Our Retirement ETF Model Portfolio

by: My ETF Hedge Fund

ETF portfolios, and particularly retirement portfolios, are too often seen, described or imagined as static portfolios. Thou shall allocate your assets (wisely if possible), forget about it and just cash your interest/dividend checks.

We make the case that managing your portfolio more actively can actually reduce your risk while significantly boosting your returns. As your life expectancy goes shorter, a bear market could have devastating consequences on your portfolio. All the more so as a bear market can occur in any asset class, including in several segments of the bond market that experienced a multi-decade run up.

Global tactical asset allocation strategies based on relative strength can be extremely powerful and comprehensive strategies when correctly implemented. We already highlighted how this can be done here and here. The idea here is to take the concept further by adapting it to the needs of retirees or soon-to-be retirees. The strategy is therefore designed in a way that aims to minimize risk, volatility, drawdowns and the number of trades to adjust the portfolio. To do so:

  • At least 75% of the portfolio is always invested in cash, bonds and dividend-yielding equities. This is required to have a significant part of the total return coming from income streams. Therefore the main universes used for ranking ETFs are mostly ETFs representing such asset classes. It is also important to have in your universe ETFs that can perform well in any kind of macroeconomic situation (inflation, deflation, stagflation, depression...)
  • The situation is reassessed at the end of every month. On average, it leads to only 1.4 buy/sell per month. In current markets, diversification is not enough to protect your capital if you only rebalance once a year. And flexibility is needed to adapt to market developments (note: for instance, the strategy allocated 75% to cash in October and November 2008, and 90% in February 2009)

Since end-December 2005, our retirement ETF portfolio has experienced a very limited volatility (7.3%) and very small maximum monthly drawdowns (-4.1%). This as achieved with an average return of 15% per year. When deciding whether to implement a strategy, one should always check several risk metrics that go beyond the mere measure of the volatility of returns. For instance, the Ulcer Index (a measure of the depth and duration of drawdowns) or the Sortino ratio (which only takes into account downside volatility) are better gauges of the risks of various investments. Let's choose a very conservative benchmark portfolio to highlight this crucial point. The benchmark is 75% aggregate bond market (NYSEARCA:AGG) and 25% SPY (U.S. Equities).

Note from the table below that a simple comparison of volatility could make you believe that the benchmark is a safer, less risky investment. However, the extent and the length of its drawdowns and the magnitude of its downside volatility proves the contrary:

Strategy Return Volatility Ulcer Index Max Drawdown Worst 12-m Sharpe ratio Sortino Ratio
Retirement Portfolio +15.1% 7.3% 3.95% -4.1% +6.4% 1.53 1.33
Benchmark +5.3% 5.8% 31.80% -12.3% -11.1% 0.27 0.36

Notes: Data as of October 31, 2011. Calculations based on monthly returns. Risk free returns proxied as the return of SHY. Sortino ratio calculated with downside deviation from a monthly return of 0.25% (return needed to preserve purchase power of your capital if inflation is at a 3% annual rate)

For December 2011, the allocation of the retirement portfolio is:

(Click to enlarge)

The 45% equity share is equally split between 3 relatively high-yielding ETFs: XLU (U.S. Utilities), XLP (U.S. Consumer Staples) and SDY (U.S. Dividend Aristocrats).

The 30% bond share is equally split between IEF (Medium-term U.S. Treasuries) and TLT (Long-term U.S. Treasuries). The 15% cash share is represented by SHY.

Finally, the portfolio currently holds 15% in GLD (gold).

Next update on January 1st, 2012 !

Disclosure: I am long XLU, XLP, GLD, IEF.

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