Explanation and Example of Tactical Overlay #1
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The technical overlay is a combination of mathematics, technical indicators employed, and the data series utilized to execute the strategy. The technical overlay seeks to identify inflection points and thus “triggers” the risk-on/risk-off posture of the portfolio. When the technical overlay indicates a risk-on posture, the strategy is invested in the underlying investment. When the technical overlay indicates a risk-off posture, the strategy is invested in the AGG (Barclay Aggregate Bond Index).
The strategy utilizes a series of intermediate exponential moving averages of US equity closing prices to determine inflection points. When these averages cross, risk-on and risk-off points are triggered. Multiple scenarios were tested and this methodology provided advantageous trigger points that avoid material downside returns while participating in most of the up-side. Moving Average Convergence Divergence (MACD) is a trend following and momentum indicator that measures rates of change between two EMAs. The MACD measures technical indicators across a different time series to indicate and subsequently validate a buy or sell signal.
In layman’s terms…Overlay #1 has a system in place that will generate a signal indicating it’s time to sell (go risk-off) and when to buy back in (to go risk-on).
The following is an example when using Overlay #1 on a very interesting 30-stock strategy who’s benchmark is the S&P 500. To learn more about the 30-stock strategy, click here. The example time frame below is 01-01-2003 to 01-01-2011. The Risk Score, max drawdown, and CAGR come from the OnPointe Risk Analyzer software.
What should jump out at readers is that the risk score is 26 vs. 72, the drawdown is 13.91% vs. 50.75% and the CAGR is 32.81% vs. 6.82%. This is the perfect storm (in a good way) when you are looking for a strategy with less risk and more upside than a particular benchmark.
If you wondered what the 30-stock strategy looks like without the overlay for the same time period, look at the following image. It’s still a very interesting strategy that many consumers would have rather been in than the S&P 500, but when add the tactical overlay it significantly lowers the maximum drawdown risk and also increases the return.
The question then becomes to advisors (especially those who are fiduciaries), should you learn more about using tactical overlay #1 on passives investment strategies. The answer should be abundantly clear.
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Due keep in mind that past performance is no guarantee of future performance. You should do your due diligence on this tactical overlay to determine if it can give you a better chance of helping your client generate the returns they are seeking but with less drawdown risk.
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Use a Tactical Overlay to Provide Drawdown Insurance for Buy & Hold Strategies
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