Managing Risk With Moving Averages | Part 2

Author: Nathan Rowader
Date: March 20, 2015
Category: Financial Planning
Tags: , , , ,

In part 1 of this blog series, we looked at using simple moving averages as a guide to determining an allocation to stock or bonds. The results of our simulation showed that investors can improve their risk-adjusted returns by incorporating a more active approach into an otherwise static investment process. In today’s post, we are going to look at how you can take what we have learned so far and extend the process to achieve a specific investment objective—reduced volatility.

The buy and hold fallacy
There is a very popular study that shows what happens when an investor misses the 10 best days in the market. I suspect that most people who look at the study conclude that an active approach to allocating toward stocks and bonds is pointless since it is likely that most investors will be unable to predict the best days in the market. I actually agree that, by and large, investors can’t predict the best days in the market. In fact, prediction of market performance as a whole is pretty much impossible. However, I don’t believe that buy-and-hold strategies deliver the best results. The key to great performance isn’t amazing prediction skills but taking an “edge” (such as the one demonstrated in part 1) and building a risk-managed portfolio around that edge. Below I demonstrate how an investor can build upon the edge provided by moving averages.

Targeting your portfolio objectives
From December 1989 to February 2015, an investor who rotated between the S&P 500 Index when the price of the index was above its 50-day moving average and the Barclays U.S. Treasury Index when the price was below the moving average would have realized a return of 7.28% and an annualized standard deviation of 10.12%. This return would have slightly underperformed the S&P 500, which increased by 7.35% and had a standard deviation of 14.62%. At the outset, the performance of the moving average strategy relative the index is underwhelming and, when costs are factored, the performance would likely be downright lackluster. However, the “edge” in this strategy is not in the performance but in the reduced volatility—a more than 4% difference. As investors, our objectives are a combination of financial need and the likelihood of achieving that financial need. That likelihood is measured by the standard deviation of your portfolio, and the moving average strategy has a similar return (albeit lower) but with 30% less volatility. If an investor were to replace the equity with the simple moving average strategy (this is labeled “SMA Strategy” in the chart below) in a 60% stock and 40% bond portfolio, we would see the following results:

Measuring the edge

12/31/89 – 02/27/15

Indices Return Volatility Worst Month Sharpe Ratio
60% SMA Strategy/40% Barclays U.S. Treasury Index 6.99% 6.62% -6.31% 0.35
60% S&P 500 Index/40% Barclays U.S. Treasury Index 7.21% 8.79% -10.21% 0.29
Source: Bloomberg
This hypothetical example is for illustrative purposes only and does not represent the returns of any particular investment. Past performance does not guarantee future results.

Using the simple moving average strategy produces a lower return but a higher Sharpe ratio than a simple buy-and-hold strategy, so any rational person would probably just opt to buy and hold. However, the 60/40 investor has already decided to adopt a higher risk profile than the 6.62% volatility of the portfolio that utilizes the SMA strategy. To address this difference, I created a levered version of the SMA strategy (something that could be easily accomplished using futures) in order to achieve the 8.79% volatility of the 60/40 portfolio. The results of this variation are below.

A levered simple moving average strategy

12/31/89 – 02/27/15

Indices Return Volatility Worst Month Sharpe Ratio
Levered SMA Strategy 12.99% 13.82% -18.91% 0.60
S&P 500 Index 7.35% 14.62% -16.94% 0.18
60% Levered SMA Strategy/40% Barclays U.S. Treasury Index 10.48% 8.80% -10.26% 0.66
60% SMA Strategy/40% Barclays U.S. Treasury Index 6.99% 6.62% -6.31% 0.35
60% S&P 500 Index/40% Barclays U.S. Treasury Index 7.21% 8.79% -10.21% 0.29
Source: Bloomberg
This hypothetical example is for illustrative purposes only and does not represent the returns of any particular investment. Past performance does not guarantee future results.

Now we’re cooking with gas! The levered SMA strategy gets much closer to the risk of the S&P 500, and then when combined as part of a broader portfolio, it delivers better results than the simple buy-and-hold strategy. So, in this example, we took an edge that honestly isn’t all that great in the form of the 50-day moving average. But, by applying some simple risk targeting, we end up with a portfolio that, on an annualized basis, is more than 3% better than a simple buy-and-hold approach without adopting any additional risk. We also accomplished this result with the moving average strategy that had the worst performance of those we tested in part 1. If we use better moving average strategies, the results are even better.

On balance, I think that there is an important message here—one that tells us that active positioning and good risk management can lead to better results. However, I believe that there is an intellectual weak point to the results we have discussed in parts 1 and 2. Have you spotted it yet? This will be the subject of the final part of the blog series.

See the rest of the series: Part 1 | Part 3


The information contained on this web site reflects thoughts and opinions of Salient Capital Advisors, LLC (“Salient”) employees only, and the firm is not soliciting any transaction based upon such information.

The contents of this web site are for informational purposes only and may not reflect current financial developments or market conditions. You should not act or refrain from acting on the basis of any content included in this web site without seeking financial or professional advice on the particular facts and circumstances at issue. Salient reserves the right to change any information contained herein without prior notice. Salient is not responsible for any third-party content that may be accessed through this web site. The distribution or photocopying of Salient information contained on or downloaded from this site is strictly prohibited without the express written consent of Salient.

Salient research has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Salient recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial adviser. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

Salient research or any portion thereof may not be reprinted, sold or redistributed without the written consent of Salient. Salient research is disseminated and available primarily electronically, and, in some cases, in printed form. The information on this web site is for U.S. residents only.

Research and Advisory Services provided by Salient Capital Advisors, LLC, a wholly owned affiliate of Salient Partners, L.P. Salient Capital Advisors, LLC is an investment advisor registered with the U.S. Securities and Exchange Commission.