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The Muscular Portfolios Newsletter — No. 16 — Mar. 31, 2019
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A proposed change to the Mama Bear
 By Brian Livingston
As you know, the fully disclosed investing strategies in Muscular Portfolios are "cloned" from the advice of financial experts, such as Jack Bogle, Mebane Faber, and Steve LeCompte. The Muscular Portfolios monthly newsletter is intended to keep you informed of the latest developments, such as new exchange-traded funds that may have even lower fees or better performances than the ones in the book.
Now we're considering an issue with the Mama Bear Portfolio. This is a clone of nine asset classes, with three ETFs held each month based on a formula by Steve LeCompte, CEO of the CXO Advisory Group. The rule is that you hold whichever three ETFs have the strongest total return over the past five months. This is called a "5-month lookback period."
LeCompte recently published an article on his site, saying that he would start using a four-month lookback. He tracked the performance of the nine ETFs in his menu of securities (as called an investing universe) over a 12½-year period: August 2006 through December 2018. Using his ETFs, these years showed a slightly higher annualized return and a slightly lower maximum drawdown with a 4-month lookback. If you're interested in the details, see LeCompte's article at CXO Advisory.
Newsletter subscribers are already weighing in
I would never make a change of such magnitude in the Mama Bear without consulting you, the reader. For one thing, as LeCompte himself says in his article, "the available sample period is not long enough for confident discrimination." For another, the Mama Bear uses some ETFs that are newer, have lower fees, and exhibit better performance than the ETFs LeCompte has been using since 2006. I asked our paying subscribers last month to comment. Here's a sample:
"Essentially, if you look at the data, one might reasonably conclude that, first, this is a very small sample to make a judgment and, second, if you throw out the one outsize ranking of the nine available, then the 4-month choice does not look so good. Therefore, I see no reason to change it, but it doesn't matter to me, or anyone else for that matter, as they can choose any 'switch point' they want off the ETF screener [ETFScreen.com]." —Dave G.
"Thanks for digging into Steve’s revised lookback interval. I am voting 'for' you to change the Mama Bear look-back to 4 months to coincide with Steve's latest work. If others are against this, then maybe you can post both 4- and 5-month lookbacks. Just a thought..." —Tom F.
"(1) I think the period shown in the chart is too small of a time frame to determine which is better, 4 or 5 months of lookback period. (2) You may get a different answer going from 1950 to 1970 or 1970 to 2000. (I know this is before ETFs were created.) (3) Looking at the chart results for 2018, most people would sleep better with a 5-month lookback. Especially since 2018 was a bad year for most investors. My conclusion: Stay with 5 months for now and keep collecting more data." —Andy R.
"Wanted to vote for shortening the lookback period to 4 months, as it seems the performance benefits reflected in LeCompte’s testing/analysis merit the change. Thanks for your efforts on our behalf!" —Roger P.
I'll go into using ETFScreen.com to calculate alternative lookbacks a bit later in this newsletter. For now, let me share with you what I've found in my own tests going back to 1973.
Results from actual ETFs since August 2006
As I mentioned previously, the Mama Bear uses a slightly different set of ETFs than LeCompte's menu. To try to replicate his 2006–2018 study, I entered into ETFScreen.com the Mama Bear ETFs, except for any that didn't exist in August 2006. For those, I substituted the older ETFs that LeCompte uses, or ones that track the same indexes.
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Figure 1. The Mama Bear ETFs with a 5-month lookback returned 10.2% annualized. Source: ETFScreen.com.
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Figure 2. With a 4-month lookback, the return was the same 10.2%, but you see larger losses in 2007, 2008, 2012, 2014, and 2018. Source: ETFScreen.com.
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Figures 1 and 2 show that the gain for this set of ETFs was exactly the same, whether a 5-month lookback period was used or a 4-month lookback: a 10.2% annualized return. However, the losses in five of the calendar years were larger for the 4-month version. The small differences between ETFScreen's numbers and LeCompte's are probably due to the substitution of the Mama Bear's newer ETFs for some of the older ones in LeCompte's menu.
You'll notice that both of the asset-rotation portfolios outperformed the S&P 500's 8.8% annualized return (also known as CAGR). This is true due to both portfolios having much smaller losses during the 2007–2009 bear market. Because of broad diversification, a Muscular Portfolio will seldom outperform during a bull market, when the S&P 500 tends to be a strong asset. Enjoying better-than-market returns over the complete bear-bull market cycle — an average of eight years — is how we achieve great lifetime results.
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Figure 3. Both the 5-month and 4-month models hold the three strongest ETFs, with a tune-up no more than once every 21 market days (one month). Source: ETFScreen.com.
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The 12½-year tests show that the 4-month version of the Mama Bear has no advantage over the 5-month version. The small differences are within the margin of error for such a short historical period.
To get a much longer view, I turned to The Idea Farm's Quant simulator. (The program is free with a paid subscription to the Idea Farm Newsletter.) The 2018 version of Quant contains 46 years of price data on the asset classes in the Mama Bear and the Papa Bear, all the way back to 1973. Since ETFs are proven to deliver 99% of the return of any asset class, using raw price data simulates what might have happened if today's ETFs — with their low transaction costs — had been available to investors for decades.
As in my book, I charged the portfolios in the Quant simulations 0.20% per year to represent today's average annual fees of the ETFs in the Mama Bear. In addition, the portfolios that used a Momentum Rule were charged today's 0.10% round-trip transaction cost every time one asset was sold and another one purchased. My tests don't try to simulate the costs of 46 years ago. It would have been impossible to make these trades in that era, and what we want to know is our results going forward. (Costs will only decline in future years.)
In the 46-year simulations, after subtracting all costs, the 5-month lookback generated an annualized return of 13.7%. The 4-month lookback returned slightly less: 12.9%. I don't consider that to be a huge difference, but it does indicate that the 4-month lookback has no particular benefit. (Holding an equal weight of all nine asset classes — what's called a Lazy Portfolio — returned only 9.4%. In the same 46 years, the S&P 500's total return was 10.0%.)
46-year tests show larger losses for 4-mo. lookback
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Figure 4. The 5-month Momentum Rule never delivered losses of more than 18%, measured between any two month-ends. The blue line is a portfolio that holds an equal weight of all nine asset classes at all times. The S&P 500 is not shown. Source: Quant simulator.
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Figure 5. The 4-month Momentum Rule would have subjected investors to losses of 27% in 1987 and almost 21% in 2016 — notably worse than the relative safety of the standard Mama Bear Portfolio. Source: Quant simulator.
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Figures 4 and 5 show that, expanded to a longer testing history, the 4-month lookback period exposes investors to losses than are significantly worse than the 5-month version.
The 5-month lookback, as documented in the book, never rattled investors' patience with losses greater than 18%. By contrast, in 1987 and 2015–2016, the 4-month lookback exposed you to losses in the 20% to 27% range. (Quant doesn't subtract transaction costs from its drawdown graphs. If it did, the losses would be slightly worse.).
I examined the selections each rule made in 1987 and 2015–2016, month-by-month. The 4-month rule seems to have a bad habit of putting its portfolio 100% into equities at the end of a "sucker's rally." A sucker's rally is a short price rise in US and global equities after the first leg down of a correction or bear market. It convinces many people that the decline is over and they can pile back into stocks. But the second leg down is horrifying.
In general, holding an equal weight of all nine asset classes produces lower gains and worse losses than either of the asset-rotation strategies. Both momentum portfolios hold only the three strongest ETFs each month. But the 5-month Momentum Rule seems to deliver a smoother ride than the 4-month version. More investors could tolerate 18% losses without "throwing in the towel" and hurting their long-term performance.
How you can learn more
Steve LeCompte's lengthy response to my findings is provided in the paid version of today's newsletter. In addition, I provide specific instructions on how you can get a list of the strongest ETFs each month at ETFScreen.com using a 4-month lookback period — or whatever rule you wish!
If you're receiving the free version of this newsletter, I'll immediately send you the paid version if you send ANY DONATION of ANY AMOUNT. There's no fixed fee. If you support this effort, you'll receive 12 months of our longer, paid newsletters. Use this link to donate.
Now it's your turn to comment! If you have an opinion about the tests I've shown you here, please start a new message to a special email address that goes directly to me. I'll print some of the responses in next month's newsletter. Please use your real name and email address, so I can get back to you for more information. But I'll print only first names and last initials in the publication.
I'll continue to report on the best enhancements to Muscular Portfolios using the latest research in the economic and behavioral sciences. We won't switch to a four-month lookback — or make any other change — unless there's clear evidence that it keeps losses under 20% while providing market-like returns. The promise of healthy lifetime gains with no fear of crashes has made many readers choose the less-volatile Mama Bear, although higher long-term returns are offered by the Papa Bear (with its occasional 25% losses, as shown in the book). The choice will always be yours.
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• LeCompte responds to tests of 4-month lookback
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