Trading Thoughts - 1 Year Relative Strength Bond Strategy

I showed in previous posts how FGMNX is a bond fund that gives your portfolio domestic exposure with monthly dividends, linear returns, and very minimal risk during market drawdowns.  FNMIX gives you the power of increased returns of foreign (emerging market) exposure with less volatility than a stock equivalent, while also providing consistent monthly dividends.  Combining the performance of both of these funds could be a simple strategy to include bond exposure in your investment portfolio to provide some diversification while maintaining reasonable returns versus risk.  We looked at averaging the performance of FGMNX and FNMIX to produce returns that have exceeded the SPY over the past 18 years with less risk.  In this post we will use a simple relative strength strategy to time the market and allocate our equity between each bond fund to help boost returns further while maintaining low risk exposure.  The performance of the relative strength bond strategy will be compared to the performance of a buy-and-hold strategy on the SPY, which is our usual benchmark (I presented the equity curve and drawdown profile previously).

There are countless formulas for determining relative strength and momentum.  In this analysis, I am using a comparison of the rolling 1 year returns for each fund using dividend adjusted data.  In simpler terms, I take the current price and subtract the price 252 days ago, then divide the difference by the price 252 days ago.  I compare the 1 year rolling return for FGMNX and FNMIX.  The portfolio will allocate all of its equity to whichever fund has the larger 1 year rolling return and the portfolio is always 100% invested.  Below is a chart comparing the 1 year rolling return of FGMNX and FNMIX.

I believe these funds are a good pair to use because they represent two types of market perspectives.    Typically, when the market is weak and times are tough, money tends to flow towards US domestic equities because the thought is that they are a safe investment during bear markets.  So this would be a risk-off trade.  FGMNX is a good vehicle to represent this behavior because it has dow well during weak markets.  When the market is strong and trending up, the risk trade is on.  Money tends to flow to more speculative foreign investments to try and capture larger returns.  FNMIX is a foreign bond fund that will produce larger returns than some domestic bond funds during bull markets.  You could use a basket of bond funds, but I think simple is better.

Let's take a peek at the numbers and the past performance of the relative strength strategy (I will call it the RS1Yr strat).   The RS1Yr strat has an average annual return of 11.86% over the past 18 years.  The max drawdown over the past 18 years was -15%.    The equity curve is fairly linear with a very few drawdowns exceeding -10%.  Below is a chart of the equity curve for RS1Yr strat compared to the equity curve of SPY, a surrogate for the performance of the S&P500.  The RS1Yr strat performs well compared to the performance of SPY which had an average annual return of 6.04% with a max drawdown of -55%.  Both curves are dividend adjusted.

Like its individual components, the RS1Yr strat has done a good job of providing consistent returns that have exceeded the market, yet with less risk as indicated by the smaller drawdowns.  There have certainly been times during bull markets when the SPY has outperformed the RS1Yr strat, but the RS1Yr strat returns have far exceeded the returns of SPY during bear markets.  This is typical of bond performance.  Below is a chart of the equity curve drawdowns for the RS1Yr strat and SPY that highlight the improved risk performance of the combined bond strategy.

Let's see what you can expect from the strategy's historical performance.  The one year rolling returns for the RS1Yr strat have averaged a return of 13.7%.  What this tells me is that had I chose to invest in the RS1Yr strat anytime in the past 18 years and held it for one year, I would have averaged about 13.7% returns on that one year investment.  Also, 99% of the 4250 rolling one year returns were above 0%, so the odds are very good that you will make money on your investment over the course of one year.  Below is a chart that shows the one year rolling returns for RS1Yr strat (green) with the average of all the rolling one year returns shown in blue.

The rolling one year max drawdowns show that there have been very few drawdowns exceeding -5%.  The average rolling max drawdown was -1.7%.  This tells me I can expect a drawdown of at least -1.7% over the course of an entire year.  Also, 90% of the rolling one year max drawdowns were -4.3% or better, which is much better than the SPY (90% are -22.1% or better).  Below is a chart that shows the one year rolling max drawdowns for RS1Yr strat (red) with the average of all these drawdowns in blue. 

This relative strength bond strategy has done an exceptional job of providing consistent returns through some rough times.  The SPY has had a total return of about 288% over the past 18 years because it has been range-bound for most of that time.  If you were an exceptional market timer, you could have made much more during this period.  For a simpler approach, the relative strength bond strategy has a total return of 756% over the past 18 years with smaller comparative drawdowns (-15% RS1Yr strat compared to -55% SPY).  You would have made almost 12% a year using the relative strength bond strategy, which is a very good return considering bonds are supposed to be a conservative investment.

Despite the performance of the strategy presented here, there are some important notes that must be considered.  First, the relative strength algo determines when to switch equity from one fund to another.  There are also some other limitations on switching funds.  You will incur short term trading fees if you hold FGMNX less than 30 days and FNMIX less than 90 days.  These fees can stack up and hurt the performance of the strategy, plus you could incur further trading penalties from Fidelity.  you could modify the relative strength algo to reduce whipsaws, or you may choose to only switch a portion of the the portfolio to the other fund instead of all of it.  Second, you must also consider the dividend payouts.  If you switch from one fund to the other in the middle of the month, you will not collect the full dividend from the bond fund.  This will also reduce returns.  I leave it up to the reader to test these factors to see there impact on the strategy.  Regardless, there certainly does seem to be plenty of potential for this strategy.