A Simple 5 ETF, 10% Return Portfolio That Minimizes the Mean Absolute Deviation

Includes: IYY, SDS, SHY, SLV, SMH
by: Jeff D. Hamann

Each week, we post the results of a backward looking portfolio of five funds using the Konno and Yamazaki Mean-Absolute Deviation Portfolio. We compute a basic set of statistics, determine which funds should have been included, and determine the allocations that would have generated a 10% return AND minimize the mean absolute deviation. The results can be written on the back of business card, sent to someone's hand-held device, or broadcast on twitter (which we do regularly). We assume the investor is at or near retirement and include common constraints like "don't include more than 10% in silver."

Given a universe of the following 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
U.S. Equities: OEF, IVV, ISI, IYY, JKD, JKG, JKJ
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
U.S. Equity Sectors: XLF, IYM, XLE, VNQ, XLI, XLY, SMH

The resulting 10% MAD portfolio allocation for the previous 252 trading days was:

Exchange Traded Fund Symbol Return Std Dev Weight
iShares Barclays 1-3 Year Treasury Bond Fund SHY 1.79% 1.18% 60.00%
iShares Silver Trust SLV 145.01% 32.40% 8.67%
iShares Dow Jones U.S. Total Market Index Fund IYY 18.25% 17.71% 18.19%
ProShares UltraShort S&P500 SDS -27.72% 34.92% 9.83%
HOLDRS Merrill Lynch Semiconductor SMH 28.50% 24.71% 3.31%

which yielded a 10% return, with a standard deviation of 3.04%.

Had we allocated our investable capital into the assets listed above 252 days ago, our performance would have looked something like this:

(Click to enlarge)

Here are the take home messages for today:

  1. The bond asset remains iShares Barclays 1-3 Year Treasury Bond ETF (NYSEARCA:SHY). The estimated annualized performance has decreased slightly from 1.84% last week to 1.79% this week and the estimated volatility, annualized, has decreased from 1.21% last week to 1.18% this week. The weight for this single bond asset has remained at the maximum allowed allocation of 60% for a several months and this allocation seem out of control for retired, near retired, or conservative return seekers. The other bond assets we're tracking (TIP, IEF, TLT, AGG) have also been relatively stable (i.e. low volatility) but have decreased annualized returns since last week.

  2. Whoa! The commodities asset remains iShares Silver Trust ETF (NYSEARCA:SLV). Considering the little-b-bubble that popped yesterday and today (any maybe tomorrow), it's a good thing we've maintained less than 10% of this commodity in the portfolio. Regardless, today's allocation has not changed from last week's 8% as the estimated annualized return continues to increase it's triple digit returns despite yesterday's -8% day and today's -5%. The other commodity ETFs we're tracking (IAU, GSG, DBC, and USO) have all been showing strengthening performance too, but none have entered into the 10% portfolio for several periods and they don't appear to do so anytime in the near future. Our portfolio picked up SLV some time back in October 2010 and has been going like gangbusters since. The streak was just a little long for the nay-sayer in me to think it was going to continue.

  3. A big change is in the US equity assets. The portfolio has switched out of IVV and OEF in favor of iShares Dow Jones U.S. Total Market Index Fund (NYSEARCA:IYY) and HOLDRS Merrill Lynch Semiconductor (NYSEARCA:SMH) Sector Rotation Asset. Since this is the first time we've seen this switch (we only run this portfolio once a week), a wait and see approach might be more appropriate until stronger signals are present. As we enter the "Sell in May and go away" season, this could signal a trend to the larger cap assets (OEF, IVV, and JKD) and we may see the return of a global/emerging equity in the Fall. The entrance of SMH into the portfolio signals both a new allocation to sector rotation which has been putting on a very nice mean annualized return of 28%. Regardless, U.S. equity allocation remains about 20%, which doesn't sound irrational for a conservative retirement portfolio.

  4. The short/leveraged hedge position remains ProShares UltraShort S&P500 (NYSEARCA:SDS) and has stayed at the maximum allocation of 10% for a few months. The estimated annualized return has decreased from last week's -24% to -27% this week. While normally a declining return in any asset would cause heartburn, this asset provides a signal suggesting the underlying inverse asset (S&P500) is increasing, which the S&P500 indexes we're tracking are in fact, increasing. Like last time, when this asset declined by 3%, the inverse assets ("the market") increased by 3%. Regardless, this might be a good time to consider looking further into strategies to protect yourself against downward movements and create a smoother ride for your portfolio if you haven't already done so.

Comparing these results to the S&P500 as our benchmark, which for the previous 252 trading days, has returned about 15% with a standard deviation of 17%, respectively, and I think this portfolio has performed well given our desire obtain a 10% return AND minimize volatility. Like always, these results simply provide a reality-check against poorly allocated portfolios, and are not intended to predict asset prices or market movements in the future.

Disclosure: I am long TIP, AGG, SLV, IAU, XLE, VXX.

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