New Enhancements to Our Investment Models

Here at Model Investing, we’re constantly trying to innovate to ensure that we deliver the best performance possible for our clients. Over the past couple of years, we’ve been working to refine and enhance our suite of Investment Models, and today we’re proud to announce the upcoming release of new versions of each of our models.

This article is intended to bring you up to speed on the nature of those changes, as well as provide some guidance on what to expect regarding the timing and implementation of our updated models.

Importantly, these changes will not require any additional action on your behalf. Simply continue to implement our model recommendations as usual, and you’ll automatically begin taking full advantage of the new updates.

Timing

We plan to roll out the new versions of our investment models over the coming week. During this time, you may notice some changes to the content and data on our site.

The bulk of these changes will occur over this coming weekend (May 25th – 26th) in order to minimize disruption. However, please be aware that the site may be under maintenance until May 29th. If you encounter any critical issues during this period, please let us know, and we’ll address them immediately.

Assuming everything goes smoothly, we plan to transition completely to our updated models by May 31st. This means that the June Recommendations will be the first set of monthly updates to utilize our updated logic.

Model Updates

In the following section, we’ve outlined the major changes to each of our investment models. Please note that the changes mentioned below will not be reflected throughout the rest of the website until this weekend.

Click the links below to jump to a specific model:

Asset Rotation Model (ARM)

We made two key changes to the Asset Rotation Model: The “Cash” option has now been removed, and we’ve incorporated new logic to dampen the effect of whipsaw.

Removal of the “Cash” Option

The older version of the ARM rotated between stocks, bonds and cash. Our new version eliminates the cash option, forcing the model to always be invested in either stocks or bonds.

New Asset Rotation Model (ARM) Investment Options
ETF Description Asset Class
SPY SPDR S&P 500 ETF Stocks
AGG iShares Core U.S. Aggregate Bond ETF Bonds

The reason for this change is twofold. First, the old version of the ARM rarely utilized the cash option. In addition, during our testing we found that in each case where cash was recommended, the model would have performed better had the allocation been placed in bonds instead.

In reality, cash tends to be a poor investment choice because of the general inverse relationship between stocks and bonds. During various phases of the business cycle, one of the two asset classes is always performing well.

When economic conditions are favorable (the economy is expanding) stocks tend to outperform both bonds and cash by a wide margin. However, when economic conditions deteriorate, bond prices tend to outperform as a result of a) investors shifting their investments towards bonds for safety and b) the Federal Reserve taking actions to stimulate the economy by easing monetary policy.

As a result, in either of these situations (favorable or unfavorable economic conditions), cash tends to underperform one or both of the other asset classes. That’s why we’ve eliminated it as an option from the ARM.

New Logic to Dampen the Effect of Whipsaw

One of the key issues we have to deal with as investors is whipsaw. Whipsaw refers to a specific behavior in the financial markets where asset prices trend in one direction for a long period of time, only to make a quick counter-trend move, before resuming their original trend.

This behavior is also sometimes referred to as a correction of the primary trend, or a period of mean-reversion, in which security prices have become too extended in one direction and must revert back towards their longer-term trend.

These episodes are a natural part of the financial markets and cannot be avoided completely. However, we’ve taken steps in this latest round of updates to minimize the impact of whipsaw on our overall performance.

By identifying conditions when whipsaw is likely to arise, we hope to do a better job of anticipating and avoiding these frustrating market moves.

Sector Rotation Model (SRM)

The primary changes to the Sector Rotation Model include the addition of two new sectors (Real Estate and Communication Services), new logic to dampen the effect of whipsaw, and an improvement in overall responsiveness.

Addition of New Sectors

The older version of the SRM utilized nine sector funds, because when the original model was developed, that’s how many sectors there were. However, over the years, the GICS (Global Industry Classification Standard) has expanded to now include 11 sectors.

The two new sectors are Real Estate – which was broken out of Financials and made into a new sector on August 31st, 2016, and Communication Services – which used to be Telecommunication Services, but was expanded to include companies from the Consumer Discretionary and Information Technology sectors and renamed Communication Services on September 21st, 2018.

New Sector Rotation Model (SRM) Investment Options
ETF Description Sector
XLRE Real Estate Select Sector SPDR Fund Real Estate
XLC Communication Services Select Sector SPDR Fund Communication Services

Moving forward, you’ll now see the Sector Rotation Model utilize these two new sectors in addition to the existing ones.

New Logic to Dampen the Effect of Whipsaw

Just as with the ARM, and all of our models, we’ve incorporated new logic into the SRM designed to minimize the effect of whipsaw. For more on this, please see the “New Logic to Dampen the Effect of Whipsaw” section under the Asset Rotation Model (go there now).

Improvement in Responsiveness

Experienced investors have long understood that the financial markets operate as “discounting mechanisms.” That is, they discount (incorporate) information from all over the world, and reflect that information in the form of asset prices.

This information includes everything from the emotions of investors, to inflation, interest rates, corporate earnings, macroeconomic data, potential policy changes, etc. And as a result of improvements in technology, this information is continually being discounted by the market at a faster and faster rate.

As a result, the pace at which the financial markets move is constantly increasing. While it used to take hours, days, or sometimes weeks for certain types of information to be priced into the market, that same information can now affect asset prices in minutes – sometimes seconds.

Due to this increase in the speed at which markets move, we’ve made some adjustments to the SRM that will improve its responsiveness to changing conditions. The end result is that the SRM will be more agile, and less susceptible to being behind major market shifts.

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401(k) Allocation Model (401)

Of all of our investment models, we’ve made the most significant changes to our 401k Allocation Model. These changes include a reduction in the number of funds used in the model, a change to the general allocation structure, new logic to dampen the effect of whipsaw, and an improvement in overall responsiveness.

Reduction in the Number of Funds

The older version of the 401 Model used 10 separate funds. These were originally selected based on an analysis of the 401(k) plan options for a handful of the top employers in the U.S. However, over the years we’ve realized that 401(k) plan options are much more diverse (and often lacking) than we had originally thought.

As a result, we took everything that we’ve learned from examining hundreds of 401(k) plans and narrowed down our list of investment options to just five funds. These five funds are included in nearly every 401(k) plan that we’ve ever looked at, which makes our 401 Model now usable by a much larger audience.

New 401 Model Investment Options
ETF Description Objective Benchmark
Domestic
SPY SPDR S&P 500 ETF Exposure to domestic large-cap companies S&P 500
IJH iShares Core S&P Mid-Cap ETF Exposure to domestic mid-cap companies S&P MidCap 400 Index
IJR iShares Core S&P Small-Cap ETF Exposure to domestic small-cap companies S&P SmallCap 600 Index
International
EFA iShares MSCI EAFE ETF Exposure to companies in Europe, Australia, Asia and the Far East MSCI EAFE Index
Fixed Income
AGG iShares Core U.S. Aggregate Bond ETF Exposure to the domestic fixed-income market Barclays U.S. Aggregate Bond Index

In addition to narrowing down the number of funds for usability purposes, the reduction in funds also allowed us to change up the allocation structure (discussed in the next section), which in turn allows us to make more targeted investments in certain areas of the market. In our testing, this dramatically improved overall results, and we expect to see a substantial improvement in performance moving forward.

Changes to the Overall Allocation Structure

The older version of the 401 Model utilized the top five ranked funds, and allocated the portfolio according to the table below:

401 Model Allocations by Rank (Old Version)
Fund Rank: 1 2 3 4 5
Allocation 30% 25% 20% 15% 10%

In the new version of the 401 Model, only the top three funds are used, and the recommended allocations are as follows:

401 Model Allocations by Rank (New Version)
Fund Rank: 1 2 3
Allocation 50% 30% 20%

As mentioned above, the result of this change is that we are able to make more targeted investments in specific areas of the market. This allows us to be more precise and tactical with the portfolio, and deliver higher returns as a result. It also results in a model that is easier to understand and implement.

New Logic to Dampen the Effect of Whipsaw

As with all of our investment models, we’ve incorporated logic into the 401 Model designed to minimize the effect of whipsaw. For more on this, please see the “New Logic to Dampen the Effect of Whipsaw” section under the Asset Rotation Model.

Improvement in Responsiveness

The 401 Model’s core logic has been updated to allow for better responsiveness to changing conditions. For more on this, please see the “Improvement in Responsiveness” section under the Sector Rotation Model.

TSP Allocation Model (TSP)

The primary changes to the TSP Allocation Model include less reliance on the G Fund, new logic to dampen the effect of whipsaw, and an improvement in overall responsiveness.

Less Reliance on the G Fund

For many TSP investors, the G Fund is a coveted investment fund because it provides the opportunity for small returns with no potential loss of principal. While that sounds good in theory, our testing has shown that the G Fund is rarely, if ever, the best place to have your money.

To understand why this is, we need to appreciate how stocks and bonds behave during various phases of the business cycle.

Generally speaking, when the economy is expanding, stocks will provide the highest returns of any asset class. These returns will dwarf that of the G Fund, which means that any money allocated to the G Fund during these periods will act as a significant drag on overall returns.

Most people understand this intuitively, which is why the G Fund is commonly viewed as a good place to park funds during recessions and other periods of market turmoil. However, while the G Fund is certainly a better option than stocks during these treacherous periods (as stocks typically lose value), the F Fund is almost always a better option than the G Fund.

This is because during periods of economic turmoil, two things happen: Investors shun stocks in favor of bonds, and the Federal Reserve takes steps to ease monetary policy. Both of these actions have the effect of lifting bond prices, which results in strong F Fund performance.

As a result, regardless of where we are in the economic cycle, there is almost always a better alternative than allocating money to the G Fund. That’s why in this latest round of enhancements, we’ve reduced the TSP Model’s reliance on the G Fund. The G Fund is still utilized within the model, but not to the extent that it was in the prior version.

New Logic to Dampen the Effect of Whipsaw

As with all of our investment models, we’ve incorporated logic into the TSP Model designed to minimize the effect of whipsaw. For more on this, please see the “New Logic to Dampen the Effect of Whipsaw” section under the Asset Rotation Model.

Improvement in Responsiveness

The TSP Model’s core logic has been updated to allow for better responsiveness to changing conditions. For more on this, please see the “Improvement in Responsiveness” section under the Sector Rotation Model.

Gold Rotation Model (GRM)

The primary changes to the Gold Rotation Model include the use of a short-term bond fund instead of cash, and new logic to dampen the effect of whipsaw.

Use of a Short-Term Bond Fund Instead of Cash

The older version of the GRM included two options: GLD – a gold ETF, and cash. The new version of the GRM has replaced the cash option with BSV – a short-term bond fund.

New Gold Rotation Model (GRM) Investment Options
ETF Description Asset Class
GLD SPDR Gold Shares ETF Gold
BSV Vanguard Short-Term Bond ETF Bonds

The reason for this change is relatively straightforward. When an investment in gold is not recommended, money following the GRM should not sit in cash, which earns nothing and loses purchasing power over time. Instead, that money should be invested elsewhere, either in one of our other investment models, or at the very least, in a short-term bond fund.

Utilizing BSV instead of cash in the new version of the GRM allows you to earn a small, but safe return on that money during periods of poor gold price performance. That small return will boost overall returns, while also acting as a hedge against inflation.

New Logic to Dampen the Effect of Whipsaw

As with all of our investment models, we’ve incorporated logic into the GRM designed to minimize the effect of whipsaw. For more on this, please see the “New Logic to Dampen the Effect of Whipsaw” section under the Asset Rotation Model.