In May 2012, I wrote an article on creating a portfolio designed to outperform a broad bond ETF like the iShares Core Total U.S. Bond Market ETF (NYSEARCA:AGG), and since rates have risen 1% since the time of writing my article, I thought it would be a good time to review how the portfolio has performed. When I wrote my article, the rate on the 10-year Treasury bond was 1.70%, and recently hit a high of 2.73%, but has since fallen slightly back down to 2.63%.
The reasoning behind my rising rates article was that low rates were a product of the financial crisis and a poor economy, and when the economy started picking up in 2012, I assumed rates would rise because of improved economic growth. While it is true that the economy is growing, the pace is not what I thought it would be, and even today, the IMF cut its estimates of global growth from 3.3% to 3.1% citing the weakness in emerging markets, and the ending of monetary stimulus in the United States. Interest rates have gone up not because of great economic growth or inflation, but rather fear of the Federal Reserve stopping purchases of treasuries.
My portfolio consisted of five categories of ETFs that were all designed to rise in an environment where global economic growth was improving, and inflation was rising. The five categories of ETFs I constructed the portfolio with were: TIPS, floating rate bonds, emerging market bonds, high dividend equities, and inverse long-term bonds. The table below shows each fund that I choose for each category as well as the volatility and weight I used to
PIMCO 1-5 Year U.S. TIPS Index Fund
iShares Floating Rate Note Fund
PowerShares Emerging Mkts Sovereign Debt
iShares High Dividend Equity
ProShares Short 20+ Year Treasury
I used ETFreplay.com to show the performance of the portfolio compared to AGG since the time of writing my article. The chart below shows the performance of my portfolio compared to AGG since I created it, and as the chart clearly shows, my portfolio provided a positive return where AGG has posted a negative return. Therefore, I accomplished my goal of outperforming AGG, but when I looked at the return chart, I noticed the significant drop off at the end of the chart because of the spike in interest rates, and I thought my portfolio would rise in a rising rate environment, so I had to investigate.
The chart below shows the return of my portfolio from May 2nd 2013, which was the 2013 low in interest rates. It shows my portfolio had a negative total return, but did outperform AGG, which was a positive aspect.
In the first table, I looked at the returns for each ETF in my portfolio from May 2nd. The second chart below shows the individual returns since the portfolio's inception in May 2012, and I noticed some interesting information, which I detail in the lessons learned section below.
What went wrong?
- TIPS are good in a rising rate environment ONLY IF the rise in rates is because of inflation.
- I expected if rates were rising, emerging markets would be growing along with rates, and the bonds from emerging markets would rise as well.
What went right?
- Inverse long-term bonds performed very well in the short period of rates increasing quickly.
- High dividend equities outperformed bonds even with the rise in rates where some investors with higher rates might think about switching from dividend equities to bonds.
I asked myself, based on the performance of the portfolio so far, would I change anything about the portfolio? I would have to say my answer is I would not change anything about the portfolio. I think the portfolio is constructed very well because it minimizes interest rate risk, it minimizes volatility because of how I choose to allocate more to the lowest volatility ETFs, and because for each individual ETF selection I choose the least volatile ETF for each asset category. Going forward, if rates continue rising, the portfolio should continue outperforming AGG as designed, but for the portfolio to post positive returns over the long-term, the rise in interest rates has to be because of improved economic growth and rising inflation, and not because of the fear of the Federal Reserve cutting off its asset purchases.