Trend Investing with Newfound’s U.S. Trend Index

If you are interested in shifting your portfolio towards a trend strategy, but maybe have some hesitation with certain basic trend models or are not sure how to move away from a buy-and-hold portfolio, Newfound Research has recently released a new trend index based on the U.S. stock market that you can track in your account for free.

As any regular reader of this blog knows, I am a fan of investing with the trend. For example, I believe Dual Momentum is a great choice for individual investors who want diversification and risk mitigation but are managing their own account with time and portfolio size constraints. I personally use both Dual Momentum and a slightly more complex trend strategy in my investment portfolio.

There are countless ways to easily measure trends in equity markets. Dual Momentum uses a 12-month lookback strategy. If the measured asset had a positive return above the risk-free rate over the past twelve months, you invest; if not, move to bonds.

If you had applied this 12-month lookback time-series momentum technique to the S&P 500 and monitored just once a month, you would have outperformed the index by about 200 basis points per year over the past five decades. These one-signal models are easy to track and follow and have shown a lot of benefits for investors. They deftly avoid extended market drawdowns, see nice gains in uptrends, and don't introduce the added risk and complexity of short selling (which is extremely difficult to do profitably).

However, one-signal systems are not without their risks and drawbacks. Over the past few months this has been widely discussed in the quantitative finance world in relation to Dual Momentum.

We don't know which signal will be the best in the future, so reliance on one signal could provide significant underperformance compared with investor expectations going forward. There's the added downside that a one-signal model has you all in or all out of the market.

For more information on these discussions and the added complexities surrounding them, look at:

A Better Look at Dual Momentum Fragility

Fragility Case Study: Dual Momentum GEM (Newfound)

Global Equity Momentum: A Craftsman's Perspective (ReSolve)

Valeriy Zakamulin's Research Papers on Trend Measurements

Whither Fragility: Dual Momentum GEM (Antonacci)

There are ways to reduce the risks associated with one-signal models, but they are not always easy to formulate or track for your average self-directed investor. It may not even be feasible or practical if your account size is limited.

However, part of the drawbacks on implementing more complex models correctly has changed thanks to Corey Hoffstein and the team at Newfound Research.

Newfound Research U.S. Trend Equity Index

Newfound Index Information with Link to Updated Excel File

The Newfound team have put together a long/flat U.S. stock trend index that is updated daily on their website. It is completely free and easy to follow. The depth of information put into this system, as well as the complexity of the numerous calculations involved, make this type of index very valuable.

Speaking as someone who is fairly proficient in Excel and has done a lot of backtesting, I can assure you it would take a lot of time executing data analysis, cleaning, and formulation on a spreadsheet to come up with even a semblance of this strategy on your own. The amount of data and calculation involved would probably have crashed your average computer fifteen years ago.

In this index, Newfound has taken three separate trend measurement styles and calculated them across 120 time periods for each style. This is a longer-term system that covers trends approximately six through twelve months in length.

  1. Time-series momentum: This is close to the trend measurement used in Dual Momentum. It simply looks back a specific number of days and determines the direction of the trend based on a positive or negative return during the period.
  2. Price minus exponential moving average: This is the simple moving average method where the trend is determined to be up if the price is above the specified moving average and down if it is below the moving average.
  3. Moving average cross-over: This method uses a shorter exponential moving average and a longer exponential moving average. If the shorter moving average is above the longer moving average the trend is up.

Put together, this complex index gives an investor an approximately equal exposure to 360 different individual trend models. In this index, Newfound has divided the 360 trend models into twenty separate tranches where each tranche is corrected to the signal weighting every twenty trading days.

To get a picture of the results, I've put together a few basic charts comparing the Newfound Research U.S. Trend Equity Index to the MSCI USA Index going back through 1970. On their site Newfound has data on the index from 1927.

Performance Chart

Credit: TheRichMoose.com, Newfound Research, MSCI Inc.

I would say the performance is very much what an investor would expect from a long-term trend style applied to a single market. We see avoidance of extended drawdowns, catches on the sharp and sudden corrections, and general outperformance over the longer term.

Drawdown Chart

Credit: TheRichMoose.com, Newfound Research, MSCI Inc.

In 1987, Newfound's index caught most of the drawdown experienced by U.S. stocks as a whole. As you might recall, the 1987 market crash was sudden and into a long-term uptrend. Every model that invests with long-term trends would have full, or nearly full exposure to the market in those conditions.

However, in every other major correction we see the Newfound index showing much smaller drawdowns. Even in 2008-2009, the worst U.S. stock bear market since the 1930s, Newfound's index lost a mere 11 percent as it methodically pulled stock exposure out of the investor portfolio.

3-Year Rolling Return Comparison

Credit: TheRichMoose.com, Newfound Research, MSCI Inc.

The lagging performance of Newfound's index in bull market phases can be seen when we look at rolling period returns. Newfound's index outperforms the U.S. market when stocks are falling and underperforms when stocks are in secular uptrends.

A drawdown has more impact on a portfolio than an upwards move (when measured in percentages). Combining the dynamic stock exposure with short-term bonds, the overall performance is positive and smoother than the S&P 500 Index.

Putting This Into Practice

If you are interested in following this model in your personal portfolio, you can click on the link I shared above and navigate to the Excel file that is available for download. The Excel file is regularly updated and contains all the information you need to follow the strategy.

Newfound has taken an easy approach with this information using two popular, low-cost ETFs: VTI (Vanguard's U.S. Total Market Index fund) and SHV (iShares' Short-term Treasury fund).

If the signal in the VTI column is "1", you fully allocate to VTI (or a similar U.S. stock ETF). If the signal in the SHV column is "1", you fully allocate to SHV (or a similar bond ETF). During transition periods there will be mixed signals across the 360 models. In this case, the column will specify the exact allocation to make to VTI and SHV.

If you don't want to make tiny trades because your portfolio is small or you are busy with other things in your life, I can't see the harm in checking the signal just once a week and making the portfolio adjustments as needed. Your returns will still be very similar to the index.

Summary

I'm excited to see good quantitative finance firms such as Newfound sharing this kind of detailed trend model with interested investors. This is quality research and quality information. My guess is only one in fifty knowledgeable investors could correctly calculate a trend index with this level of detail and complexity. At this stage in my life it is certainly well out of my league.

Not only does Newfound's U.S. Trend Equity Index show great historical results that are consistent with any long-term trend application to the U.S. stock market, the structure of the index is very diverse. This significantly reduces model specification risk.

In other words, it is highly likely that this system will provide investors with future returns that are close to what one would expect investing in any other longer-term trend model without the risk of chronic underperformance in any one trend measurement due to small changes in the market.

If the 12-month lookback period lags the 7-month lookback period over the next 20 years by 5 percent annually, no problem; each individual model only has a minute impact on the total portfolio. Same can be said for the small differences in returns between comparable time-series momentum and moving average measurements.

While this index is great in its own regard, it does not cover all the bases. It is not a replacement for Dual Momentum, shorter-term long/short strategies, or other trend strategies that provide exposure to different markets.

However, if you are invested in a passive portfolio with 60 percent U.S. stocks and 40 percent bonds, you should ask yourself why you are investing with that simple structure when a tiny bit more dynamism will drastically improve your results in absolute and risk-adjusted terms.

Also, if you are playing around with single market trend investing on the U.S. market at home, you should ask yourself if you can design a strategy that covers the range of risks even close to this one by Newfound.

Corey hinted the Newfound team will post more of these indices in the future. I'm crossing my fingers for a similar application with the MSCI EAFE and Emerging markets indices. Once those are available, it may be time to replace 12-month Dual Momentum or other more diversified strategies.

I will be playing around with Newfound's U.S. Trend Equity Index. I see some interesting applications when paired with a Leveraged Barbell Portfolio. It has also given me some ideas for further developing my own knowledge in more complex applications of trend investing.

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Building GIC Ladders for Daily Spending

Rising interest rates on bonds and the central bank overnight rate may have held down your bond returns in the past year, but there is a silver lining.

All of a sudden, when it seemed like interest income was forever lost, your cash is finally worth something again.

Since the Financial Crisis in 2008-2009, money in the bank has returned essentially nothing. Even so-called high interest savings accounts paid a pitiful 0.5% interest while inflation roared ahead at 2% per year or more.

The cautious folks in this world who used to count on 3% or higher interest income have taken massive financial hits this past decade thanks to an ugly combination of no interest income paired with erosion of spending power.

Retirees have been stuck depleting their savings while expenses were steadily climbing. But this is finally turning a corner thanks to the recent rate hikes.

On this blog I talk a lot about ETFs, stocks, houses, and bonds. But so far I haven't said much about cash in the bank.

I think cash plays an important role in your overall financial health. Especially if you are retired and living off your assets.

Although most of your assets should be hard at work in stock and bond ETFs, it is important to have a moderate amount of cash set aside for daily living expenses.

This can help you reduce stress during portfolio drawdowns and while ensuring your portfolio recovers with the market. Portfolios recover from drawdowns quicker when you are not taking equity away from them.

One of the better ways to hold cash is by using high interest GICs.

GICs (Guaranteed Investment Certificates)

A GIC is locked-in loan you make to a bank for a specified term. It's the Canadian version of the American CD (Certificate of Deposit).

The terms for GICs in Canada generally range from 3 months to 5 years. The longer the term, the higher the annual interest rate should be.

Since GICs are a locked-in loan, if you ask for your money back early, you typically will pay steep penalties to the bank. Those penalties can be equal to or higher than the interest you should have earned on your GIC for the entire term!

GICs can be held in every type of investment account (TFSA, RRSP, RRIF, and non-registered accounts).

For tax and investment efficiency reasons, I would say it is best for most people to hold their GICs inside their RRSP, particularly if they only have investments in RRSPs and TFSAs.

If you have money outside of your registered accounts, it could make sense to hold some GICs in a non-registered account.

GIC interest income is classified as "Other Income", so it is not necessarily very tax efficient. But generally the income generated by GICs wouldn't be that high.

That is if you are using GICs appropriately to form a small part of your overall portfolio.

Understanding the "Guaranteed" Part of GICs

A GIC, or combination of GICs at the same bank, up to C$100,000 is not only "guaranteed" by the bank, but ultimately backstopped by the Canadian Deposit Insurance Corporation (CDIC) if the bank fails.

The guaranteed part is important to understand. For all intents and purposes, a GIC is as good as a government bond since the CDIC is a federal Crown corporation.

But there are some important caveats.

  • CDIC will only cover an amount up to $100,000 per account type, per institution.
  • CDIC only covers products with terms equal to or less than 5 years.
  • If the bank fails, count on it taking a long time to get your money back through CDIC.

There are strategies you can use to address some of these issues. First, if you plan to have more than $100,000 in GICs, you will need to use more than one banking institution.

Simply buy part of your overall GIC holding at one bank and part at another with each bank having less than $100,000 worth of GICs.

Bank loyalty or a slightly higher interest rate at your preferred bank is not good reason to subject your investment to banking risk!

The next part is easy, buy GICs with terms less than 5 years. As best I can tell GICs are only sold with terms up to 5 years, so this should not be an issue. You should also question the benefits of holding 5 years worth of cash.

Finally, it rarely hurts to use more than one bank. Your odds of having all your cash tied up in a CDIC boondoggle are lower if you spread your GICs across two different banks.

Setting Up a GIC Ladder

Most investors who use GICs as a place to put aside living expenses will set up what's called a GIC Ladder.

This is a strategy where the retiree buys several GICs with different expiry dates. The goal is to release money for spending at regular intervals without paying penalties to get your money when you need it.

For example, if you want to have 3 years of living expenses set aside (probably at the higher end for a typical retiree), you might choose 3 different GIC terms to get started.

First, keep some cash in a savings account for the first 6 months of spending needs.

Next, buy a 6-month GIC to cover your spending for the period 6 to 12 months from now.

Next, buy a 1-year GIC to cover spending for the period 12 to 24 months from now.

Finally, buy a 2-year GIC to cover spending for the period 24 to 36 months from now.

As long as your investment portfolio is doing reasonably well, continue buying 2-year GICs every six months. This ensures you will get a fresh stream of GICs expiring every 6 months providing future spending money for you.

The only exception is during a market crash. If your stock portfolio is down more than 20% (indicative of a bear market), hold off on buying new GICs until the market recovers.

It is important to remember that the relatively small amount of interest a GIC pays typically won't grow your wealth. But it will cushion much of the creeping costs of inflation and maybe provide a tiny profit.

Make sure you shop around for a good rate when buying GICs and building your GIC Ladder.

Stick with CDIC insured banks for safety, but don't run into your big bank and think they will pay a competitive interest rate to you. Generally the second tier federal banks are a better choice.

Right now, second tier federal banks like EQ Bank, Oaken Financial, and Haventree yield between 2.5% - 3% annual interest for a 2-year GIC.

That's not a bad rate considering our current inflation rate is a little under 2.5%.

Keep in Mind

There are many ways to protect your portfolio in market downturns—GICs are a small part of the total portfolio structure. The main objective of GICs is to try not deplete your portfolio for spending needs when you are in a large drawdown.

We mainly protect our portfolios through diversification with stocks, foreign stocks, bonds, precious metals, or maybe even real estate.

High quality short-term bonds, long-term government bonds, and gold can do very well when stocks are suffering.

Alternatively, you can use a more active, but highly disciplined investment approach to protect the downside. Dual Momentum and trend-based strategies are great for this!

It can also be very beneficial to split your portfolio into two different strategies. Put half of your portfolio in a passive strategy and half in a systematic active strategy.

However, don't put too much money in GICs. If you are a nervous investor it is almost certainly better to increase your bond allocation. Bonds will always provide higher returns than GICs over the medium term.

Before allocating money into GICs based on your spending needs, remember to calculate your other income and deduct this from your spending needs.

If you spend $20,000 every 6 months, don't just buy $20,000 worth of GICs every six months. Instead, deduct your CPP/OAS income, deduct any dividend and interest income generated by your portfolio, and deduct any employment or other income.

Once this is all done, chances are you will need less than $10,000 every 6 months from your GICs.

When interest rates on GICs are around the inflation rate, GICs are a great way to have some cash set aside for spending that earns some interest.

But when GICs are paying way below the inflation rate, avoid them and look to other options instead. It is not worth having your money locked up in a negative real return for years.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.