When thinking about how I wanted to construct this portfolio I had a short qualifications list for each fund I picked as well as goals for the overall portfolio. The qualifications for picking my funds are as follows:
- The ETF should have at least 100 million in AUM.
- The ETF must be in existence for at least one year.
- The ETF must not be a leveraged ETF.
- The ETF must not track the same or similar index as another ETF in the portfolio.
- The bond fund ETFs chosen cannot be total bond market funds.
The goals that I wanted this portfolio to achieve are:
My main goal is to construct the portfolio with as near to zero correlation to the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) as possible.
- Have all five funds at an equal weight of the portfolio.
- Include one equity fund that is not a large cap fund.
- Include three bond funds.
- Include one precious metals or commodities fund.
Keeping to my main goal in mind I found a chart from ETFscreen.com that shows a large list of ETF correlations to the SPY. My selection process for each fund is as follows:
- Equity Fund: When looking for an equity fund to include in the portfolio I started at the top of the correlation chart where correlations to the SPY are 1.0, and worked my way down until I spotted the S&P MidCap 400 SPDRs (NYSEARCA:MDY), and I included it in my portfolio because it fit my qualifications and the goal of an equity fund that was not a large cap fund.
- Bond Fund No. 1: Since I picked an equity fund that has a high correlation to the SPY, I needed to pick a bond fund with a low correlation to the SPY. Scrolling to the bottom of the correlation chart, I found the Vanguard Extended Duration Treasury ETF (NYSEARCA:EDV) which was the lowest correlated bond fund.
- Precious Metals/Commodity Fund: Since I had picked one fund with high and another fund with low correlation to the SPY, I thought it would be a good idea to pick a fund with a correlation near 0. So I went to the correlation chart and went to zero, and found the PowerShares DB Precious Metals (NYSEARCA:DBP) as being the closest to zero correlation Precious metals or commodities ETF.
- Bond Fund No. 2: For this choice I wanted a bond fund that was not a U.S. Treasury Bond ETF, so that left my choices to corporate bonds, municipal bonds, foreign bonds or convertible bonds. So I started on the correlation chart near -1.0 and scrolled through until I found the lowest correlated bond ETF out of the remaining bond categories, and found the Vanguard Long-Term Corp Bond ETF (NASDAQ:VCLT).
- Bond Fund No. 3: For the final fund in the portfolio I wanted the fund to have a shorter duration than EDV or VCLT. So I started looking through the correlation chart for bond funds with the lowest negative correlations that were not a long term treasury or corporate bond fund and found that the iShares Barclays 7-10 Year Treasury Bond Fund (NYSEARCA:IEF).
Below are two tables, the first showing each fund and weight of the portfolio, and the second showing the correlations of each fund to the SPY and other funds in the portfolio to each other.
Portfolio Description and Weight
Symbol | Description | Weight |
MDY | S&P MidCap 400 SPDRs | 20% |
EDV | Vanguard Extended Duration Tsy (25+yr) | 20% |
DBP | PowerShares DB Precious Metals | 20% |
VCLT | Vanguard Long-Term Corp Bond (12+yr) | 20% |
IEF | iShares Barclays 7-10 Yr Treasury (7-8yr) | 20% |
Correlations
DBP | EDV | IEF | MDY | SPY | VCLT | |
DBP | 1 | |||||
EDV | 0.1 | 1 | ||||
IEF | 0.11 | 0.89 | 1 | |||
MDY | 0.02 | -0.71 | -0.66 | 1 | ||
SPY | 0.01 | -0.75 | -0.72 | 0.98 | 1 | |
VCLT | 0.14 | 0.81 | 0.76 | -0.41 | -0.44 | 1 |
Portfolio vs. SPY
To see what the portfolio correlation is and to backtest the portfolio against the SPY and the iShares Barclays Agg Bond (NYSEARCA:AGG) I used the ETF portfolio backtest tool on etfreplay.com. I entered each of the five funds into the tool, and weighted them all equally at 20%, and set the date to the first date that all five ETFs were available for trading, which was Nov. 23, 2009. Below are the statistics and charts of that backtest of the portfolio against the SPY and the AGG.
The first chart shows the return of the portfolio of ETFs against the SPY, and I noticed the portfolio outperformed when the SPY was moving lower and underperformed when the SPY was moving higher. This makes sense because 60% of the portfolio is made up of bond funds which tend to outperform when stocks are weak and underperform when stocks are strong. The portfolio easily beat the SPY in total return with 33.3% vs. 14.7% from the SPY over the same period. The portfolio accomplished that with a little over half as much volatility as the SPY had.
Under the summary statistics section I focused on two CAGR (Compound Annual Growth Rate), and Correlation. First the CAGR of the portfolio beat the SPY with 15% over the time of the backtest compared to 6.9% for the SPY. The correlation of the portfolio to the SPY was 0.00 for the time period, which met my main goal for the portfolio of having as near to zero correlation as possible. A note about correlation is that correlations can change over time and the portfolio correlation now is zero, but in the future it could become more or less correlated with the SPY.
Below are all the charts and statistics as described above for the portfolio compared to the SPY.
Total Returns (including all dividends): Nov 23, 2009 - Dec 15, 2011
Total Return
Volatility
Summary Statistics | |||||
CAGR | Sharpe Ratio | SPY Correlation | Max Draw vs Start | Max Drawdown | |
Portfolio | 15.00% | 1.46 | 0.00 | -3.88% | -5.16% |
SPY | 6.90% | 0.35 | 1.00 | -6.45% | -18.61% |
Portfolio vs. AGG
The following set of charts and date shows the return of the portfolio of ETFs against the AGG. I looked at the chart and noticed the portfolio outperformed the AGG almost the entire period of the chart. This makes sense because 40% of the portfolio is made up of a stock ETF and precious metals ETF which tend to outperform bonds when the stock market is rising which has occurred over the time period in the chart. The portfolio easily beat the AGG in total return with 33.3% vs. 12.5% from the AGG over the same period. The portfolio accomplished that but at almost two and a half times the volatility as the AGG.
I expected that the volatility would be higher than the AGG because my portfolio held 20% in a stock ETF and 20% in precious metals ETF. Under the summary statistics section I focused on CAGR (Compound Annual Growth Rate) and Correlation. First the CAGR of the portfolio beat the AGG with 15% over the time of the backtest compared to 5.9% for the AGG. The correlation of the portfolio to the AGG was 0.63 for the time period, which is lower than I thought it would be for having 60% of the portfolio in bond funds.
Below are all the charts and statistics as described above for the portfolio compared to the AGG.
Total Returns (including all dividends): Nov 23, 2009 - Dec 15, 2011
Total Return
Volatility
Summary Statistics | |||||
CAGR | Sharpe Ratio | AGG Correlation | Max Draw vs Start | Max Drawdown | |
Portfolio | 15.00% | 1.46 | 0.63 | -3.88% | -5.16% |
AGG | 5.90% | 1.36 | 1.00 | -1.49% | -3.52% |
AGG | DBP | EDV | IEF | MDY | VCLT | |
AGG | 1 | |||||
DBP | 0.22 | 1 | ||||
EDV | 0.8 | 0.1 | 1 | |||
IEF | 0.87 | 0.11 | 0.89 | 1 | ||
MDY | -0.46 | 0.02 | -0.71 | -0.66 | 1 | |
VCLT | 0.79 | 0.14 | 0.81 | 0.76 | -0.41 | 1 |
Closing Thoughts
This portfolio strategy worked well over the last two years, easily outperforming both the SPY and the AGG. I believe that was true because of the portfolioâ€™s allocation, by having three different asset classes and within the bond funds I chose, having included different kinds of bonds: Corporate and treasuries as well as each fund having a different duration of the bonds each fund holds, I think made a big difference.
Also, including the precious metals fund which holds roughly 80% gold futures and 20% silver futures made a big difference because of steady climb in gold over the last two years, and the silver super spike that occurred from February 2011 until the end of April 2011. Having included the mid-cap stocks instead of large cap stocks also benefitted the portfolio because mid-cap stocks tend to outperform large-cap stocks off a stock market bottom, which had occurred in March of 2009. Overall at the end of the process I was happy with the funds I chosen, the portfolio outperforming both the SPY and AGG and also meeting my main goal that I set out for of having a portfolio correlation near zero.
Disclaimers:
The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.
The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications or other transactions costs, which may significantly affect the economic consequences of a given strategy.
This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.