The hybrid approach: Passive + active investing

Couch Potato portfolio not for you? Try the “Hot Potato”

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There’s nothing like indulging in a few potato chips on a hot summer day with a cold beverage close at hand. You might prefer the salty kick of regular potato chips or maybe you like to spice things up with a little barbecue flavour, or perhaps, a touch of jalapeño.

When it comes to investing, the MoneySense Couch Potato represents the regular option for portfolios. It’s not fancy, but it is effective and has been very satisfying over the long term.

Investors looking for a little more spice might consider an aggressive style of indexing that has provided fiery returns without much downside. Call it the “Hot Potato,” if you will.      

Before getting to the hot stuff, it’s useful to remember what the regular Couch Potato has to offer. In an effort to highlight its merits, I’m going to focus on a portfolio that’s composed of equal amounts of four basic asset classes. It starts with the stability of Canadian bonds, which are represented by the DEX Universe bond index. Canadian stocks and U.S. stocks provide upside potential and are tracked by the S&P/TSX Composite and S&P 500 respectively. Finally, international stocks round out the portfolio’s holdings via the MSCI EAFE index.

A Couch Potato portfolio composed of an equal mix of the four indexes, rebalanced annually, performed quite well over the years. It gained an average of 10.1% per year from the start of 1981 through to the end of April 2015. The very respectable showing was helped along by a general decline in interest rates and the expansion of stock market valuations.

Investors looking for a little spice might consider following an admittedly unconventional path with the Hot Potato. It tries to hitch a ride on the hottest asset of the day. That is, instead of investing in an equal mix of the four asset classes, the Hot Potato plunges into the single asset class that fared the best over the prior year.    

Hot Potato investors who rebalanced each month into the top performing asset class of the prior 12 months gained an average of 16.6% annually from the start of 1981 to the end of April 2015.  They beat the regular Couch Potato by a whopping 6.5 percentage points annually. You can examine the return history of both in the accompanying graph.

Couch Potato Investor vs Hot Potato Investor

While the Hot Potato was more volatile than the regular couch potato, it came mostly from the sort of upside volatility that few investors complain about. It was also nimble enough to sidestep several market crashes along the way.

The Hot Potato’s largest drawdown came when the Internet bubble popped and it declined 21.4%. But the portfolio bounced back almost 2 years faster than the Couch Potato which fell 29.2%.

The Couch Potato’s biggest loss was 31.1% and it occurred during the 2008 collapse. Its portfolio didn’t recover until 2011. The Hot Potato fared better because it was in bonds for a good part of the time. It fell 10.0% from its 2007 highs to its 2008 lows and fully recovered by the summer of 2009.

It is important to point out that good past performance does not guarantee that either portfolio will fare as well in the future. Indeed, we’re in a period of low interest rates and relatively high stock market valuations, which suggests that returns might be muted in the future.

In addition, the Hot Potato is more active than the regular couch potato. It made an average of 1.7 large trades per year from 1981 to 2015. As a result, trading costs (commissions and bid-ask spreads) will reduce its returns and are not factored into the numbers above. (The method also frequently triggers capital gains taxes in taxable accounts.) Hot Potato investors should try to minimize trading costs by favouring liquid low-cost index funds or similar exchange-traded funds.

Before leaving you to nibble on the portfolio of your choice, I have to confess that I’m not a big trader myself. Nonetheless, I savour the idea of being able to outperform the Couch Potato using its own ingredients.

    

24 comments on “The hybrid approach: Passive + active investing

  1. I’d love to hear more about this. What asset classes were best over the last few years?

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  2. Doesn’t this idea of “Riding which index is hot in the past year” go against what the couch potato portfolio re-balance theory really is? Buy low, sell high? Seems like it would work sometimes, but like mentioned in the article, it is a guessing game.

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    • Agreed. This doesn’t seem to be any more of an investing system than simply guessing what’s going to go up and trying to time the market. Although, I guess doing this with index funds rather than specific stocks still limits volatility (especially downward).

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  3. So if you’re rebalancing into the hottest asset class each month, what are you new percentage goals for each class? If you start at 25% each and one class rises to 30%, you’re saying to rebalance into it? The idea sounds good, but you need much more explaining in this article.

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    • Yes how does this work? I rebalance back to my original 40% bonds, 20% every thing else once a year. So, what does it mean to rebalance back into the hottest asset class each month? The US have been the hottest asset class for a while now, and I have been selling US and buying CDN to rebalance. Tell us more!!

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    • I wonder if this takes into account the trade costs. Unless you do it only with the TD e-series funds, monthly trades will probably eat you alive!

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    • I agree. I don’t know what “rebalancing into the hottest asset” entails. Does this mean having 100% of the funds invested in the category which performed best over the previous 12 month period? Might this result in being 100% in bond funds but then moving the entire portfolio into US equities, if US equities suddenly reach the point where they performed best over the previous 12 months?

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      • Sounds like attempting to drive with access only to the rear view mirror!

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  4. I think, readers need more explanation and some guidance to explore it further . Where to get this best performing asset data each month. Examples of low cost different ETFs . An example of hot couch potato portfolio will help.

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  5. This is a somewhat altered version of Global Equity Momentum as described in Gary Antonacci’s book “Dual Momentum”, with a lot of detail left out including how to do it for non US investors. Readers should read the book and review his website before trying this strategy.

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  6. is this simply a theory, thats been backtested.. if not can you be more specific… also you mention 1.7 trades a year.. but then you say “adjusted monthly” also by “plunging into the hottest asset” what percentage are you doing so… it appears to me to be a 100% plunge..

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  7. Perhaps it is similar to “drifting”. Where you simply do not rebalance and let the stronger asset class units build up? I’ve considered doing this as I’ve heard in the long run you will have a higher rate of return. Then I read something about the importance of rebalancing and change my mind. Too much information! :)

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  8. I need more information on this Hot Potato strategy. How do I implement this in my portfolio?

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  9. What exactly is the recommended “Hot Potato” portfolio?

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  10. You cannot just state a strategy that beats passive investing but don’t do anything to tell readers how to implement it or to scrutinize it. Are we supposed to go to your website? Contact you? Is there a fee for implementing this strategy before you reveal it? At least be transparent

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  11. These are widely used but often thinly understood concepts. On top of that, active and passive investor advisors are often framed as two hostile camps with diametrically opposed aims. Passive investment managers invest in broad sectors of the economy through asset classes or indexes. The aim is portfolio diversification and steady performance. It’s a no-frills approach but has some built-in advantages for investors.

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  12. Can we please get a followup article/video to explain this further. In more detail because as it stands now it isn’t clear enough, tell us which tools you use to decide when to buy and when to sell each index. Again past performance does not indicate future returns, so how has this strategy worked consistently?

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  13. As for your chart please indicate when, what, and why you bought or sold. Looks like your team clearly back-tested this approach but more detail as to how you came up with the numbers and charts would help.

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  14. Hi Norm,
    This is a great momentum strategy. I am interested to find out if you can post the link to backtest with lookback period and perhaps the use of top two assets than just one. Thank you!

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  15. Alright. Correct me if I am wrong. So, say you decide end if April to do this. The US Index has been the strongest in the last 12 months. Right? So, you sell your international index, your CDN Bond Index and your CDN Equities Index funds. Put it all into US Index. The whole kit and caboodle, right? You hold on to that until the end of May. Check and see if the US Index is still the leader of the pact, if so (and honestly, what could happen in one month to change it, right?), then you hold. Again, at the end of June, July, August etc., you check. If the US Index still has the strongest return of the four, then you hold. If one of the others come out on top, say, International Index, then you sell all the US Index, and buy International. All in. Am I right? Is this how this works? Is this what everyone else gets?

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    • That’s my understanding. You put 100% of your money in one fund at the time. At the end of each month you look at the 12-month performance of the four types of index and move ALL your money into the index fund that did best over that period of time.

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  16. Hello,
    How do we get in contact with Norm? I have a few questions. Thanks

    Reply

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