Generally speaking, it is safe to say that most investors want to lower their risk while trying to achieve high returns. So, why aren’t more investors considering rotational, rules-based investing strategies?
What Is Rotational, Rule-based Investing?
Rotational investing is a modern-day investment strategy that has gained more and more attention in the last few years. As the name implies, it involves the rotation of a portfolio’s assets over time. In other words, the strategy is the opposite of a buy-and-hold or a targeted “tactical” asset allocation strategy, which is often the status-quo approach to investing.
How it Works
The rotation of assets is based on a set of rules. The rules are typically based on a momentum investing technique called “relative strength” and widely used market indicators called “moving averages”.
The “relative strength” rule is used to determine which investment positions (asset classes, stocks or ETFs) are the strongest and weakest performers over a given time period. Using this technique, positions are sold as performance shows weakness, and positions are purchased or held as performance becomes stronger. An over-simplified way to think of relative strength is to apply a basic question to each position you own, “Relatively speaking, has the recent performance been strong or weak?” If the relative performance has been strong, it is typically held. If the relative performance has been weak, then it typically is sold and a stronger asset is purchased. The general idea is that you want to invest in the strongest areas of the market and avoid the weakest. The “moving average” rule adds a second layer to the process. When the moving averages are applied the best performing assets must be above the moving average to be selected.
One of the many benefits of a rotational, rules-based strategy is it is designed to provide downside protection from bear markets. In 2008, a simple rotation strategy selecting an ETF from one of the five basic asset classes (US stocks, US bonds, Foreign Stocks, Real Estate, Commodities), rotated in to the safest asset class – US bonds (IEF: iShares 7-10 Year Treasuries) – which was up over 15% in 2008. In hindsight, the result was that the rotation provided performance that was significantly better than the overall broad market (S&P 500 benchmark), while doing so with a reduced amount of risk, as measured by standard deviation.
The primary drawback of using rotational, rules-based strategies is that they can underperform when markets are lacking an overall direction (moving back and forth) or if the broad market is in a significant uptrend. However, many investors will gladly accept a return that doesn’t “beat the overall market” in a good year, for a return that provides downside in a really bad year.
Various rotation, rules-based strategies can be backdated to see historical and/or hypothetical results of rotations over time. In many cases the strategies outperform the broad stock market with a lower level of volatility and drawdown (peak-to-trough decline). While past performance is not an indicator of future performance, the historical evidence serves as a basis for the strategy and decision making.
How it Diversifies Different
This strategy is different from traditional “strategic asset allocation”, which targets and remains invested in a diversified mix of assets (i.e. 60% stocks vs. 40% bonds). Rotational strategies don’t have a predetermined target allocation due to the fact that the strategies are always seeking to place you in the strongest relative asset.