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February 2016 Update
COUNTERPOINT
M U T U A L
F U N D S
The Buy and Hold Religion
In investing, the following commandments are the religious truths governing the cult of Buy and Hold. If
your belief wavers, you risk committing moral blasphemy:
1. The stock market will make 10% a year in the long run.
Any correction or bear market is a long term buying opportunity.
2. Market timing is impossible. To attempt it is to waste money and effort.
3. Diversification is the only responsible approach to downside risk management.
Especially in the US, stock market investors have been consistently rewarded for taking risk. Past
technological leadership, supportive population and economic growth fundamentals, military and
geopolitical advantages, high participation rates in stock investments amongst the US population, and past
economic and regulatory stability have all benefited the “equity risk premium” justification that says you
should get paid extra to take on the risk of buying equities.
We don’t know for certain if technological leadership will continue to drive growth (we hope it will). We
also don’t know how economic growth will pan out going forward.
With substantial challenges to the 10% number on the horizon, it is now reasonable to question
diversification alone as the almighty investment strategy, and to take a serious look at market timing as a
risk management tool.
So can the market be timed successfully? Mebane Faber proposes a simple moving average trend following
model that may help us answer the question. His system idea: On a monthly basis (to avoid noise and false
signals), own the S&P 500 (and/or other risky index type assets) when it has closed above its 10 month
moving average, and sell the same index when it crosses below the 10 month moving average.
Growth of $1 of Buy and Hold vs Tactical Market Strategies Since S&P
500 Inception
$1,000
$100
$10
Tactical S&P 500
2013
2010
2007
2004
1998
2001
1992
1995
1989
1983
50%/50% Tactical/Buy and Hold
1986
1977
1980
1971
1974
1968
1962
1965
1959
1956
1953
1950
1947
1944
1941
1935
1938
1932
1929
$0
1926
$1
S&P 500 Buy and Hold
The indices shown in the illustration above are for informational purposes only and are not reflective of any investment. Investors
are not able to invest directly in the indices and unmanaged index returns do not reflect and fees, expenses of sales charges. Past
performance is no guarantee of future results.
1
Displayed with a logarithmic scale, we modeled the system (Tactical S&P 500) since the inception of the
S&P 500, alternating between the total return of the S&P 500 index and an approximation of holding short
term treasuries by earning a monthly yield equivalent to the 3-month US treasury interest rate. Monthly
S&P 500 data since inception in 1926 was provided by CRSP, with treasury data from the St. Louis Fed.
The apparent result: Over a very long time horizon, $1 invested in the buy and hold strategy
underperforms the market timing approach by nearly 90%. Over almost a century of time, despite being a
material number, we do not consider this difference (of a little more than 2% return annualized) in return
the most interesting improvement, particularly since implementation and transaction costs by an active
manager would consume a meaningful part of those returns.
What we do consider spectacular is the differences among the different strategies’ downside risk profiles:
2013
2010
2007
2004
2001
1998
1995
1992
1989
1986
1983
1980
1977
1974
1971
1968
1965
1962
1959
1956
1953
1950
1947
1944
1941
1938
1935
1932
1929
1926
Index Strategy Portfolio Drawdowns
0%
-20%
-40%
-60%
-80%
-100%
Tactical S&P 500
50%/50% Tactical/Buy and Hold
Buy and Hold S&P 500
The indices shown in the illustration above are for informational purposes only and are not reflective of any investment. Investors
are not able to invest directly in the indices and unmanaged index returns do not reflect and fees, expenses of sales charges. Past
performance is no guarantee of future results.
Such a substantial difference in realized downside risk strikes us as very impressive. For human investors,
the biggest problem isn’t achieving an acceptable total return; it is their willingness or ability to stick to
the program. An 80% loss during the Great Depression coupled with the loss of a job would have been
catastrophic to savings, forcing sales at exactly the wrong time. This is Buy and Hold’s fatal flaw.
Trend-Following
The mechanism that describes this system is trend-following, a type of tactical strategy. It has the potential
to work because news – good or bad – takes time to reveal itself and become reflected in stock prices. It
might be worth revising the Second Commandment:
2. Market timing is impossible. To attempt it is to waste money and effort pursue an alternative risk-reward tradeoff.
Tactical approaches may serve to help diversify a portfolio and improve risk traits. A combined strategy
that evenly weights and monthly rebalances the S&P 500 with a tactical approach lowered standard
deviation from 18.9% to 13.9%, lowered beta exposure to 70% on average while retaining substantial
overall correlation of 94%, and amazingly cut maximum drawdown from 53% to 31% (in 1950 to present
period).
2
Risk and Drawdown Characteristics of Tactical versus Buy and Hold
Annualized Standard Deviation
Beta to S&P 500
Correlation to S&P 500
Max Drawdown Since 1950
Max Drawdown Since 1926
Tactical S&P 500
11.8%
0.39
0.62
-24%
-49%
50%/50% Tactical/Buy and Hold
13.9%
0.70
0.94
-31%
-67%
Buy and Hold S&P 500
18.9%
-53%
-86%
The investment community seems to broadly believe that acceptance of a tactical investment approach
means rejection of Modern Portfolio Theory (MPT) – the driving force behind diversification. We do not
see tactical versus passive approaches as mutually exclusive. These results instead show tactical strategies
can potentially enhance a portfolio, and absolutely do not conflict with tried and true conclusions about
the benefits of using MPT to improve a portfolio’s risk-return tradeoff.
Diversification and implementation of MPT through a buy-and-hold approach is an investment strategy,
not a moral choice. As such, we suggest revising the Third Commandment to:
3. Diversification is the only responsible an excellent approach to downside risk management that may be
improved by the addition of a tactical trend-following strategy.
Like all things to do with the markets, past results are not a guarantee of future results. Despite the
possible benefits to downside risk management, tactical approaches will always have periods of
underperformance relative to buy and hold approaches, particularly when markets chop around and give
false trading signals.
Detractors of market timing approaches will readily cite underperformance periods as a justification to
abandon tactical approaches.
40%
30%
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
1929
1932
1935
1938
1940
1943
1946
1949
1951
1954
1957
1960
1962
1965
1968
1971
1973
1976
1979
1982
1984
1987
1990
1993
1995
1998
2001
2004
2006
2009
2012
2015
Buy and Hold S&P 500 Versus Tactical Rolling 36 Month Outperformance
(Annualized)
The indices shown in the illustration above are for informational purposes only and are not reflective of any investment. Investors
are not able to invest directly in the indices and unmanaged index returns do not reflect and fees, expenses of sales charges. Past
performance is no guarantee of future results.
An empirical look reveals a much more consistent relationship between buy and hold and tactical
management returns. Black represents periods of Buy and Hold outperforming where green represents
Tactical leading. Relative outperformance of each approach cycles for extended multi-year periods. If
anything, the oscillation of this relationship is to be expected, and is arguably a consistent feature through 3
history. The shifting relative outperformance between both strategies lends credibility to the idea that tactical
strategies have their place in a portfolio next to passive ones, as they offer genuinely needed diversification.
Systematically deployed, market timing is not a mortal sin. It’s a strategy for pursuit of the greater good.
Michael Krause, CFA
Partner and Portfolio Manager
Counterpoint Mutual Funds
The material provided herein has been provided by Counterpoint Mutual Funds, LLC, and is for informational purposes only.
Counterpoint Mutual Funds, LLC serves as investment adviser to one or more mutual funds distributed through Northern Lights
Distributors, LLC member FINRA. Northern Lights Distributors, LLC and Counterpoint Mutual Funds, LLC are not affiliated entities.
4287-NLD-4/19/2016
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