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varan
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  • The Basic Portfolio 15 comments
    Apr 5, 2013 2:38 PM | about stocks: IJJ, IJS, EFA, EEM, IYR, CEF, TLT, IEF, EMB, MBB, LQD, AGG

    This is a follow up to an earlier post. I have changed the basket a bit to minimize the number of ETFs that cannot be traded without commission at Fidelity. The performance of this basket is slightly better.

    The strategy is derived from a synthesis of various ideas: relative strength and persistence of momentum, polygamous paired switching, and averaging over multiple time scales. The last one is just the antithesis of any strategy that optimizes with respect to the holding and evaluation periods. My view is that any such optimization would lead to a method that works very well in back testing but is quite fragile/brittle for the future. Averaging over multiple pairs of holding and evaluation periods provides the possibility of robustness with respect to future market movements whose time scales are generally unpredictable.

    Although this strategy can be easily implemented without too many complex calculations, it seems to provide a very attractive method to adaptively change not only the weights of various components of the basket but also the number of ETFs that are invested in at any given time.

    This quarterly rebalancing strategy works well to minimize portfolio volatility without any significant deleterious effect on the returns.

    1. The basket consists of two parts (a) a set of assets nominally correlated with the market, typically equity ETFs and (b) a set of assets which have low or negative correlation with the market, typically fixed income ETFs. The number of fixed income assets should be as many or preferably more than the number of equity assets.
    2. The rebalancing schedule consists of three tranches:

    (a)at the beginning of every quarter choose a set of assets that performed the best during the immediately preceding month,

    (b) at the beginning of every half-year choose a set of assets that performed the best during the immediately preceding month, and

    (c) at the beginning of every year choose a set of assets that performed the best during the immediately preceding quarter.

    Obviously the assets from the three tranches can be commingled at the beginning of each quarter to be equally divided in the three tranches. Further the number of selected assets should be close to the number of equity ETFs in the basket (as in 1(a)).

    Note that each of the three tranches specifies a set of weights for each of the components of the basket, with the weights for the first one changing every quarter, for the second one every six-months and for the third one only once a year. At the beginning of each quarter, these three sets of weights are averaged to construct the portfolio.

    The basket consists of the following:

    IJJ IJS EFA EEM IYR CEF AGG LQD TLT IEF EMB MBB

    Apart from EFA, EEM, CEF, all these ETFs can be traded commission free at Fidelity. Commission free versions of EFA and EEM are available, but not much historical data exist for those ones, and so we have used EFA and EEM for back testing.

    At each update for each tranch, five assets were chosen. However, since three different set of weights are averaged, the actual number of ETFs in the portfolio at any given time may range from five to fifteen. The following figure shows the number of ETFs that were in the portfolio during 2003-2013.

    (click to enlarge)

    Here are the detailed results for 2003:2013

    CAGR 14.6%

    Sharpe Ratio .99

    Kelly Fraction .42

    Maximum Monthly Drawdown 13.7%

    Monthly One Factor Alpha .70%

    Monthly One Factor Beta .48

    Monthly One Factor R^2 .42

    The equity curve, the Manhattan asset allocation diagram and the basic asset allocation diagram are shown below.

    (click to enlarge)

    (click to enlarge)

    (click to enlarge)

    Disclosure: I am long IJS, LQD, CEF, AGG.

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Comments (15)
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  • MrBobDobalina
    , contributor
    Comments (69) | Send Message
     
    Great update, Varan!

     

    One question - 15 ETF's is quite a few, depending on your account size. Did you test this choosing 4 or even 2 or 3 for each time frame? Just curious if that make a big difference on CAGR and max drawdown. Thansk!
    5 Apr 2013, 05:51 PM Reply Like
  • varan
    , contributor
    Comments (3888) | Send Message
     
    Author’s reply » This is the general idea. The method is almost universal if you follow the guidelines.

     

    For example you can remove all but two of the non-fixed income ETFs in the basket from IJJ, IJS, EEM, EFA, IYR and CEF, retain all the other (fixed-income ) ETFs in the basket and select two instead of five as described above, and you will get similar results.

     

    It works well with mutual funds as well.
    6 Apr 2013, 02:36 PM Reply Like
  • Lowell Herr
    , contributor
    Comments (988) | Send Message
     
    Varan,

     

    Have you been using this model since 2003 or are these back-tested results?

     

    I'm just in the beginning stages of implementing a momentum/volatility model. The time period I am using for momentum is longer than what you recommend.

     

    Thanks for the notification of the update. Keep me in the loop.

     

    Lowell
    6 Apr 2013, 03:02 PM Reply Like
  • varan
    , contributor
    Comments (3888) | Send Message
     
    Author’s reply » These are back testing results. Thanks.
    7 Apr 2013, 10:49 AM Reply Like
  • Lowell Herr
    , contributor
    Comments (988) | Send Message
     
    Varan,

     

    A similar set of ETFs available commission free from TD Ameritrade are: VOE, VBR, VEU, VWO, VNQ, DBC, BND, LQD, TLT, IEF (not free), PCY, and BIV. I would also add VTI to cover the entire U.S. Equities market.

     

    Lowell
    6 Apr 2013, 03:19 PM Reply Like
  • Lowell Herr
    , contributor
    Comments (988) | Send Message
     
    Varan,

     

    I noted this statement in your article.

     

    "The number of fixed income assets should be as many or preferably more than the number of equity assets."

     

    Is the reason for including fixed income securities to lower portfolio volatility?

     

    Lowell
    7 Apr 2013, 07:38 AM Reply Like
  • varan
    , contributor
    Comments (3888) | Send Message
     
    Author’s reply » That and the fact that (a) you are selecting as many ETFs as there are equity ETFs, and, therefore, (b) during times like 2008 you want to have very strict criteria to hold an equity ETF: if you can find a fixed income asset that presumably will do better than the equity ETF, you invest in the former.
    7 Apr 2013, 10:52 AM Reply Like
  • varan
    , contributor
    Comments (3888) | Send Message
     
    Author’s reply » YTD 6.88%

     

    This year almost all 'defensive' strategies have been hampered by fixed income assets travel to the dump. But the year is not over yer.
    21 Jul 2013, 09:53 PM Reply Like
  • drftr
    , contributor
    Comments (128) | Send Message
     
    Varan & Lowell,

     

    After a lot of studying over the last 1.5 year or so I still can't make up my mind about the construction of my portfolio. I'm very attracted to both the simplicity and the 40 year average results of Harry Browne's Permanent Portfolio but a well diversified dividend growth portfolio is very tempting as well. Since I'm almost permanently travelling developing countries internet access is often hard to find and that makes trading or even paying attention troublesome. For that reason I'm trying to find a "best of both worlds" kind of combination that produces enough income to travel and at the same time limiting downside risk. Since I'm only 45 a big risk is that I have to take too much to make the portfolio everlasting. An annual 5% withdrawal would work if the results make up for inflation. An average annual result of 10% is what I consider safe until the very day I die. One of the options that comes close to this kind of result (but not close enough) is a 33.3% total market equities / 33.3% long term bond ladder / 33.3% gold allocation. Remembering your comments about trading ETFs when they're trending (200 day MA?) I wonder if you could share any insights on the following questions. Any help would be highly appreciated!

     

    1) Do you think a portfolio consisting out of 3 holdings would benefit from trading according to your "rules" instead of a buy / hold / rebalance approach?

     

    2) Can something like this be done if I hold a 30 year US treasury bond ladder for let's say a 5-6-7-8-9% yield (if this will happen at all - if not I will hold that part in cash)? I guess TLT wouldn't necessarily work as then I can't hold the bonds to maturity if I have to because of market conditions or trade them after let's say 20 years if they trade at a high premium.

     

    3) For the equity part I could use dividend growth stocks to grow the dividends "forever" but that makes trading difficult. Would VTI or VIG or so do?

     

    4) Are there any tools available that I can use to check the performance of a 200 day (?) moving average with these or similar holdings, preferably going all the way back to the early 70s?

     

    5) I'm always tempted to add more than may be essential like some ETFs for silver, oil, aggriculture (corn / soybeans / coffee), the cheapest (according to CAPE) emerging & frontier markets, some emerging market real estate and volatility like SVXY, just to trade to hopefully get better results. Don't know if the same kind of trends would work, if it can be done fully automated and if the costs are not too high though.

     

    6) Any other suggestions, warnings, et cetera?

     

    Thanks so much for reading and, if you both have the time, responding!

     

    drftr
    26 Apr, 02:35 AM Reply Like
  • Lowell Herr
    , contributor
    Comments (988) | Send Message
     
    Drftr,

     

    Looks like I got to this message first, so let me take a quick crack. 1) Gold would not be one of my big three investments. 2) Would you consider William J. Bernstein's recommendation of these three areas for investing? They are: U.S. Total Equities or 34% in VTI, 33% in VEU or Total International Markets including some Emerging Markets, and 33% in BND to cover the Total Bond Market. Then rebalance approximately once a year.

     

    I am setting up some portfolios that expand on these three ETFs to include International Bonds, Domestic REITs and International REIT.

     

    Lowell
    26 Apr, 06:39 AM Reply Like
  • drftr
    , contributor
    Comments (128) | Send Message
     
    Thanks Lowell!

     

    I'm afraid REITs and international equities are too much correlated with US equities when there's a market crash. I would want to try to make my pool of ETFs as small as possible, only use non- or negatively correlated assets, only be invested in the top 1 or 2 performers and only if they're above their 200 day MA. Or something similar.

     

    Yesterday I downloaded 50 or so articles that I've read before to see if I can come with a decent strategy and of course your and Varan's work show up prominently. In all studies about adaptive allocation, minimum correlation, risk parity, minimum variance, maximum diversification, et cetera results seems to be very good in neutral or negative market trends as downside risks are nicely limited. But they all seem to lag in bull markets. So maybe for all non-correlated assets you should always choose the more aggressive ones? So not total-market but small-caps instead to really benefit of the run up. Harry Browne found something similar if I remember well. You have to find the best performer once the sector/asset is trending. Or maybe use a levered product for that trending time. What could also offset underperforming VTI or so is a negative volatility ETF. Just thinking out loud now.

     

    So for me gold would defenitely be on my shortlist. It would just not be bought very often I assume. But if the trend is there, why not? And then check every month/quarter/year (no clue...) if the trend is still there or that I have to change my runners.

     

    Any other ideas?

     

    Thanks again!

     

    drftr
    26 Apr, 11:34 PM Reply Like
  • Lowell Herr
    , contributor
    Comments (988) | Send Message
     
    Drftr,

     

    What you are suggesting is right along the lines of what goes by the name Cluster Weighting Momentum on my blog. There are several ways to go about this, but one can begin with about 40 ETFs (more if one is willing to run multiple filters) and then run something called a cluster analysis were the ETFs are grouped into as many as ten cluster based on correlations. Then the top performers with low correlation are extracted from the list and those four to ten ETFs become the portfolio until the next review.

     

    Bear markets are avoided by investing only in an ETF so long as it is outperforming SHY.

     

    Lowell
    27 Apr, 08:25 AM Reply Like
  • Lowell Herr
    , contributor
    Comments (988) | Send Message
     
    "In all studies about adaptive allocation, minimum correlation, risk parity, minimum variance, maximum diversification, et cetera results seems to be very good in neutral or negative market trends as downside risks are nicely limited. But they all seem to lag in bull markets. So maybe for all non-correlated assets you should always choose the more aggressive ones?"

     

    If one selects low correlated ETFs, that act alone will cause a portfolio to lag a U.S. Equities bull market. The idea is prepare for the next big bear market.

     

    Lowell
    27 Apr, 11:04 AM Reply Like
  • drftr
    , contributor
    Comments (128) | Send Message
     
    Found it - Tnx!

     

    drftr
    27 Apr, 08:41 AM Reply Like
  • Lowell Herr
    , contributor
    Comments (988) | Send Message
     
    If you search for Cluster you will find lots of titles with that word. Not all are free blogs as you likely found out.

     

    Lowell
    27 Apr, 09:04 AM Reply Like
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