Rules-Based Strategy Summary: 12% Solution Investing
The 12% Solution investing strategy is a rules-based investment system that automates decision making, reduces risk and volatility, and produces a claimed 12% average annual return. I found this book when searching for other books like Dual Momentum, which uses a momentum strategy to rotate in and out of ETFs.
The full title promises a lot: The 12% Solution: Earn A 12% Average Annual Return On Your Money, Beating The S&P 500, Mad Money’s Jim Cramer, And 99% Of All Mutual Fund Managers… By Making 2-4 Trades Per Month. The book offers up just the right amount of background and research.
As always, I want to really encourage readers of this blog to make sure you read the book. There is a lot more information than I can cover in this blog.
As a Dual Momentum investor myself, I wanted to track the portfolio here at Robotic Investing using the same methodology.
How the 12% Solution Works (High-Level)
The system works by getting into “Risk-On” trades and “Hedge” trades (at the same time). An investor’s portfolio is divided into a 60/40 split, with 60% of the available cash being deployed into the “Risk-On” trade which are equities. The other 40% is invested into “Hedge” trades which are bond ETFs. The system therefore provides the investor with a classic 60/40 split with their portfolio, while adding in the benefits of a momentum screen.
The momentum screen comes into play when determining which ETF to hold for each portion of the portfolio.
With the “Risk-On” trade, the investor buys one of four ETFs. The ETF that is bought has the best month momentum (performance) based on a set period of time. These four ETFs track different equity portions of the market, so you are effectively buying the strongest trending of the four.
The four indexes are: the Russell 2000, the Nasdaq-100, the S&P MidCap 400, and the S&P 500.
An additional rule for the “Risk-On” trade is the threshold for either investing in one of the four ETFs, or a cash-trigger. The equity ETF is only bought if it passes a threshold.
If none of the four ETFs pass the threshold, then the equity portion moves completely to cash. A cash alternative can be used here as well.
With the “Hedge” allocation of the portfolio the investor buys one of two ETF bond funds. The bond fund that is purchased is the one with the best momentum based on the same period as the equity ETFs.
The result is a portfolio with two ETFs, split up with a 60%/40% split. 60% is in the strongest performing equity ETF,as long as one of them passes the cash threshold. The other 40% is in the strongest performing bond ETF.
The returns are calculated each month and the portfolio is adjusted as required.
Summary of 12% Solution Investing
Overall, this is a pretty simple system but according to the book has been effective in beating the market over long periods of time. Like all momentum strategies, there will be periods where it underperforms. That is primarily due to the times it goes to cash. This keeps the volatility of the portfolio down, making it easier to hold when the proverbial crap hits the fan.
Later in this post I will show the performance of the portfolio based on backtest data.
Rules-Based Portfolio Construction & Management
As discussed above, the 12% Solution investing rules are based on momentum and a positive trend in equities. In addition, it uses a 60% allocation to equities and a 40% allocation to bonds. The objective is to earn better than average returns, with reduced volatility over a long period of time.
Like all momentum investing strategies, the investor needs to commit for the long-term. Short-term performance can be poor. Keep that in mind if you decide to use a strategy like this.
This type of system involves monthly trades to buy the best performing ETFs on both the equity and bond allocation. You will need to make sure your trading costs are on the low end. Trading frequency is not crazy here, but there can be years where there are more trades than others.
Here is a very high level overview of how a portfolio following the 12% solution is built. I do not want to provide the exact details of the system as readers should check out the 12% solution investing book.
- The 12% Solution investing system trades four different equity ETFs and two different bond ETFs. When the equity portion goes to cash, a cash alternative is used.
- The portfolio is separated into 60% equities and 40% bonds.
- Buy Rules: Equity: If the return is greater than the threshold specified in the book, buy the best performing equity ETF based on the return period. Bond: Buy the best performing bond ETF based on the same return period.
- Sell Rules: At the end of each month, calculate the momentum returns for each ETF. Replace the equity ETF with the best performing ETF, as long as the equity ETF passes the cash threshold. If not, then hold a cash-based ETF for the next month. Replace the bond ETF with the best performing bond ETF.
- Rebalance: Maintain the 60/40 portfolio split by rebalancing funds every month. For the Robotic Investing portfolio, this is done only if the rebalance amount requires a 10% reallocation. This is done to minimize portfolio costs.
Research & Backtest Results
For more information on the 12% Solution rules-based investment strategy, here are a couple resources to check out:
- The 12% Solution: Earn A 12% Average Annual Return On Your Money, Beating The S&P 500, Mad Money’s Jim Cramer, And 99% Of All Mutual Fund Managers… By Making 2-4 Trades Per Month
- David Alan Carter – Author
In particular, if you read the book and want access to Mr. Carter’s FAQ as well as the monthly signals, you can shoot him an email. The book includes information on how to do that in the last chapter.
Rather than rely on backtest results from the book, I went over to an independent backtest site to see if I could see how the system performed.
Using ETFReplay.com as the backtest engine, I ran the strategy with the earliest possible dates to see how the system performs based on the above rules. Here are the backtest results from that:
The results are impressive to say the least. Compared to a 7.5% CAGR for the 60/40 benchmark, this strategy provided a 13.3% CAGR. The bonus is that the maximum drawdown is significantly lower with the 12% solution portfolio.
Overall positive results. I track real-world implementation of this version of the 12% solution investing system. To see how the portfolio performs in real-time and the real world, check out all the blog posts tagged with the 12% Solution Investing Strategy category (see sidebar).
Why I Don’t Trade the 12% Solution
The reason I don’t trade the 12% solution is due to the lack of global diversity. Unlike the Dual Momentum approach, the 12% solution does not cycle between U.S. and global stocks. The U.S. is a big market, however it is not the only market in the world so I like to have access to other markets.
Overall, this is an interesting strategy and a great application of the momentum principles. I look forward to running the strategy here at RoboticInvesting.com to see how the results fare over time.
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