Our Conservative ETF Model Portfolio

by: My ETF Hedge Fund

The is the first article of a series which will try to underscore how the use of ETFs in the framework of a sound investing strategy can deliver outstanding and consistent returns with very limited risk. We feature several portfolios with varying degrees of risk. This article will use the conservative model portfolio to highlight our point.

Beyond the fact that they trade like stocks, ETFs now allow any investor to easily take granular exposure to virtually any asset class in the world, be it stocks, bonds, currencies, commodities, either on the long or the short side. Such flexibility makes it possible to implement dynamic strategies at low cost, even for smaller portfolios.

The strategy detailed here is based on three broad investing themes:

1. There is momentum everywhere, not only within one asset class, but across asset classes and countries. This feature of global capital markets have been clearly identified in academic literature. Investors can benefit from this powerful market force by determining a consistent universe of asset classes and adequately rank them to base trading decisions.

2. Such momentum can be taken advantage of by regularly updating a portfolio’s tactical asset allocation in order to benefit from trends as they develop. Provided these trends are long enough, a well crafted relative strength system allows riding them. The flip side is that unless strong trends are developing somewhere in the world, such system will rarely “catch the top”. Nevertheless, monthly rebalancing has proved to be an effective way to considerably limit both drawdowns and trading frequency (and therefore fees and time).

3. Relative strength needs to be complemented by fundamental (value) analysis, technical analysis and risk-management rules to offer a comprehensive strategy. At the end of every month, we take into account all these considerations to determine the portfolio that will be held for the next month.

Our Conservative model portfolio is constructed in a way that it remains at any point in time invested at least for 50% in bonds and cash (mix of SHY for cash, TLT for long-term treasuries and AGG for the aggregate bond market). The other 50% are split in equal 5 positions in the Top 5 ETFs ranked best by our system among the 20+ ETFs in our universe. Depending on market conditions, the share of fixed-income assets and cash therefore varies between 50 and 100%. The portfolio is never leveraged. At some point, it may hold a long position in an inverse non leveraged ETF such as SH for no more than 10% of the total portfolio.

The backtested results are outstanding. For illustrative purposes, although the objective is to achieve absolute return in any market environment, we compare the performance of this conservative model portfolio to a benchmark portfolio divided in 50% SPY and 50% Intermediate Term US Treasury Bonds (NYSEARCA:IEF). The chart below highlights the equity curve of the two portfolios between 2003 and 2010.

click to enlarge

Click to enlarge

The visual impression of consistency and low drawdown, including during the stock market crash of 2008-2009 is confirmed by the data. The table below gives the Compounded Annual Growth Rate (CAGR), the overall annualized daily volatility and the maximum drawdown over the entire period. The latter, which is particularly relevant when one tries to assess risk and the ability of an investor to withstand losses, is maybe the best selling argument for this portfolio. Also note the relatively low correlation of the portfolio's behavior compared to the S&P500.

For the month of June 2011, the model portfolio asset allocation is the following:

§ 60% in fixed-income: 25% in Cash (NYSEARCA:SHY), 25% in Long-Term Tresuries (NYSEARCA:TLT), 10% in AGG

§ 20% in equity/quasi-equity: 10% in preferred shares (NYSEARCA:PFF) and 10% in Chinese equity (NYSEARCA:FXI)


§ 10% in Commodities: 10% in Gold (NYSEARCA:GLD)

In future articles, we will take time to detail operational issues arising when implementing such strategies. We will also analyze the historic and future performance of this portfolio, and provide some insights on a more aggressive model portfolio.

Disclosure: I am long TLT, VNQ, GLD.

Additional disclosure: We are long the above ETFs through our more aggressive model portfolio.