The following letters are in response to Ted Wong’s article, Moving Average: Holy Grail or Fairy Tale - Part 3, which appeared last week.
The following is a letter to the editor responding to a series of articles written by Theodore Wong titled “Moving Average: Holy Grail or Fairy Tale”.
At Merriman, we’ve managed both buy and hold and timing portfolios for over two decades. Our timing models are mechanical trend-following systems and our real-time, performance is similar to the simulated results of the 6-month MAC system.
The study presented by Mr. Wong unfortunately suffers from multiple issues that overstate the case for timing versus buy and hold. There are many subtleties in using back-tested results and simulated indices to predict how a trading strategy may perform in the future. These subtleties, while small, can compound to produce what appear to be superior risk-adjusted returns.
For starters, the Shiller S&P 500 price index is calculated by taking the average of the daily closing prices of the S&P 500 in a given month. Using a trend-following timing model with such an average introduces an upward bias on returns because transactions are hypothetically made at the average price rather than the actual monthly closing price. When the index crosses a moving average to the upside, the closing (purchasing) price will typically be higher than the average monthly price. When the index crosses a moving average to the downside, the closing (selling) price will typically be lower than the average monthly price.
For instance, when the S&P 500 index fell below the moving average at the end of June 2008, the index closed the month at 1280. The monthly average price for June 2008 was 1341, which is 4.8% higher. Only with the benefit of a time machine could such a sale be made at the average price. I performed a quick study from 1951 to mid-2009, with a range of look back periods and found that buying and selling at the average price outperformed buying and selling at the closing price by about 2% a year. Mr. Wong’s hypothetical results significantly overstate the performance of the MAC system because of this effect.
Second, every stock market back-tester wants to apply today’s trading costs, technology, and tax rates to yesterday’s stock market. By neglecting these factors, the MAC strategy was not properly simulated. The additional implied assumption in the study was that the MAC system user also had the competitive advantage of no trading costs, an IRA account, and their own personal trading vehicle to implement the strategy, while everyone else had none of these advantages. Yet, now none of those competitive advantages exist.
Before the mid-1980s, when S&P500 futures were introduced, there was no convenient trading vehicle to implement the strategy. How would the MAC system be implemented before then? The costs associated with transacting 500 stocks at each crossover would have been prohibitively high. Prior to May 1975, brokerage commissions were fixed and very high. Bid/ask spreads were much higher than today. If managing a large amount of money with the MAC system, the effective spreads are even higher. There is a large body of literature estimating historical transaction costs; these studies should be consulted and simulated in the MAC study. See a paper by Joel Hasbrouk of NYU titled “Trading costs and returns for US equities: Estimating Effective Costs from Daily Data” for a start.
Investors and traders were no less clever in the past than we are now. Technical analysis, moving averages, and the Dow Jones Industrial Average have been around at least 100 years. Why was a moving average system not used extensively in the past, especially after the 1930s? My guess is that a number of smart traders threw the idea in the trash bin after running the numbers and accounting for actual implementation costs at the time.
Including T-bill returns, when the MAC system is in cash, will certainly enhance returns (about 1%/year). From a risk-adjusted performance comparison, most clients do not invest 100% of their portfolio in equities. Thus it’s better to compare a MAC system with an equal-risk portfolio of stocks and intermediate-term bonds. After accounting for all the above factors, I expect the comparison will show the MAC system will at best be of similar risk-adjusted performance as a buy and hold portfolio.
Each year I see dozens of studies, whitepapers, and academic articles providing evidence of a timing system that beats the market using simulated data. Do any of these studies prove that markets aren’t efficient? Not really; in my experience none ever add value in real time with a real trading vehicle. Once the barriers to implement a trading strategy collapse, actual results are always disappointing.
Ultimately, the real question is how do we expect a one-round-trip-per-year trend-following system to perform compared to the S&P 500 index over the long-term (the next 138 years)? The MAC system will definitely reduce risk and add enormous value in severe bear markets. The MAC system will definitely outperform buy and hold in secular bear markets, such as what we’ve experienced the last nine and a half years.
Do we expect the MAC system to outperform a buy and hold portfolio over the long-term? My expectation is that the MAC system will provide a similar risk-adjusted return as a 70% equity, 30% intermediate-term bond portfolio. The much more frequent whipsaw trades that occur in sideways and bull markets will offset the enormous gains created by the occasional side-stepping of a severe bear market.
Most clients in our timing programs psychologically need an approach that places them in cash when the market is crashing. Buy and hold will not work for them. Market timing allows these clients to have higher long-term equity exposure while also reducing the risk of panic selling near the market bottom. There’s no question that timing adds value for our clients. Let’s not overstate the case.
Director of Alternative Investments
Portfolio Manager, Leveraged Global Opportunity Fund, L.P.
Ted Wong replies:
When I started my series of articles critical of the buy-and-hold approach, I expected critical responses from indexed investing advocates in the buy/hold community. To my surprise, I received very little critiques (in fact zero) from them. So when I read your letter, I was surprised and delighted. There is no better critic of my writings than someone who employs both market timing and buy-and-hold practices in managing money.
First, I have tremendous respect for Paul Merriman and have read many of his excellent writings. His fair-and-balanced view on market timing vs. buy/hold is the best on the subject. I am equally impressed with your assessment of my articles. You touched on several important subtleties that would only surface during system implementation. I attribute your keen observations not only to your investment experience, but also to your engineering background. I believe that engineers have certain unique qualities enabling them to be more pragmatic and objective in discussing financial topics.
As I mentioned in Part 3, the MAC system was not meant to be a real trading system because of those subtleties you articulated. I purposely avoided in-sample/out-of-sample types of optimization because I didn't want to treat it as a trading system. I used MAC as an illustration of comparative analysis because it's simple, well-known, and based on sound engineering principles.
You and I agree that market timing adds value both in financial and emotional terms in secular bear markets. The 6-month MAC returns about 1% higher than that of buy/hold over 138 years. If I subtract 2% from this margin due to the difference between average vs. actual price (according to Dennis' research), MAC would underperform buy/hold by 1%. When I talked to many financial planners, they would be glad to give up a couple of percentage points in ROI if they could sidestep major bear markets for their clients.
I agree that I should not overstate the case. The theme of my articles is not that the MAC system can beat buy/hold in CAGR, but rather in risk-adjusted return. I hope that message is clear.
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