Ranking the top and bottom TAA strategies

Following up on my last post, I’d like to take a deeper dive into the performance of TAA strategies. In particular, I’ll take a look at the differences between the top performing TAA strategies and the bottom performing ones. There are some important points that come out of this analysis which I think are quite useful when deciding which TAA strategies are right for you.

As in my last post…

The data I’m using is from Allocate Smartly. I’ve taken return data for all the TAA strategies they track, 60/40, and the All Weather Portfolio (a globally diversified portfolio). Data is from 1970 through October 2016 (note: not all the strategies have performance data going back to 1972). I averaged the performance of all the TAA strategies to compare them as a whole to the two other ‘static’ strategies. Finally, to smooth out the data somewhat I calculated three year rolling returns for all the portfolios.

The additional piece of work I did here was to rank the strategies by annual return over the period and separate them out into the top 3 and bottom 3 strategies. Below is the chart of rolling 3 year returns for the top 3 and bottom 3 TAA strategies compared to the 60/40 portfolio.

Note: I don’t think annual returns are the only metric by which one should choose any strategy, in particular TAA strategies. TAA is more about risk adjusted returns. This is just one way, a common and convenient way, of ranking these strategies. 

It’s a bit hard tell but there is quite a difference between the top 3 and bottom 3 TAA strategies. Let’s quantify the difference a little more clearly. The table below shows the performance metrics, in particular the average outperformance and underperformance of these strategies vs the 60/40 portfolio.

Quite the difference. Not only do the top 3 TAA strategies have higher annual returns but they average outperformance is higher, the average underperformance is lower, and the outperformance rate is higher. And you still have a max of one down year. It’s not all a free lunch though, you do have to tolerate a worst year of almost double that of the bottom 3. Now, lets break out the top and bottom 3 into the actual details of the strategies. See below.

Now, some of the differences really become clear. Calling these strategies top 3 and bottom 3 is not really fair. They are just optimizing for different things. Look at the Sharpe ratio for the top and bottom 3. It’s the same. The bottom 3 strategies have lower returns but you have half of the volatility, half of the drawdowns, and half the worst year. And vice versa for the top 3. Higher returns, higher drawdowns, lower worst year. And they’re all better than 60/40. The top and bottom TAA strategies are designed for different purposes, for different investors. In my opinion, drawdowns and worst year are (or should be) one of the primary determinants of in choosing a TAA strategy. And of course, that varies by investor. Sure, that 5% higher annual return sounds great. That 5% extra annual return with the low-ish drawdowns translates not only into much higher wealth in the long run but also significantly higher safe withdrawal rates in retirement. But what does that matter if you have no hope in sticking with such strategies?

Finally, why do the top 3 perform so much better than the bottom 3 in terms of annual returns? What is the primary determinant of this outperformance? It’s pretty simple – higher average allocation to stocks over the long term. The top 3 strategies over time have spend a higher percentage of the their time invested in equities – the asset class with the highest expected returns over the long haul. For example, a strategy like Antonacci’s GEM can be 100% long equites while Antonacci’s Composite Dual Momentum can be maximum 50% allocated to equities. Another thing to keep in mind when choosing TAA strategies.

In summary, there is quite a difference in the performance of TAA strategies when looked at from an annual return perspective. But not so much when analyzed from a risk adjusted return perspective. Different strategies and designed for different purposes. Which one is right for you and most importantly which one you can stick with depends on your tolerance for volatility and drawdowns.