Retirement Investing With A Simple ETF Portfolio

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Includes: MDY, QQQ, SHY, TLT
by: Toma Hentea

Summary

An equally weighted portfolio with two equity ETFs and two bond ETFs could support a 7% annual withdrawal rate from 7/2003 to 7/2015 without any decrease in equity.

Over the same period, the portfolio with a mean-variance optimization algorithm for a low volatility target could support 9% annual withdrawal rate.

The portfolio with a mean-variance optimization algorithm for a HIGH volatility target could support 11% annual withdrawal rate.

In this article we use some of the most liquid ETFs to build a very simple portfolio for a retirement investing account. As a benchmark we analyze the performance of the portfolio with equal weight targets, rebalanced when the allocation of any asset deviates by more than 20% from the target weight. That portfolio was subjected to 10 rebalancings within the 12-year interval of the study from July 2003 to July 2015.

As an alternative, we apply monthly reallocations based on a mean-variance optimization algorithm. We investigate two versions of the strategy: a return maximization with a low volatility target, and another with a high volatility target. The version with low volatility was subjected to 131 reallocation of the assets, virtually almost every month. Except for transaction costs, the frequent trading of this strategy is not a problem in an IRA account.

Here is the list of securities used to build the portfolio:

  • SPDR S&P Mid-Cap 400 ETF Trust (NYSEARCA:MDY)
    • Power Shares QQQ Trust (NASDAQ:QQQ)
    • I-Shares 1-3 Year Treasury Bond (NYSEARCA:SHY)
    • I-Shares 20+Year Treasury Bond (NYSEARCA:TLT)

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

MDY

5/4/1995

16.34B

1.16%

Mid-Cap Blend

QQQ

3/31/1999

45B

1.01%

Technology Large-Cap

SHY

7/22/2002

11.02B

0.46%

Short Term Treasury Bond

TLT

7/22/2002

4.98B

2.68%

Long Term Treasury Bond

The data for the study were downloaded from Yahoo Finance on the Historical Prices menu for MDY, QQQ, SHY, TLT. We use the daily price data adjusted for dividend payments.

For the adaptive allocation strategy, the portfolio is managed as dictated by the mean-variance optimization algorithm developed on the Modern Portfolio Theory (Markowitz). The allocation is rebalanced monthly at market closing of the first trading day of the month. The optimization algorithm seeks to maximize the return under a constraint on the portfolio risk determined as the standard deviation of daily returns.

In table 2 we list the total return, the compound average growth rate (CAGR%), the maximum drawdown (maxDD%), the annual volatility (VOL%), the Sharpe ratio and the Sortino ratio of the portfolios without any fund withdrawals.

Table 2. Performance of the portfolios from July 2003 to July 2015 without withdrawals.

TotRet%

CAGR%

maxDD%

VOL%

Sharpe

Sortino

Equal Weight

181.79

8.99

-24.81

9.62

0.93

1.26

AA LOW volatility

354.58

13.41

-10.16

10.54

1.27

1.79

AA HIGH volatility

537.25

16.63

-16.34

14.97

1.11

1.57

SPY

163.86

8.40

-55.19

19.13

0.44

0.53

In figure 1 we show the equity curves for the portfolios without withdrawals.

Figure 1. Equity curves for the adaptive allocation (AA) portfolios and the equally weighted portfolio with rebalancing with no withdrawals.

Source: This chart is based on calculations using the adjusted daily closing share prices of securities.

In table 3 we list the excess total return after withdrawals, the compound average growth rate (CAGR%) of the excess return, the maximum drawdown (maxDD%) including the withdrawals and the annual volatility (VOL%) of returns including withdrawals.

Table 3. Performance of the portfolios from July 2003 to July 2015 with 6% annual withdrawals.

TotRet%

CAGR%

maxDD%

VOL%

Equal Weight

29.52

2.17

-32.05

9.79

AA LOW volatility

138.21

7.48

-14.92

10.61

AA HIGH volatility

260.89

11.25

-19.72

15.00

In figure 1 we show the equity curves for the portfolios with 6% annual withdrawals.

Figure 2. Equity curves for the adaptive allocation portfolios and the equally weighted portfolio with rebalancing after 6% annual withdrawals.

Source: This chart is based on calculations using the adjusted daily closing share prices of securities.

To see how reliable was the 6% annual withdrawal rate we estimated the excess compound annual return (CAGT) and the maximum drawdown for the three portfolios starting in July of each year between 2003 and 2014. The results are shown in the figures 3, 4 and 5.

Figure 3a. Compound annual return for the equal weight portfolio by starting retirement date.

Figure 3b. Maximum drawdown for the equal weight portfolio by starting retirement date.

Figure 4a. Compound annual return for the Adaptive Allocation LOW volatility portfolio by starting retirement date.

Figure 4b. Maximum drawdown for the Adaptive Allocation LOW volatility portfolio by starting retirement date.

Figure 5a. Compound annual return for the Adaptive Allocation HIGH volatility portfolio by starting retirement date.

Figure 5b. Maximum drawdown for the Adaptive Allocation HIGH volatility portfolio by starting retirement date.

Source: All the charts in this article are based on calculations using the adjusted daily closing share prices of securities.

Additionally, we determined the maximum annual withdrawal rate that preserved the initial investment for the portfolios with July 2003 as starting retirement date. The results are shown in table 4.

Table 4.

Portfolio

Max withdrawal rate

Excess total return

Equal weight

7%

2.66%

AA LOW volatility

9%

30.02%

AA HIGH volatility

11%

30.58%

Current allocations for August 2015:

  • LOW volatility portfolio: 82% QQQ + 18% SHY
  • HIGH volatility portfolio: 100% QQQ

Conclusion

The simple equally weighted portfolio could support 7% annual withdrawal rate from 7/2003 to 7/2015 without any decrease in equity. Same portfolio with a mean-variance optimization algorithm for a low volatility target could support 9% annual withdrawal rate and 11% for a high volatility target.

Disclosure: I am/we are long QQQ, SHY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.