Reducing Portfolio Risk Using A Modified 'Ivy Portfolio' Model

by: Lowell Herr

While most investors concentrate on portfolio return, 2002 and 2008 taught us to pay closer attention to portfolio risk. Based on a blog entry tracking system, there is significant interest in a risk reduction model that is patterned after a system I used in the early 1980s. The system explained below is similar to the model described in Chapter 7 of Mebane T. Faber and Eric W. Richardson's book, The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets. Avoiding bear markets is the thesis of this risk reduction model.

The rules are mechanical and simple. Whereas Faber and Richardson use a 10-month Simple Moving Average (SMA), I use a 195-Day Exponential Moving Average (EMA) as it is a little faster acting. The 10-month SMA is similar to the very popular 200-Day EMA. By sliding five days forward, there is an increased probability of moving in or out of an ETF before the crowd makes their move. There is nothing sacred about either moving average as both are designed to protect the money manager from deep bear markets.

The simple rules are as follows.

1. Buy Rule: Buy when the ETF price moves from below to above its 195-Day EMA.
2. Sell Rule: Sell when the ETF price moves from above to below its 195-Day EMA and go to cash. Cash is defined as money market or the TIP ETF.
3. Use commission free ETFs to reduce transaction costs.
4. After a trade, wait 31 days to avoid short-term trading fees, wash sale rule, and whiplash trading issues.
5. Examine each portfolio once a month. After examination, put the portfolio into "neglect mode" for one month.

The sell rule mentioned above moved me out of the market just before the October 1987 market crash.

The ITA Risk Reduction Model is undergoing testing with five portfolio on the ITA Wealth Management blog. Faber and Richardson examine their portfolio at the end of the month. Since I am experimenting with five different portfolios, the examination dates are spread throughout the month.

The five portfolios are all lagging the VTSMX benchmark. The risk reduction test is to see if the gap between the Internal Rate of Return (IRR) of the portfolio and their respective VTSMX IRR can be closed by using this risk reduction model.

It took reading The Ivy Portfolio to remind me of how well this system worked in the 1980s. At that time investors did not have access to commission free ETFs, nor were on-line tracking tools such as StockCharts available. It is now much easier to apply these simple risk reduction rules to a portfolio.

The primary ETFs used in the test portfolios are: VTI, IWN, VEU, VWO, VNQ, RWX, and DBC. The first two cover the U.S. Equities market and the remainder provides REITs, Commodities and International Markets exposure.

The following screen shot is an example look at VTI after the market closed on 27 January 2012. Note the current price is well above its 195-Day EMA and that is why I am fully invested in VTI.

Each of the five portfolios have their own asset allocation Dashboard. An example for the Gauss Portfolio is displayed below. After rebalancing last week all asset classes are within the threshold percentage. This portfolio now goes into "neglect mode" for another month.

click to enlarge

The TLH Spreadsheet is an integral tool in monitoring the various asset classes. Not pictured in this article is a data table that tells the user exactly how many shares an asset class is above or below target.

The TLH Spreadsheet is available free of charge to interested investors. In the right sidebar, under Blogroll, is a link titled, TLH Sample Spreadsheet. Click on the link to download. If you have problems opening or updating the portfolio it may be related to the version of Excel. I am using a current macro-enabled version. The spreadsheets involved in this experiment are the following: Maxwell, Euclid, Madison, Kenilworth, and Gauss. Check them out if interested.

Disclosure: I am long VTI, VEU, VWO, VNQ, RWX, TIP, IWN, DBC.