On June 3, 2019, my post What Now: Sell, Rebalance, or Rotate? launched an on-going series comparing rebalanced portfolios with a new strategy of rotation. On that date, a simple version of the rotation strategy caused a portfolio invested entirely in stocks to convert all its assets to U.S. Treasuries. On the date of this post, July 1, 2019, another instance of that strategy caused a traditional portfolio of 60% stocks and 40% bonds to switch to 100% bonds. This post describes how the rotation strategy works, using these two portfolios as examples.

Different Portfolios for Different Goals
The two portfolios are alike in some ways and very different in others. Neither portfolio is always invested in stocks or always in bonds. Both do both. Neither portfolio holds a static mix of stocks and bonds. Both vary their mixture over time. One of the two holds Exchange Traded Funds (ETFs) and may switch them several times a year. The other holds traditional mutual funds and imposes controls to limit turnover. Yet both portfolios use rotation to achieve better returns and substantially lower drawdowns than traditional alternatives.

The two portfolios are suited to investors with different goals.

Suppose your primary goal were maximize long-term gains, even at the risk of some turbulence. Then you might find the chart above to be compelling. It shows that, over various 25-year time-periods from 1919 to 2019, spanning a variety of countries and currencies, the strongest returns, adjusted for local inflation, came from rotating between a high ceiling of 100% invested in stocks and a low floor of 0% in stocks. Call it a max-gain strategy of 100-or-0 rotation. Historically, this strategy has managed to sidestep most of the damage of prolonged drawdowns in stock markets, such as happened most recently in 2008-2009. However, it is vulnerable to sudden one-month downturns, such as the October crashes that exceeded 20% in 1929 and 1987, and numerous months with losses approaching 10%, including the recent demise in December 2018.

If one-month losses of that magniture seems a bridge too far, then the goal of your journey as an investor might be a compromise between maximizing gains and minimizing losses. Your preference would be a minimax strategy, as illustrated in the next chart. Taking a different prespective on the same extensive data as the previous chart, this one shows that the best compromise imposes a ceiling of 50% to 60% in stocks and a floor of 0% in stocks. That's a minimax stategy of 60-or-0 rotation. (50-or-0 performs virtually the same.)

Two risk-controls are at work here. With a ceiling of 60% invested in stocks, your exposure during a sudden 20% downturn is reduced to 12%. Furthermore, with a floor of 0%, you have no exposure to the bulk of a long decline in the stock market, provided that you rotate from stocks to bonds early in the decline. ​

To map out the routes of these financial journeys, let's examine the two specific portfolios that used rotation to switch from stocks to bonds on June 1 and July 1 this year.

Max-Gain Rotate 100-or-0
​This portfolio aims to maximize gains by moving its assets across three basic index funds. The moves occur, on average, about four times per year, possibly with tax consequences if executed in a taxable account. Since 1996, the portfolio has never held the same assets for a full year, though it occasionally came close. At a given time, it is invested entirely in one of three indexed ETFs:

• The entire U.S. stock market, via Vanguard Total Stock Market ETF (VTI) or a similar low-cost fund such as iShared ITOT.
• Non-U.S. stock markets as represented by Vanguard Total International Stock ETF (VXUS) or a similar low-cost ETF such as State Street SPDW.
• Long-term U.S. Treasuries with average durations close to 20 years, as represented by Vanguard VGLT or alternatives such as iShares TLT or TLH.

The portfolio's strategy is to review these index ETFs at the end of every month, and invest entirely in the one whose three-month total return is the highest. On June 30, 2019, using the Vanguard ETFs, long-term Treasuries ranked first at 5.71%; U.S. stocks were next at 4.08%; and international stocks were last at 2.80%. Because the portfolio had previously moved all its assets to Treasuries on June 1, 2019, no change was indicated for July.

Historical results for this portfolio can be closely approximated by Vanguard mutual funds whose indexes match the firm's current ETFs. For the 23-year period from July 1, 1996, to June 30, 2019, the hytpothetical performance of the three mutual funds, had it been possible to trade them like ETFs, would have been as shown in the chart below. One line in the chart shows the rotation strategy for Max-Gain Rotate 100-or-0. A second line compares the results of investing equally in the same three funds, 33.3% each, and rebalancing them at the end of the month if the allocation's total drift exceeds 5% (as when a fund in this portfolio went above 38.3% or below 28.3% of the portfolio's total value).

The rotated portfolio was superior to the rebalanced alternative in measurable ways. It had a bigger nominal return (14.7% vs. 7.6%) and a superior risk-adjusted return (7.5% vs. 0.5%). To reap these substantial benefits, however, one had to endure a maximum drawdown that was large (-18.8%). Painful as it might have been, that drawdown was mild compared to the rebalanced portfolio (-36.4%). 

Minimax Rotate 60-or-0
To place stronger limits on drawdowns, Minimax Rotate 60-or-0 accepts returns that are less stellar, though still very good. This strategy may be suitable both for taxable accounts and for IRA and 401k savings. On average, the portfolio has had one change per year since 1995, although it had a few of them in some years and occasionally went without a change for two years or longer. At a given time, the portfolio is invested entirely in one of two ways:

• A mutual fund that holds 60% U.S. stocks and 40% U.S. bonds, such as Vanguard Balanced Index Admiral Shares (VBIAX) or equivalent all-U.S. funds.
• A broad mix of 5-to-10 year U.S. corporate and Treasury bonds, such as Vanguard Intermediate-Term Bond Index Admiral (VBILX) or the equivalent. 

The portfolio's strategy is to review the performance of these two funds bimonthly (at the end of even-numbered months) and invest in the one whose total return is better over the previous 12 months. The bimonthly schedule reduces the portfolio's churn and honors the one-month limit that investment firms typically place on selling and repurchasing the same mutual fund. On June 30, 2019, the 12-month total return was better for the bond fund (VBILX, 9.99%) than for the balanced fund (VBIAX, 8.91%). A month earlier, the opposite was true. Hence the portfolio moved all its assets to the bond fund on July 1, 2019, to be left there for at least two months.

The chart above shows results based on the longest available history of the two Vanguard mutual funds (VBIAX and VBILX) from March 1, 1995, to June 30, 2019. The rotation strategy successfully side-stepped long declines during the dot-com collapse of 2000-2003 and the severe recession of 2008-2009. The traditional 60-40 index fund did not. Consequently, the biggest drawdown of the Minimax Rotate 60-or-0 portfolio was much smaller (-13.0%) than that of Vanguard's 60-40 fund (-32.6%). And recall that the max-gain strategy had a drawdown of -18.8% for the same period.

Yet, as the chart shows, the minimax strategy also met its other objective of generating decent returns. Though less amazing than the max-gain portfolio, minimax rotation did somewhat better than traditional 60-40 rebalancing (8.5% vs. 8.2% in nominal returns). In short, when compared to other alternatives, minimax rotation did indeed produce commendable gains at a notably lower cost in drawdowns and churn.

Some Technical Details
To understand the measurements and data underlying the charts and analysis in this post, see my posts last month, especially Best Options to Minimize Drawdowns and Floors and Ceilings, Part 2.

My previous post examined ways to minimize drawdowns in a portfolio. This one turns the table to study how best to maximize returns.

Admittedly, it's not a clean dichotomy. When analyzing drawdowns but confronted with portfolios that impose similar limits on them, the urge is strong to see how the portfolios compare on returns. The same urge will sneak into the storyline here. Focusing primarily on portfolio returns, I'll admit some consideration of drawdowns if the returns are not decisive. 

100 Years of Large-Cap Stocks in the U.S.
Shown in the chart above are key findings for large-cap stocks in the U.S. between April 1919 and March 2019. As I've noted previously, different 25-year segments of this period exhibited dramatically different results for investors. Yet across all the historical variations of that century, the trends captured in the chart were consistent. Looking closely, you can see three of them.

1. The pair of bars on the left show that holding a high percentage of the portfolio in large-cap stocks paid sizable real returns in the long-run. These returns are annualized and adjusted for inflation. The two portfolios represented by the bars on the left were 100% invested in stocks all or most of the time.
2. On the other hand, the pair of bars on the right show that if you adjust for the risk of drawdowns, then the relative returns of these portfolios were modest. A relative return is the portfolio's surplus over investing 100% in 10-year Treasuries, after compensating for the portfolio's incremental risk of drawdowns. The risk-adjusted bars on the right show that the same stock-heavy portfolios were barely a percentage point or two better than 10-year Treasuries. For the additional risk taken, the reward was limited. (An earlier post explains how I calculate relative returns.)
3. Finally, the color-contrast in the chart compares two methods of portfolio management. The blue bars show the average outcome of buying and holding large-cap stocks for a full 25-year cycle. The red bars average the same 25-year periods, but within a period, the portfolio's holdings rotate between being completely in large-cap stocks or wholly in 10-year Treasuries. The criterion for deciding whether to hold equities or Treasuries is the total return of those two assets in recent months (as explained in What Now: Sell, Rebalance, or Rotate? and in Best Options to Minimize Drawdowns). The message of the color-contrast in the chart is that rotation delivered better outcomes than buy-and-hold, because it more effectively controlled the risk of drawdowns.

"What about rebalancing?" you might ask. Was there a portfolio that rebalanced large-cap stocks and 10-year Treasury bonds to achieve best-in-class returns? The answer for the U.S. was, "No, not with any consistency." In three of the four 25-year periods since 1919, no rebalanced portfolio outperformed one that bought and held large-caps for the duration. In one case alone, 1919 to 1944, it was a close call. Then, rebalancing 90% in stocks against 10% in Treasuries ended in a dead-heat with 100% in stocks, as both methods had real returns of 7.3% and relative returns at 4.4%.

25 Years of Large-Cap Stocks in Germany, Japan & Australia
The results in other countries, however, were sometimes different from the U.S. In a post titled Does Rotatation Work in Global Markets?, I showed recent 25-year returns in three other countries, with local large-cap stocks and local 10-year Treasuries, invested in local currencies, adjusted for local inflation. In two of the countries, Germany and Japan, Treasuries outperformed the relevant large-cap index, and in the third, Australia, they almost did.

If you believe an oft-cited legend that stocks always beat bonds for holding periods longer than 20 years, this is not supposed to happen. But it did there, implying that it could here. In the unlikely event that you might foresee this outcome in advance, you could elect to rebalance a portfolio to target levels of 25% in stocks and 75% in Treasuries. As shown in the chart, doing so for Germany, Japan, and Australia between 1994 and 2019 yielded better real returns than any other rebalanced portfolio and, on average, also bested an all-stocks portfolio in those countries.

Even better results would have accrued by using the rotation strategy, placing 100% in large-caps when their recent total returns were temporarily better than local 10-year Treasuries and otherwise investing all the portfolio's assets in those Treasuries. Happily, for this strategy, you don't have to guess whether stocks or bonds will be stronger in the future. You simply adapt to whichever has been stronger in recent months.

A cautionary note, however, is that all the foregoing comments are limited to real returns. For relative returns, which adjust for the risk of drawdowns, the results were, to be blunt, pathetic. Considering the risks taken, no strategy that invested in stocks in these countries was much better, in the last quarter-century, than one that bought and held 10-year local Treasury bonds.

25 Years of Low-Volatility Stocks Worldwide
For completeness, should low-volatility stocks be considered when the goal is to maximize returns? It makes sense to consider them when trying to limit drawdowns, because by design, stocks chosen for their low volatility should, theoretically, fall less than the average equity when the stock market takes a tumble. On the upside, however, an advantage for low-volatility stocks is not obvious.

Empirically, academic research implies that such an advantage may exist (as reviewed, for example, in Andrew Ang's textbook on asset management). In the research, when equities were selected for a portfolio because their price-fluctuations were low or because they were weakly correlated with market averages, the studies reported that the portfolio's returns approximated or modestly exceeded those of the full stock market, even when it was rising.

​Accordingly, the next chart summarizes results averaged across three indexes of low-volatility stocks from April 1994 to March 2019. The indexes are tracked by iShares ETFs for the U.S., for developed countries outside the U.S., and for stock-markets globally. The trading histories of the ETFs were too short for this analysis, which was based instead on the index histories in U.S. dollars and on U.S. 10-year Treasuries.

On close inspection, several aspects of this chart are noteworthy.

1. ​​First, as in the academic research, a 6.8% real return for these low-volatility indexes over the last 25 years compared favorably to the 7.2% real return of large-cap U.S. stocks over a much longer history, which was shown in the first chart in this post.
2. Once again, the rotation strategy outperformed buy-and-hold.
3. Perhaps surprisingly, the relative returns for these low-volatility indexes were quite good on the upside. They did double-duty, in effect, generating stock-like returns while handily limiting the risk of drawdowns.
4. Rebalancing low-volatility stocks would not have been the method of choice for maximizing returns. At its best settings, rebalancing yielded just 4.6%, well below the levels attained for buy-and-hold and rotation. Furthermore, when adjusted for risk, it was unremarkable, like its counterpart in the analysis of Germany, Japan, and Australia. That said, if one's goal were to limit drawdowns with minimal effort, rebalancing 25% in low-volatility stocks against 75% in intermediate Treasuries would be attractive.

Key Takeaways

1. If you aim to maximize returns, ask whether you are willing to exert the discipline and monthly effort to apply the strategy of rotation. If so, rotating well diversified, low-volatility ETFs may generate the best risk-adjusted returns. Rotating broad-market averages should also reward you for the risks taken, scoring slightly higher than low-volatility ETFs on real returns but slightly lower on risk-adjusted ones.
2. Buying and holding stocks may often deliver better returns than buying and holding Treasury bonds, provided that the holding period is very long. Often. But not always! Even at 25 years, there are historical cases where long-held Treasuries have beaten long-held equities.
3. Rebalancing is not optimal for maximizing returns. As a strategy, its best application may be for goals that aim to reduce drawdowns.
4. A big caveat: For a goal that seeks a compromise between maximizing returns and minimizing drawdowns, the analysis in this post offers no guidance. That's coming in my next post in this series.