MAD Portfolio: Sector Rotation Has Left the Building

by: Jeff D. Hamann

A friend of mine often quotes Mark Twain's “History doesn't repeat itself, but it does rhyme” to me to describe market dynamics and asset allocation. Assuming that's true, we should be familiar with the tune and we should be able guess what comes next, right? What if you don't? What if you've never heard the tune, it doesn't make sense, and you're not familiar with the vocabulary? It takes time to learn new tunes, time to learn from mistakes, and time to make mistakes is something we don't have.

So for today, let's ignore the current news cycle about Japan's tsunami induced nuclear meltdown, the Fed's continuation of QE2, the possibility of QE3, and the continued global commodity price climb. Take a deep breath, assume we know nothing about market dynamics and simply look at what happened to the historical Konno and Yamazaki Mean-Absolute Deviation Portfolio for a small universe of 41 Exchange Traded Funds (ETFs):

Fixed-Income/Bond Assets: TIP, SHY, IEF, TLT, AGG
Commodities: IAU, SLV, GSG, BDC, USO
Global Equities/Emerging Markets: FXI, EFA, EEM, IEV, IOO

Leveraged Assets (i.e. Double Longs): DDM, SSO, QLD, MVV
Inversely Correlated Assets (i.e. Shorts): DOG, SH, PSQ, MYY
Inversely Correlated and Leveraged Assets (i.e. Double Shorts): DXD, SDS, QID, MZZ
US Equity Sectors: XLF, IYM, XLE, VNQ, XLI, XLY, SMH

Remember, the objective of these portfolio posts is to have a historical reality check, report allocations that met (or exceeded) a target return of 10% AND minimized the volatility (i.e. standard deviation) given some set of basic constraints (e.g. don't put all my money into a single ETF!). Since the constraints can take up quite a bit of room, they can be found in previous posts.

The optimal allocations for the previous 252 days worth of daily returns was:

Exchange Traded Fund Name Symbol Return Std Dev Weight RSI MFI
iShares Barclays 1-3 Year Treasury Bond Fund SHY 1.74% 1.22% 60.00% 65.34 79.89
iShares Silver Trust SLV 118.57% 29.78% 9.43% 55.76 70.29
iShares S&P 500 Index Fund IVV 16.05% 17.44% 7.08% 38.79 39.12
iShares Morningstar Mid Core Index Fund JKG 26.88% 21.11% 13.51% 42.26 28.81
ProShares UltraShort S&P500 SDS -27.16% 35.23% 9.98% 60.39 67.15

Where the resulting target portfolio return and standard deviation (annualized) were 10.00% and 3.15%, respectively. We're hitting our target return of 10% and the volatility has not change from last time. In contrast, the annualized performance for the benchmark (S&P500) has declined another 6% from 20% to 14% this week while the volatility has remained about the same at 17%. The benchmark returns are impressive but weakening and the volatility is far from impressive. Had we allocated our money into the assets listed above 252 days ago, our performance would have looked something like this:

Here's the take home messages for today:

  1. The bond asset remains the iShares Barclays 1-3 Year Treasury Bond ETF (NYSEARCA:SHY). The estimated annualized performance has increased slightly from 1.35% last time to 1.74% this week. The volatility (i.e. standard deviation) has increased from 1.18% to 1.22%, which is pretty small compared to some of the other assets in the portfolio. The weight on the single bond pick has remained at the maximum allowed allocation of 60%. Relaxing the maximum bond constraint has the bond allocation at 76%. Not out of control for retired folks, but slightly conservative for investors at or near retirement.

  2. The commodity asset remains the iShares Silver Trust ETF (NYSEARCA:SLV). The allocation has slipped a little from last week's 8.57% to 9.43% this week, with the estimated annualized return continuing it's triple digit return performance. The other commodity ETFs we're tracking (IAU, GSG, DBC, and USO) have all been showing strong performance, but none have entered into the 10% portfolio for several periods and they don't appear to do so anytime in the near future. Considering the hit SLV has taken within the last 24 hours, it might be a good time to consider purchasing a little if you don't have any commodities.

  3. The portfolio model is still steering clear of emerging and global market assets. The standard deviations are uncomfortably high for their returns and considering global economic conditions, you're safe to steer clear of this asset class. For our longer term portfolio look backs, which include the previous four years, the global/emerging equity asset has been consistently iShares FTSE/Xinhua China 25 Index Fund (NYSEARCA:FXI).

  4. The portfolio is still allocating to the iShares Morningstar Mid Core Index ETF (NYSEARCA:JKG). The allocation changed downwards from last week's 15% to this week's 13%. The annualized performance has dropped from last week's 33% to 27%, which could be an indication that a move out of JKG is in the future. The iShares S&P 500 Index Fund ETF (NYSEARCA:IVV) has entered the portfolio at 7% offsetting the sector rotation picks. The short term performance of both assets has been dropping steadily for a few weeks now and considering the low market cap of JKG, it could be time to start shopping for a replacement in the current universe. Any suggestions?

  1. The short/leveraged hedge position remains the ProShares UltraShort S&P500 (NYSEARCA:SDS) and has stayed at the maximum allocation for a couple of weeks. The performance of SDS has been showing signs of life (i.e. positive returns), as have all the shorts and short leveraged assets in our universe. When we removed the maximum short allocation constraint of 10%, the short position switched to 15% ProShares Short S&P500 (NYSEARCA:SH), the non-leveraged slower-moving version. Volume in short/short leveraged assets have been increasing and the short term returns have trended themselves into positive territory for the first time in months. Okay, so maybe the correction will not be televised. Like the changes in the Middle East, the correction will be'd instead. Hedge-funds and HFTs; check your logfiles (i.e. SEC Rule 203(b)(3)-2).

  2. Finally, sector rotation has left the portfolio. I repeat, sector rotation has left the portfolio. For a few months, the portfolio has had a duel between the Consumer Discretionary Select Sector SPDR ETF (NYSEARCA:XLY) and the Semiconductor HOLDRs (NYSEARCA:SMH). Both ETFs have had great returns, uncomfortably high standard deviations, and when combined with the other assets in the portfolio, reduced the overall volatility of the portfolio to about 3%. Looks like the sector rotation game is over. For now.

Over the past two weeks, the US Equity portfolio assets have shifted more members than the cast of Charlie Sheen's “Two and Half Men.” As the portfolio has gone from sector rotation mode, to wait-and-see mode, it always attempts to maintain low volatility while meeting a target return of 10%. It isn't influenced by the news machine headlines about increasing oil prices, volatility in the Middle East, the imminent government default doomsday, spiking precious metal prices. The reality check is that portfolios that want the lowest volatility over the last year, did have bonds, and lots of them; at least 60% no matter what Mr. Gross says. I say, Ignore the headlines and find your own tune. We want a portfolio that gives a smoother ride, and that's difficult enough since we're new to the tune, and headlines produce more noise than signal. Even if we already know the tune.

Please stay tuned.

Disclosure: I am long AGG, SLV, IAU, SH, EEM, VXX.