Hindsight is 2021 – A Year-End Retrospective and Lessons for 2022

Barbary Macaques Monkeys, Gibraltar

Portfolio Construction

The following screenshot tells us almost all we really need to know about 2021 – it was a great year to invest in US equities:

The S&P 500 Index was up 29% on the year with 70 new highs on the way up and only two (short-lived) corrections of over 4%. Likewise, the Nasdaq Index was up 29% and the Dow 20%. Only the Russell 2000 (small-cap) Index lagged a little with a 15% gain. In retrospect a Buy-And-Hold investment in any Fund tracking US equity markets would have served us very well – our favorite ETF, VTI, that covers the broad US equity markets gained 26% on the year.

However, there were better (asset class) performers – Oil was a big mover in 2021 with USO (the Oil-linked ETF with highest Assets Under Management – AUM) being up 80% in October. It has since pulled back a little but still returned ~70% on the year:

IEO, BNO, USL and OIL are other Oil-linked ETFs that showed gains in excess of 60% in 2021 and that we might want to consider if looking to add Oil as a diversifier to our portfolios – but, of course, we may have missed the boat here.

In the Rutherford asset quiver, I include DBC as a commodity ETF that covers Oil – but it is more diversified and includes other commodities, so it did not have quite as good a year in terms of performance – although still showing a ~40% return – ahead of US equities:

When looking for diversification through commodities – especially with a threat of inflation – it is common to consider holdings in Gold. But Gold (GLD) has not responded in 2021:

Whilst trading sideways for most of the year it is still showing a ~7% loss from its 2020 closing price. Will this change in 2022 if the inflation threat continues?

Treasuries (and other bond ETFs) were also poor performers over the past year. TLT, the 20-Year Long-Term Treasury ETF ended 2021 with a ~7% loss after recovering, partially, from a ~15% correction early in the year:

Other Bond funds behaved similarly.

The last major asset class that we often include in our portfolios is Real Estate. Our most popular choice here is VNQ that also had a stellar year generating a 40% return with no major draw-downs/corrections:

So, despite the high performance of the US equity markets, this performance was beaten by Real Estate and Commodities (at least if the Fund chosen included Oil). Bonds were the assets dragging down the returns of diversified portfolios. Diversifying geographically did not offer any significant advantages in 2021 in terms of enhancing returns although probably lowering risk (volatility). International equities showed modest single digit gains that were offset by similar losses in the bond markets.

Portfolio Management

Given the above performance we might have expected diversified portfolios to perform at least moderately well in 2021 – maybe generating returns in the high teen percentage range. So, let’s check in on the Rutherford Portfolio that diversifies through all the asset classes noted above:

Here, we see very disappointing performance with an annual total portfolio return (heavy red line) of only 5%. So, let’s analyze this performance to see if there are any lessons to be learned.

The first thing to note is the wide range of performance between the five tranches into which this portfolio is broken down – with each tranche being reviewed/adjusted on a five-week schedule with one week between the five tranche review periods. The best tranche performance (top thin amber line) shows a 10% annual return whilst the worst performing tranche (lower dashed brown line) shows a 3% loss. This demonstrates the significance of review-date (or timing) luck. So, we have to make a decision as to whether we will review/adjust the portfolio only once a month (on a monthly schedule) and trust to luck as to where our performance will fall within this range – or whether we will split the portfolio into tranches and review different tranches on a weekly rotation schedule – thus averaging our luck over time. Or maybe just review the total portfolio more frequently – although this introduces the possibility of more whipsaw trades and “churning”. Factors that might influence an investor’s decision here might be aversion to risk and/or tax situation (avoiding short-term “wash-sale” rules).

However, even if we had been “lucky” and fortunate enough to fall on the top (amber line) schedule our annual return would still have been “only” 10% and we might still be disappointed. So, what else do we notice from the above plots? An obvious feature is the dislocation of the portfolio equity curve (heavy red line) from the benchmark equity curve (heavy blue line) in early October. This was a result of Trailing Stop Loss Orders (TSLOs) being hit and getting taken out of VTI (US equities) in all five tranches. Even based on the performance of our diversified benchmark fund (AOR) we clearly lost ~6% as a result of this action. Since VTI was held in all portfolios this means that the best performing tranche might have been expected to generate at least an additional 6% – or a 16% annualized return – had we not been using stop-loss orders. Adding 6% to the 5% realized by the Rutherford portfolio would have resulted in an 11% return – in line with the return from the benchmark fund – and this is probably about where this portfolio should have ended. The decision here is whether we are prepared to give up (significant) returns in exchange for reduced downside risk. Momentum systems will get us out of major corrections on our review dates but, depending on luck, we might have to accept drawdowns of 10-20%.

To demonstrate that this is not a one-off, single portfolio example, let’s look at the performance of the Kahneman-Tversky Portfolio:

TSLOs were also used for this portfolio but were a little tighter than for the Rutherford Portfolio. This means that individual losses per instance were smaller (~3-4%) – but there were more of them – three in the 12-month period. This resulted in ~10-12% lost in potential returns (~value of returns generated within the periods shown by the black arrows). One thing that I have realized from this example is that TSLOs are not particularly attractive when used with Dual Momentum (DM) portfolios since, with a restricted choice of assets (usually only 3), it is difficult to re-enter the market quickly – presumably we wouldn’t want to jump back into the same asset that we had just been stopped out of – even if seeing a BUY signal – otherwise why would we be exiting in the first place? This portfolio managed to lose a few dollars in 2021 – so, a bit of a disaster despite the strong performance from May – September.

Investment Models

At ITA Wealth we cover a range of possible investment models for consideration. There is often the temptation to look for the “best” model based on recent performance. But this is not a good idea – most well-designed systems work well – until they don’t! It is far better to diversify across different systems/models (in addition to diversification of assets within the portfolio) than it is to seek out the “best” system.

If we check Lowell’s performance update for 2021 (https://itawealth.com/performance-update-31-december-2021/) we get an idea of the range of performance that we might expect.

Buy-And-Hold (e.g. Schrodinger) worked well in 2021 because we saw a relatively smooth bullish trending market. These portfolios need little or no management but offer no downside protection in the event of a significant draw-down.

Dual Momentum portfolios are simple and easy to manage but tend to be very sensitive to “luck” – some generated returns at the top of the list (McClintock and Pauling) whilst other (Franklin and Kahneman-Tversky) ended up at the bottom of the pile. Another reason to diversify across systems/time.

Other models available within the Kipling workbook (LRPC, HA and BHS) are momentum-based (Cross-Sectional or Relative Strength) models designed to perform best with market conditions changing at different speeds – so, again, since we can’t know what the next year will bring it is probably prudent to spread risk between different systems. Overall, these systems performed well over the past year generating returns in the 10-30% range depending on timing “luck”.

I haven’t covered “Income” portfolios in this retrospective but these represent yet a different investment philosophy that offers even more diversification – and these have performed well in 2021 with returns in the high teens. Be sure to follow our posts (Hawking https://itawealth.com/hawking-portfolio-review-31-december-2021/ , Huygens https://itawealth.com/huygens-portfolio-review-6-december-2021/) that use this methodology to learn more about some of the pros and cons of the approach. It is a significantly different approach from our other models.

I also haven’t mentioned the Darwin Portfolio (https://itawealth.com/darwin-portfolio-review-23-december-2021/) that uses risk parity allocations to target volatility (risk) and represents a “core” portfolio with holdings in all assets in the investment quiver, but which is rebalanced periodically to maintain stable risk-adjusted performance. I am still working on this portfolio to (hopefully) better control the risk level and, maybe, to provide more system diversification.

One of the ideas that I have been working on for the past few months is the concept of treating Volatility as a separate asset class in it’s own right. This is a little difficult from an “investor” point of view because of the speed at which volatility can change – it is a little easier if accepted as a system to “trade”. Check the post at https://itawealth.com/using-volatility-as-a-diversifier-and-a-portfolio-hedge/ for a description of one of these new systems. Even for systems that might trade infrequently these systems need frequent (daily) attention to market conditions because of the rate at which things can change. Because of the characteristics of volatility products that can be traded, these systems are (potentially) suitable for use as a hedge for more conventional portfolios. In that vein I also continue to look for efficient ways to use Options as a portfolio hedge – without incurring excessive “insurance” costs.

Where we go in 2022 remains to be seen – but it is difficult (yet not inconceivable) to imagine the bullish trend in US equity markets continuing at the same pace as in 2021. Until we see evidence to the contrary, we should probably remain bullish (long equities) but be prepared to go on the defensive if/when there is evidence of weakness. Some gurus are suggesting that we are living in conditions very similar to those in existence at the time of the 2000 tech bubble – and they may be right. But, although the pandemic has caused a lot of economic damage, there is still a lot of money going into the markets – must be nothing else to spend it on when we can’t go anywhere.

I’ve been worried since 2013 😊 – but we’re still in an uptrend despite the pandemic scare. It’s just a matter of time before we see a major correction – as markets continue upwards at these rates the bubble gets bigger and the louder will be the bang when it does finally burst. In the meantime, we need to be a little careful without getting too paranoid.

David