to quickly lower our volatility.
Analysis of 2021 Performance
The goal of the Tactical Allocation Portfolio is to make an average of 6% yearly over time at a low risk level (defined mathematically by measuring volatility). Last year the portfolio only made 1.2% in our typical portfolio being managed according to tactical allocation. Over the last 3 years, from 1/1/19-12/31/21, this portfolio has made 4.5% a year.
These returns can be difficult for some, wishing we had been in stocks last year instead of our defensive funds. Hopefully this short analysis will explain why we continued to protect against market risk which again didn’t materialize. This lowered our returns but was, we feel, necessary given the extraordinary market landscape.
Any justification I present for falling below 6% in any year certainly doesn’t mean I’m satisfied myself. Regardless of how any market performs, there are always opportunities to prudently make more. Admittedly this becomes more challenging when risk assets are grossly overpriced and the foundation of most conservative assets – government bonds/investment grade bonds – performs poorly.
However, just because the “cost” of protecting has reduced our defensive opportunities since mid-2020 doesn’t mean we won’t meet or exceed our 6% target over the next year. Most important is to meet our target of making over 6% annually from 2010 to the end of this business cycle.
The funds we have chosen for our portfolio are designed to offer strong upside potential and also to complement each other and offset risk inside the portfolio. Managed futures in particular are known as the single best tool for diversification, as over time they have exceptionally low correlations with all other asset classes. While managed futures are sometimes described as risky or speculative types of investing, whoever describes them accordingly doesn’t understand volatility targeting.
When done properly managed futures investing is neither “risky” nor “safe” but takes the amount of risk previously calculated. When viewed from this perspective, we see managed futures typically take approximately the same amount of risk, over time, as a modestly aggressive bond fund, with less than half as much volatility as the broad stock market.
For example, my favorite “multisector” bond fund is called Loomis Sayles Bond which has volatility of 7.99 (standard deviation) versus 8.67 for our managed futures fund PIMCO Trends Managed Futures. Comparable risk, 60% higher returns over the last 5 years, & downside protection – you can see why we prefer managed futures to multisector bonds at this time.
We then combine our two managed futures funds with three other conservative funds – each with less than half as much volatility as managed futures. The result is our current portfolio with a volatility score or STD of 3.3.
Looking Ahead
We begin with a portfolio designed to make 6% annually for as long as the stock market continues to advance. For as long as the status quo continues – whether for a day, month or year – our current portfolio has, we believe, the lowest risk scores you’re likely to ever see that has an expected return of 6%.
A unique feature of the Tactical Allocation Portfolio is that it is specifically designed to recapture any shortfall in one mini-market cycle by the end of the entire cycle. In other words, the portfolio is designed to make up for any shortfall in any year since 2010 in the last 12-24 months of this cycle.
Notes on Stock Investing
We all know the stock market had another stellar year. I also know the risk versus reward in stocks is so skewed to the downside that no sane investor would allocate new money to stocks unless they had been and were continuing to follow a strict Buffett-style buy and hold discipline. Even better would be to partially or even fully hedge the stocks a person owns – which is precisely what we’ve been doing for clients who have specifically said they always prefer to have some amount allocated to stocks.
Owning some stocks or stock funds when the risk is carefully hedged is always fine. Buffett himself, for example, has a huge hedge in the form of approximately $140 billion in cash. Keep in mind Buffett has always hated cash, due to the opportunity cost of which he is vividly aware. Yet the single best stock investor our country has ever seen has been paying the cost of sitting out this stock market run with an ever-expanding mountain of cash (from 2013 and especially since Q2 2020).
Like Mr. Buffett, I also dislike paying for hedges to protect against risk. Keep in mind, Mr. Buffett prefers to make money more than anyone I’ve ever witnessed, but he’s willing to forego making money on his $140 billion in cash because that’s how much he values protecting against (stock market) risk right now. This is definitely starting to sound familiar!
There are pros and cons to hedging, as with all investment approaches, but it can allow a person concerned about risk to have some amount of their money in the most over-priced stock market ever without taking undue risk. My question is simply how many retired investors have a penny of their risk hedged, or how many have any idea how much risk they’re actually taking?
Anyone who pays for insurance may feel bad any year it costs them money but doesn’t pay off. But when the large payoff comes, those who saw the risk and prudently protected against it come out unscathed and, when successful, whole regardless of the size of the risk. The only investor I know with more protection against risk than Warren Buffett is Secure Retirement. Both plan to protect such that we will have the money to, hopefully, catapult ahead when our “insurance” pays off.