Within Mebane Faber and Eric Richardson's book, The Ivy Portfolio, there are several example portfolios of how one might invest like the top endowment funds. One of those portfolios is what I call the Ivy Ten. The following analysis applies a momentum screen to ten ETFs by first ranking them using two look-back periods plus a volatility calculation. Before proceeding with the momentum analysis let's look at the cluster correlations.
Cluster Correlations for Faber Ten: If 0.8 is the correlation cutoff then VTI, VB, VEU, RWX, and VWO are highly correlated as are DBC and GSG. It is not surprising that two commodities such as DBC and GSG are highly correlated. Another correlated pair are BND and TIP.
Out of the ten ETFs we have only four different clusters. We may as well construct the portfolio using only four ETFs rather than the ten recommended in the Ivy book. The following correlation cluster diagram is based on three years of historical data.
Tranche Momentum Recommendations: Knowing the correlation problems, we proceed with the tranche momentum recommendations. VB and VNQ are the primary recommendations based on 60 and 100 trading day look-back periods and a standard deviation volatility calculation. Commodities (NYSEARCA:DBC) is avoided as it was only recommended two weeks ago. The current price of DBC is positioned below its 195-Day Exponential Moving Average (EMA). This relative price position automatically disqualifies it from inclusion in the portfolio.
Position Sizing Recommendations: Moving on from the tranche momentum recommendations, we examine the position sizing recommendations where the investor or money manager determines what risk to take with individual holdings and the overall risk of the portfolio.
Two variables are fundamental in controlling risk and they are:
- SD Multiplier - set to 1.6 in this example so the Probability of Stop is reduced to 11%.
- Max Trade Position Risk - set to 1.4% which controls the Maximum Portfolio Risk. This variable is generally set so the portfolio risk does not exceed 6%. However, it is up to the investment manager as to what risk to take with the portfolio.
The current portfolio carries a 2.9% risk with $63,000 in cash. The suggested portfolio risk is higher at 4.8% with cash lowered to $41,300. A general rule is to hold the portfolio risk to something below 6%.
Manual Risk Adjustments: The final worksheet, shown below, allows the money manager the opportunity to insert the number of desired shares and then observe what those shares selections do to the portfolio risk. In this portfolio I will eventually hold 150 shares of VB, 350 shares of VWO, and 250 shares of VNQ.
One problem with this combination is that VB and VWO are highly correlated so those two ETFs are likely to move in the same direction when the market moves up or down.
In a future article I hope to show readers how one might avoid investing in highly correlated ETFs, yet provide for global diversification.
Disclosure: I am/we are long VNQ, VWO.
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.