In this post, I want to briefly return to putting together quantitative strategies into an overall portfolio. I wrote about this in 2014, but I have better tools and more data now. Basically, let's build a portfolio of quant strategies that reflects a typical 60/40 US stock US bond benchmark and compare portfolio statistics to the SP500 and to the 60/40 benchmark.
First things first. Picking the quant strategies (you can find the background to all the strategies in the Portfolios section of the blog). You can definitely spend a ton of time here and go way off into the weeds. Let's keep it relatively simple. I will choose 4 strategies. Why 4? Well, the tool only allows me 5 assets and one of them has to be the bond allocation in the portfolio. And 4 is plenty. I also want some value and some momentum. I'll choose the two most conservative quant strategies I've presented, the Utilities Value Strategy and the Consumer Staples Strategy. Then I will add the Trending Value Strategy and the Pure Momentum Strategy. The strategies will buy and hold a portfolio of stocks for one year, then re-balance. The strategies will hold 10 stocks each. While the strategies on a standalone basis normally hold 25 stocks in a portfolio, it would lead to too many stocks for no benefit. Actually, holding fewer stocks leads to some benefits - higher performance for the individual strategies and some diversification benefit when value and momentum strategies are combined (see this great post from Alpha Architect). We are targeting a 60/40 allocation, so we'll hold 40% of the portfolio in US Govt. bonds (NYSEARCA:IEF) and the 60% equally divided among the 4 quant strategies (15% each). Finally, we'll re-balance the entire portfolio once a year.
Below are the results for the backtest of the 60/40 quant strategy US bond portfolio from the beginning of 1999 through about mid-November of 2016 compared against the SPY.
Returns are 13.7% a year vs. about 6% for SPY, but with less than half the drawdowns which leads to a much higher Sharpe ratio. In the same time frame, the 60/40 US stock bond portfolio has returned about 7.4% a year with -29.5% in drawdowns. So the diversified quant bond portfolio delivers better than equity returns at drawdown levels of a classic 60/40 portfolio. Impressive to say the least. Two more things I want to touch on before I conclude; correlations and implementation costs.
If you analyze each individual quant strategy, you may have noticed the large drawdowns, especially in the more concentrated 10-stock portfolios. What's great when you put them in a portfolio is the diversification benefit you get. Below is the correlation table from the portfolio simulation.
Bonds are the best diversifier by far and are what keeps the portfolio drawdown at the 60/40 type level. But the quant strategies help also. The highest correlation among the strategies is at a pretty low level of 0.59. Basically, it's important to keep your focus on the portfolio level and not too much at the individual strategy level.
Finally, let's talk about implementation costs. In this portfolio, we are talking about 40 stocks re-balanced once a year. If you assume the entire portfolio turns over once a year, you're looking at 80 trades a year. At a high trade cost of $10/trade, you're looking at $800 in commissions. That's 0.8% for a $100K portfolio and lower for larger portfolios. If you do a bit of searching on trade costs, you can get this much lower, even for free in some cases. But even $5/trade is not too hard to find these days. Slippage can also be kept to a minimum. The portfolio simulation buys at the close of trading. You can use MOC or last minute conditional orders to minimize the difference between the buy/sell price and the actual closing price. You also need to be slightly careful to choose a broker with good execution.
In summary, it is relatively straightforward to build a portfolio of individual quant strategies and US bonds that has significantly better performance characteristics than the classic 60/40 portfolio and even 100% equity portfolios.