Reducing Risk In A Portfolio Of Funds

by: Charles Bolin


A hypothetical million-dollar portfolio is constructed to reduce risk in a decelerating economy.

Risk is defined by the Morningstar Bear Ranking System, correlation to my Investment Model Risk Indicator, and monthly draw down. Beta and standard deviation are used as tiebreakers.

The economy is growing moderately, but it is prudent for investors to review their allocations given that we are in the latter part of a business cycle.


This article focuses on reducing risk in a low volatility portfolio. Beta and standard deviation are measures of volatility and do not directly measure risk. The standard deviation of the Vanguard S&P 500 ETF (VOO) and the ProShares Short S&P 500 (SH) are both about 10. Beta measures the variation of an ETF compared to its underlying index, so the beta of VOO is about 1, while the beta of SH is a negative 1. The Morningstar Bear Ranking System measures the performance in down markets during the past five years. The Bear rank for VOO is 56 and 2 for SH. I also use the correlation to my Investment Model Risk Indicator, described later, which is 0.63 for VOO and negative 0.38 for SH.

The objective is to build a portfolio that lowers risk appropriate for an economy growing at a slower rate. According to Morningstar's Premium Service X-Ray Interpreter, the May Portfolio is moderately risky, appropriate for someone with a 3- to 10-year time frame. It is biased toward small- and mid-cap funds but has a healthy mix of conservatively priced value stocks and aggressively-priced growth stock funds. There are 20 funds in the portfolio and risk can be lowered by allocating more toward the conservative bond and money market funds.

The economy continues to grow, and the outlook is positive. Below is my Investment Model Leading Indicator composited from The Conference Board Leading Indicator, Philadelphia Fed Leading Indicator, National Activity Index, and Organization of Economic Co-Operation and Development. The Atlanta Fed GDPNow forecast for real economic growth in the second quarter is currently 4.8% as of June 1st.

Source: Created by the Author using data from the St. Louis Federal Reserve FRED Database, Conference Board, and OECD.

Ed Easterling, details secular bull and bear markets well in Probable Outcomes where he describes the relationship between valuations, inflation, and future returns. A recent article by Mr. Easterling called "Serious Implications: Forecast Skew Over the Next Decade" discusses likely returns over the next decade as being between 0 and 7 percent.

Supporting Mr. Easterling's view is Vanguard's "2018 Economic and Market Outlook" of higher risks and lower returns over the next five years due to "elevated valuations" and downside risks. To these points, the annualized return of the S&P 500 since May 1998 is 6.4%, while the S&P 500 returned 9.8% since January 1995. The difference between poor and better returns is largely related to recognizing and managing risk.

May Portfolio (Lower Risk, Diversified, Low Volatility)

In this article, I build a hypothetical million-dollar portfolio of funds ranked 40 or below in Morningstar's bear market ranking and/or with a correlation of 0.6 or lower to the Investment Model's Risk Indicator. Other criteria are standard deviations below 14, beta below 1.2, minimum net assets of about $100 million, and lower monthly draw downs. The allocations maximize the volatility adjusted, monthly weighted 6-month return constrained by correlation to other funds in the portfolio. The objective is to select funds that do better in a bear market, are less volatile, and are doing well now. The portfolio consists of 35 percent domestic stocks, 15 percent foreign stocks, and 50 percent cash and bonds.

In May, I installed the Fidelity Wealth Lab Pro platform. The great feature of it, from a preliminary look, is the ease of creating a data set and downloading data, and then quickly looking at the funds that I track. As an example, I show the Invesco S&P Midcap Low Volatility ETF (XMLV). The indicators that I include are the Relative Strength, the Parabolic Indicator, 200-day moving average, and exponential moving average. I include a subjective rating in the Portfolio below (such as Up, Down, Topping).

Source: Fidelity Wealth Lab Pro.

Many of the funds are Smart Beta, minimum volatility, or hedged. The bonds are mostly short term, floating interest rate, or international. The average standard deviation for the portfolio is 6.1 and the average beta is 0.45. The funds in the May Model Portfolio are: Money Markets and Short-Term Bonds (FLOT, MINT, VMMXX, VTIP); Domestic Funds (HIMCX, HUSE, LRGF, PSL, PWB, XMLV); Foreign and World Funds (EUSC, IHDG, PDRDX, VMVFX), Sector and Theme Funds (FTEC, FTGC, IBUY), and Convertible Securities, Non-Traditional Bond and Loan Funds (CWB, HYZD, SRLN).

Source: Risk and Fund correlation calculated by the Author. Data from Morningstar

My comfort zone is to have 20% in cash and short- to medium-term investments during the expansion phase of the business cycle. During a decelerating phase which is more volatile, I want to have more in reserve to buy the dips. The technical trends in the previous table show that the market is cooling for many of the funds.

Below is the May Model Portfolio categorized by standard deviation "buckets".

Source: Created by the author.

The May Portfolio Funds are graphed below.

Source: Created by the Author using Morningstar data.

The table below shows the correlation of the funds in the portfolio.

Source: Calculated by the Author using data from Morningstar.

"A Lifetime Investment Strategy" by James B. Cloonan, written for The American Association of Individual Investors, describes a retirement approach of maintaining a portion of capital in the higher, short-term risk stocks, and controlling the overall portfolio risk by shifting a substantial portion of capital into low-risk, short-term interest-paying investments. This is the approach that I am taking.

The AAII Investor Conference is being held in Las Vegas this year in October. Some of the topics of interest are: Retirement Planning by Christine Benz of Morningstar; Low Expected Return Environment by Kevin Grogan of Buckingham Strategic Wealth; Value, Momentum, and Quality by Charles Rotblut of AAII; and Factor Investing by Jack Vogel of Alpha Architect, among many others including Sam Stovall of Equity and Fund Research and Mebane Faber of Cambria Investment Research.

In a rising interest rate environment, it makes sense to own short-term bonds and is why I sought out funds like PIMCO Enhanced Short Maturity Strategy ETF, iShares Floating Rate Bond ETF, and Vanguard Short-Term Inflation-Protected Securities ETF to be in the funds that are evaluated. Certificates of Deposits are a good alternative or supplement to short-term bond funds.

Principal Diversified Real Asset Fund Institutional Class is an anomaly. It only has a Morningstar one-star rating but is also rated "Bronze" because of its inflation protection, multi-asset-class diversification. The managers of the fund have updated their strategy over the past several years.

SPDR Blackstone/GSO Senior Loan ETF has a conservative management philosophy but has risk due to lack of liquidity.

Foreign Funds

The strengthening dollar (UUP, black line shown for comparison) has reduced returns of foreign funds lately. The Foreign funds that are likely to do better in a more volatile environment, using the same criteria as in this article are shown below. They are mostly hedged (DBEF, DBEU, HEFA, IHDG), low volatility (EFAV, IDLB, VMVFX), or factor funds (INTF, RODM).

Source: Rank is calculated by the Author. Data presented is from Morningstar.

Source: Chart by the Author. Data is from Morningstar.

Investment Model

Below is one view of the Investment Model. It divides the Business Cycle into four stages (black line): 1) Accelerating, 2) Expansion, 3) Decelerating, and 4) Contraction (Recession). The Index (blue line) is composited from about 100 indicators. It shows that while still in the Expansion Stage, the Investment Environment is not robust. The green and red area show when the model would be invested more or less aggressively, and it is trending to the more conservative. For this reason, I believe now is the time to "buy the dip" and rotate into more conservative investments.

Source: Created by the Author using data from the St. Louis Federal Reserve FRED database among other sources.

The economy may be starting to decelerate, and investors are becoming more conservative. The chart below shows the average six-month return of the S&P 500 by stage of the business cycle from the Investment Model representing the past 22 years by month. The model does not show us in the Deceleration Phase. When this does occur, returns have typically been volatile and low or negative. For this reason, many investors are rotating into late business cycle funds.

Source: Created by the Author using data from the St. Louis Federal Reserve FRED Database.

Risk Indicators

This article is about reducing risk in a fund portfolio and the following indicators reflect current risk levels.

The Risk Indicator is composited from the Chicago Fed Adjusted National Financial Conditions Index, St. Louis Fed Financial Stress Index, Kansas City Financial Stress Index, CBOE S&P 100 Volatility Index, and the Economic Policy Uncertainty Index for United States available from the FRED database. The index has fallen from a strong level (100%) to a more modest 40% and has rebound to 65% reflecting that it is probably a short-term fluctuation.

Source: Compiled by the Author using data from the St. Louis Federal Reserve FRED database.

My Valuation Indicator is a composite of market capitalization to Gross Domestic Product, Tobin Q, Cyclically Adjusted Price to Earnings Ratio, and Price to Earnings Ratio. It is an excellent long-term indicator of returns, but not short term. Its negative value reflects higher than average valuations.

Source: Compiled by the Author using data from the St. Louis Federal Reserve FRED database.

The yield curve has a reliable indicator of recessions over a one- or two-year time frame and is often caused by the Federal Reserve raising short-term interest rates to prevent the economy from overheating. The Interest Indicator shown below is based on the yield curve, ICE BofAML US Corp Master Total Return Index, ICE BofAML US Corporate Master Option-Adjusted Spread, TED Spread, ICE BofAML US High Yield Master II Option-Adjusted Spread, Bank Prime Loan Rate, Commercial Bank Interest Rate on Credit Card Plans. The index shows that the Investment Environment is moderating, but it is not overly concerning at this time.

Source: Compiled by the Author using data from the St. Louis Federal Reserve FRED database.

I added this Savings Indicator to the Investment Model last year. It is the monthly (YOY) growth rate of savings deposits. Over the past 22 years, savings rates have contracted one to three years prior to a recession. Perhaps through optimism or necessity, savings accounts are getting smaller, providing less cushion for down turns.

Source: Compiled by the Author using data from the St. Louis Federal Reserve FRED database.

Conversely, institutional investors (Smart Money) are increasing flow to money funds seeking safety, another trend worth noting.

Source: St. Louis Federal Reserve FRED database.

There are many ways to measure inflation. The Personal Consumption Expenditures Price Index has almost reached the Fed's 2% target, while the Producer Price Index is around 5%. I use the St. Louis Federal Reserve Price Measures series, which show a probability of low to moderate inflation, as part of the Inflation Indicator. There is cause to prepare for inflation, but at this time, inflation is not increasing at a high rate.

Source: Chart created by the author. Data from the St. Louis Federal Reserve FRED database.

Investments that do better (relatively) with increasing inflation are often commodities and materials, gold, short duration bonds, inflation-protected bonds, floating rate bank loans, and real estate. The April and May Portfolios contain funds that are doing well now and typically do better with increasing inflation. The Portfolios do not contain gold or real estate, but of the funds that I rank, iShares Global Metals and Mining Producers (PICK), Fidelity Real Estate Income (FRIFX), and VanEck Vectors Mortgage REIT Income (MORT) are ranked higher with PICK being the most volatile.

Inflation (PCE Price Index, blue line) is often influenced by money supply (red line, M2). Rising interest rates and slowing growth of money supply may have dampening impacts on the rate of inflation.

Source: The St. Louis Federal Reserve FRED database.

Buy And Hold

A reader asked what I think of buy and hold? Like most investment philosophies, it works well during particular circumstances for some investors. From a business cycle standpoint, certain investments do better over the different stages of the business cycle. Below is a chart that I consolidated from "The Era Of Uncertainty" by Francois Trahan and Katherine Krantz (2011) suggesting where to invest based on inflation and growth. What we saw in the first months of 2018 is a shift from Neutral Growth investments to Low Growth and to investments that do better with higher inflation. What we are seeing now is a topping process for these funds and a decline in foreign funds.

Source: Compiled by the Author from "The Age of Uncertainty"

In a Meet The Press interview in 1970, Paul Samuelson said, "Well, when events change, I change my mind. What do you do?" I put more upfront rational into the funds that I buy now and hold them until my ranking system tells me that I should change my mind. I generally limit trades to a few percent of my portfolio each month.

Review of the April Portfolio (Diversified, Low Volatility)

Below is the portfolio from my April article, "Building A Diversified, Low-Volatility ETF Portfolio". The April Portfolio is doing well. The May portfolio focuses on funds that do better in a bear market, so those with high correlation to risk or high bear market rankings in the April Portfolio are absent in the May Portfolio. I own some of the funds from the April Portfolio that are not in the May Portfolio such as WOOD, VDE, PSCH, and COMT and will continue to own them until they fall in my ranking system. (The ranking shown in the table is from April.)

Source: Risk and Fund correlation calculated by the Author. Data from Morningstar


The Vanguard Balanced Index Fund (VBINX) is a 60% stock/40% bond fund which has returned 2.4% for the past month and 2.1% for the past 3 months. According to Morningstar, VBINX's success is attributable to its low-cost fees, simple approach, and focus on quality bonds. It currently has a 16% allocation to small-cap stocks and very low exposure to foreign funds. VBINX has a standard deviation of 6.2. VBINX did well, compared to stock funds, in 2008, losing only 22% of its value. BlackRock has four ETFs that use allocation strategies (AOA, AOK, AOM, and AOR).

The purpose of the April and May model portfolios was to build a portfolio that provides upside growth and downside protection during a decelerating investment environment. They are intended to reduce risk. What I am striving for is a system that varies allocation according to the business cycle. Excel Solver is used to select and allocate funds in the June Model Portfolio. I loosen some of the constraints and allow a little more volatility into the portfolio.

Disclosure: I am/we are long CWB, PSL, FTEC, IBUY, PDRDX, VMVFX.

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.

Additional disclosure: I am not an economist nor an investment professional. I am an engineer with an MBA nearing retirement. Investors should do their own research and/or consult with an investment professional.