Adaptive Allocation Of Income ETFs May Generate High Returns At Low Risk

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Includes: IDV, IYR, JNK, SHY, TLT
by: Toma Hentea

Summary

Adaptive asset allocation strategy applied to a portfolio of five income ETFs may deliver stock market competitive returns.

By adjusting the target volatility of the optimization algorithms, one can accommodate any investor risk profile.

This study was performed assuming reallocation of the funds at monthly intervals.

In our article we demonstrate that high yielding income funds are suitable for building portfolios that can deliver high returns with low risk.

The following ETFs are used for building the portfolio:

  • SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK)
  • iShares U.S. Real Estate ETF (NYSEARCA:IYR)
  • iShares International Select Dividend ETF (BATS:IDV)
  • iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT)
  • iShares 1-3 Year Treasury Bond ETF (NYSEARCA:SHY)

For simplicity, only two different strategies will be presented:

(1) Fixed Allocation - Portfolio is initially invested 20% in each fund without rebalancing.

(2) Adaptive Allocation -Portfolio is invested dynamically among the five funds based on a variance-return optimization algorithm developed on the Modern Portfolio Theory (Markowitz). The allocation is rebalanced at fixed one month intervals.

Basic information about the funds was extracted from Yahoo Finance and is shown in table 1.

Table 1

Symbol

Inception Date

Net Assets

Yield%

Category

JNK

11/28/2007

11.39B

5.77

Corporate Bonds

IYR

6/12/2000

4.57B

3.59

REITs

IDV

6/11/2007

4.46B

5.06

Foreign Large Value

TLT

7/22/2002

5.01B

1.59

LONG Term Treasury

SHY

7/22/2002

9.17B

0.42

SHORT Term Treasury

Regarding the composition of the portfolio, JNK, IDV and IYR are high yielding funds of relatively low quality, meaning that they may suffer large losses during market downturns or financial crises. The other two, TLT and SHY, are of high quality and as such, they are very resilient and may even gain during market distress.

The results reported in this article cover a period of over seven years between March 1, 2008 and May 31, 2015. The starting day was selected based on availability of historical data of the funds by adding a period of 65 trading days for initial estimation of the parameters used for optimization.

In table 2 we show the buy-and-hold results of investing in each fund.

Table 2.

Symbol

TReturn%

CAGR %

maxDD%

VOL%

Sharpe

Sortino

JNK

64.34

7.12

-38.13

15.2

0.47

0.49

IYR

73.9

7.96

-67.47

38.39

0.21

0.24

IDV

20.96

2.67

-65.14

27.41

0.1

0.12

TLT

69.86

7.61

-26.59

16.06

0.47

0.74

SHY

9.53

1.27

-2.23

1.41

0.9

1.07

SPY

81.53

8.61

-51.48

22.6

0.38

0.46

As can be seen in table 2, none of the income funds outperforms, from the total return standpoint, the equity market as represented by SPY. SHY, TLT and JNK do have higher Sharpe ratios, meaning higher risk-adjusted returns. IYR and IDV have extremely low Sharpe ratios, and so, they were not suitable as buy-and-hold investments. Also, their maximum drawdowns are extremely high, losing about two thirds of their value at their worst.

In table 3 we show the simulation results for the portfolios from March 1, 2008 to June 1, 2015. We applied four strategies:

  1. Fixed equal weight allocation
  2. Adaptive allocation for a LOW volatility target
  3. Adaptive allocation for a MEDIUM volatility target
  4. Adaptive allocation for a HIGH volatility target

Table 3.

 

TotRet%

CAGR%

NO.trad

maxDD%

VOL%

Sharpe

Sortino

Fixed allocation

47.72

5.55

0

-31.85

10.40

0.53

0.68

Adapt. allocation LOW

116.11

11.26

86

-12.72

8.56

1.32

1.78

Adapt. allocation MED

215.74

17.26

86

-15.71

14.20

1.21

1.69

Adapt. allocation HIGH

310.98

21.62

86

-22.36

19.50

1.11

1.52

As can be seen in table 3, the adaptive allocation with a low volatility target realizes the highest risk adjusted returns, i.e. the highest Sharpe ratio. Getting an average annual compounded return of 11.26% with a maximum daily drawdown of -12.72% and an annualized volatility of 8.56% is much superior to those obtained by the fixed allocation strategy.

Also, the investors willing to take on high risk, could achieve an exceptional compounded return of 21.62% vs. 8.61% of the equity market, or 5.55% of the equal weight strategy.

In figure 1 we show the graphs of the portfolio equities.

Figure 1. Equity curves for the portfolio with adaptive allocation and the portfolio with fixed allocation without rebalancing.

Source: This chart is based on calculations using the adjusted daily closing share prices from finance.yahoo.com.

In figure 2 we show the time variation of the adaptive allocation with a low volatility target. As can be seen, the strategy allocated most of the funds to the short term treasury fund SHY during the 2008-09 financial crises.

Source: This chart is based on calculations using the adjusted daily closing share prices from finance.yahoo.com.

Figure 2. Portfolio allocation for a low volatility target.

Source: This chart is based on calculations using the adjusted daily closing share prices from finance.yahoo.com.

In figure 3 we show the time variation of the adaptive allocation with a high volatility target. As can be seen, the strategy allocated most of the funds to the long term treasury fund TLT during the 2008-09 financial crises.

Figure 3. Portfolio allocation for a high volatility target.

Source: This chart is based on calculations using the adjusted daily closing share prices from finance.yahoo.com.

Conclusion

The adaptive allocation strategy is very flexible and allows the investor to adjust the level of risk with the market circumstances. It performs well at any volatility target. In fact, it turns out that its risk-adjusted return as represented by the Sharpe ratio, varies very little with the volatility target. In general, one can achieve slightly higher Sharpe ratios at lower volatility targets. That comes, though, at the expense of lower returns.

Regarding the current fear of investors due to expectations of rising interest rates, the portfolio proposed in this article is expected to handle well this adversity by switching the funds mostly to short term treasuries and corporate bonds.

Disclosure: The author is long TLT, SHY.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The article was written for educational purposes and should not be considered as specific investment advice.