The purpose of this article is to evaluate alternative portfolio strategies in preparation for the next bear market.
The Investment Model continues to show growth at a decelerating rate. Recession risk is very small in the near term but rising slowly.
Up to four funds based on risk-adjusted performance are provided for 32 top Lipper categories as ranked by Martin Ratio, Ulcer Index and three-month trend.
Seven portfolio strategies are evaluated using Portfolio Visualizer to see how they compare during the 2015 to 2018 time period. One rolling allocation strategy is evaluated.
In 2018, 538,659 job cuts were announced, 28.6 percent higher than the 418,770 announced in 2017. This is the highest annual total since 598,510 cuts were recorded in 2015, and the second-highest total since 2011, when 606,082 cuts were announced. - 2018 Challenger Report: Annual Total Up 29 Percent, Highest Since 2015", Challenger Gray & Christmas, Inc.
In a recent interview with Barron’s, [John] Bogle warned that “trees don’t grow to the sky, and I see clouds on the horizon. I don’t know if and when they’ll arrive. A little extra caution should be the watchword.” Those clouds, he said, include large amounts of sovereign and corporate debt, the “great upheaval” in global trade, and “the mystery of Brexit, which will be very disruptive to the world trade system. Those things add up.” - Vanguard Founder Jack Bogle Says It’s Time to Play It Safe, by Leslie P. Norton, Barron’s
The most common theme that I have read on how to be a successful investor is to have a system and follow it. There are five steps to my investment strategy:
- Investment Model that provides the macro view. It is automated using about 100 indicators mostly from the St. Louis Federal Reserve FRED database.
- Mutual Fund Observer to select lower risk, higher risk adjusted returns with low expense ratios. It is now automated to select the best funds on a risk-adjusted basis in 32 diverse, best performing Lipper categories each month.
- Asset allocation using Portfolio Visualizer: My current strategy is to maximize returns at a target volatility slightly below the Vanguard Wellesley Income Fund's (VWIAX) standard deviation.
- Final review using Morningstar and Portfolio Visualizer to ensure diversification. Data can easily be transferred between Morningstar, Portfolio Visualizer and Excel using comma delimited (csv) files.
- Checking current market conditions.
So if one allows the cold science of asset allocation to let a portfolio optimizer run unconstrained, then you're just begging to lose a lot of money in no time. - About Investment Portfolio Optimization, Tools For Money
The above cited article explains the "Perils of Using Portfolio Optimizers". Some of the reasons are that returns are historical and correlations change over time and length of period evaluated. Portfolio Visualizer FAQ lists some of the issues such as over concentration of assets. The benefit to me, is to focus on reducing risk by determining what is working and what isn't working each month. At one point in December, the S&P 500 was down 16% over the past three months while my target baseline fund, the Vanguard Wellesley Income Fund, was down about 3%.
In this article, I look at alternative strategies available in Portfolio Visualizer:
- Maximize Return at 4.5% Volatility
- Minimize Variance
- Risk Parity
- Minimize Drawdown
- Maximizing Diversification
- Maximize Sharpe Ratio
The descriptions for the different methodologies can be found in Portfolio Visualizer's Frequently Asked Questions.
The above process assigns different allocations to 13 mutual funds and ETFs using the above strategies for a period from July 2015 through December 2018. The allocations are capped at a maximum of 15% for all funds except sector funds which had a cap of 4%. Each fund had a minimum allocation constraint of 2%. Below, the January Model Portfolio (black line) was created based upon the performance during the twelve months of 2018, and is what I use as my target allocation. My baseline fund is the Vanguard Wellesley Income Fund (VWIAX, dashed black line) which I consider to be a great all around conservative fund. Maximizing the return with 4.5% target volatility (red line) over the 3-year period produced the highest return. Risk Parity (grey line) and minimum variance (light blue line) produced similar results. Maximum Diversification (dashed blue line) produced results close to the Maximum Sharpe Ratio. Minimum Drawdown (green dashed line) has a return intermediate to the Sharpe Ratio and Risk Parity.
Source: Chart by Author Based on results from Portfolio Visualizer
STEP 1: INVESTMENT MODEL
Despite the risks, it’s not yet obvious that a softer macro trend for the US is destined to deteriorate into a new recession in the near term. As discussed late last month, the probability that a new NBER-defined contraction has started remains low... Reviewing the GDP outlook from the perspective of one-year changes also suggests that moderate growth will prevail for the foreseeable future. - The Capital Spectator by James Picerno.
The Investment Model (dashed blue line) shows that the investment environment, which includes risk, volatility, monetary policy, growth, and capacity, among others, continues to deteriorate. The model has been estimating a weakening investment environment for the past 12 months. The Allocation Index (solid blue line) is built upon Benjamin Graham's guidelines of never having less than 25% in equities and never more than 75%. The model allocation currently is at 40% equities.
Source: Chart By Author
Investment Model - Recession Risk
So it may be that some of that recession scare may begin to fade here in the near term as economic growth rebounds a little bit, and that may offer some relief to stocks as we close out the year. - Has Global Recession Already Begun?, Charles Schwab
Below is the Organisation for Economic Co-operation and Development (OECD) forecast of Real GDP for the US (black), Developed Countries (blue) and World (red), along with the U.S. Federal Open Market Committee projection of Real GDP (dashed). Growth in developed countries is decelerating, but indications are that growth will be moderate.
Source: By Author based on OECD and St. Louis Federal Reserve (FRED)
Below is my Recession Indicator. It is based on the percent of 15 indicators that are negative. The probability of a recession starting in about 6 months is a low 13%. Smoothed U.S. Recession Probabilities and GDP-Based Recession Indicator are also shown. Recession risk is currently low. Jeff Miller in Weighing The Week Ahead: Should We Worry About Peaking Economic Data? has Dr. Bob Dieli's C-Score which puts the 9 Month Recession Probability at about 22%, and the 3 to 4 Recession Probability at about 3%.
Indicator Spotlight - The Market is Overvalued
For readers that are interested, I have attached additional indicators from the Investment Model, "Supplemental Investment Model Indicators", that can be opened. They cover my version of Dr. Bob Dieli's Mr. Model, Labor, Inflation, Leading, and Margin Leverage Free Cash.
The one indicator that I choose to spotlight is Valuation:
Stephanie Pomboy, founder of the economic research firm MacroMavens, avers that the "enormity of the role of buybacks" in supporting the stock bull market isn't fully appreciated. "But it will be in its absence," she says... Since 2011, S&P 500 "buy-back inflated" EPS rose 67% she points out, compared with the 23% gain in aggregate U.S. corporate profits recorded for the same period by the U.S. Bureau of Economic Analysis.
- Up & Down Wall Street, by Vito Racanelli in Barron's.
Below is the Investment Model Valuation Indicator composited from Warren Buffett's Market Capitalization to Gross Domestic Product, Market Capitalization to Corporate Profits, Tobin's Q Ratio, Cyclically Adjusted Price to Earnings, and the relationship of dividends to 10-year Treasury rate.
Source: Created By Author
STEP 2: MUTUAL FUND OBSERVER - Fund Selection
With the potential for a slowing rate of economic growth, some Fidelity managers are looking for more defensive stocks. - 2019: What may lie ahead for stocks, Fidelity
While the Investment Model is forward looking, I use Mutual Fund Observer to measure how funds are currently performing using the trends over the past 12 months.
There are four criteria for selection: 1) Great Owl Classification, 2) MFO Risk, 3) MFO Rating, and 4) 3-month trend. There are also over a dozen criteria used to exclude funds from consideration: 1) Expenses greater than 1.25%, 2) Funds have loads, 3) Minimum initial investment is greater than $50,000, 4) Fund has less than $25M in assets, 5) Fund is closed to new investors, 6) Fund has a Three Alarm Rating, 7) Fund is in the lowest 15% below the 3-month or 10-month moving average, 8) Ulcer Index is in the highest 20%, 9) Maximum Drawdown is in the highest 20%, 10) Bear Market Deviation is in the top 20%, 11) Bear Market Rating is in the worst 20% for the Lipper category, 12) Price to Earnings ratio is in the highest 20% of the funds, 13) and exclude below investment grade bonds and loans.
These criteria are available in Mutual Fund Observer MultiSearch, a Premium Service for $100 per year. The definitions of the criteria are available here.
The results for December are shown below. For bonds, risk and trends suggest that it may be time to shift from short-term investments to high quality intermediate bond funds; the alternative investments don't interest me when compared to bonds; large and mid-cap value funds are attractive for US Equities; and Low Volatility World Funds are the best of the global and international funds. Finally, of the sector funds, pharmaceuticals, utilities and real estate did well during the past year on a risk-adjusted basis. Some of the defensive funds are automatically excluded because the price to earnings ratio has become high due to investors seeking safety.
|1) International Income||IAGG||VTABX|
|2) U.S. Gov Intermediate||RMAGX|
|3) U.S. Gov General||AGZ||FGOVX||TBFIX|
|4) U.S. Treasury General||ITE||VFITX||FBLTX||BTTRX|
|1) Muni General & Insrd Debt||FMB||VWAHX||FTABX||WFCMX|
|2) Muni Short-Intmdt Debt||SMB||VMLTX||FSTFX||CCMPX|
|1) Alt. Managed Futures||WTMF|
|2) Alt. Multi-Strategy||JPHF||DRRIX|
|3) Alt. Global Macro||DVRIX|
|1) Flexible Portfolio||INKM||FAYZX||MBEAX|
|2) Mixed-Asset Target Today||VTINX||FIKFX||JRFOX|
|3) Retirement Income||SWLRX|
|1) Large-Cap Value||VAMO||FSDIX||YACKX|
|2) Mid-Cap Core||PTMC||FMCSX||TMCPX|
|3) Multi-Cap Core||SPLV||VTCLX||FAMVX|
|4) Large-Cap Core||QUS||VFTSX||FLCEX||PRDGX|
|1) Global Multi-Cap Core||ACWV||MVGIX|
|2) Global Large-Cap Growth||DGLRX|
|3) Global Small/Mid-Cap||JPGE||VMNVX|
|1) Pacific Region||ENZL|
|2) Intern Multi-Cap Growth||EFAV||FSKLX||LLINX|
|3) Global Health/Bio||FPHAX|
|1) Com Precious Metals||PALL|
Summaries by Lipper Category are shown below:
|CATEGORY||Risk||Rating||Martin||Sharpe||Ulcer||3 Mon Return|
|1) International Income||1.0||5.0||5.7||0.6||0.2||2.3|
|2) U.S. Gov Intmdt||1.0||4.0||(0.9)||(0.4)||1.1||3.0|
|3) U.S. Gov General||1.3||4.0||(1.1)||(0.4)||1.2||2.8|
|4) U.S. Treasury General||2.0||3.5||(0.5)||(0.3)||2.4||4.8|
|1) Muni General & Insrd Debt||1.3||3.8||(0.4)||(0.2)||0.9||2.4|
|2) Muni Short-Intmdt Debt||1.0||3.0||(1.7)||(0.4)||0.3||1.5|
|1) Alt. Managed Futures||1.0||4.0||(1.5)||(0.5)||1.1||(2.2)|
|2) Alt. Multi-Strategy||2.0||3.5||(1.3)||(1.3)||3.1||(1.3)|
|3) Alt. Global Macro||2.0||4.0||(1.7)||(0.7)||1.4||(3.0)|
|1) Flexible Portfolio||2.3||4.0||(1.6)||(0.8)||3.6||(4.2)|
|2) Mxd-Ast Target Today||1.3||5.0||(2.4)||(1.0)||1.3||(0.8)|
|3) Retirement Income||1.0||5.0||(2.5)||(1.5)||1.7||(0.1)|
|1) Large-Cap Value||3.0||3.7||(1.2)||(0.6)||4.4||(5.7)|
|2) Mid-Cap Core||3.7||5.0||(1.0)||(0.4)||5.0||(8.4)|
|3) Multi-Cap Core||4.0||4.3||(1.1)||(0.4)||4.7||(9.6)|
|4) Large-Cap Core||4.0||4.3||(1.0)||(0.3)||4.8||(10.6)|
|1) Global Multi-Cap Core||3.0||5.0||(1.1)||(0.4)||3.4||(5.1)|
|2) Global Large-Cap Growth||4.0||5.0||(0.7)||(0.3)||5.0||(8.8)|
|3) Global Small/Mid-Cap||3.5||4.5||(1.5)||(0.7)||4.8||(7.0)|
|1) Pacific Region||4.0||5.0||(0.6)||(0.2)||3.6||0.5|
|2) Intern Multi-Cap Growth||3.3||5.0||(1.7)||(0.7)||4.7||(4.4)|
|3) Global Health/Bio||4.0||5.0||1.0||0.2||3.9||(8.0)|
|1) Com Precious Metals||5.0||5.0||2.6||0.9||6.5||25.2|
Source: Mutual Fund Observer. Morningstar for 3 month return.
STEP 3: PORTFOLIO VISUALIZER - Strategy Comparison
There are many modules available in Portfolio Visualizer, of which I mostly use Portfolio Optimization\Portfolio Optimization and Backtest Portfolio. There is no fee for using the software. Below are the allocations for different strategies.
|Symbol||Max Sharpe||Max RTN @ 4.5 Vol||Risk Parity||Model Portfolio||Minimum Variance||Minimum Drawdown||Max Diversif.|
Portfolio Metrics and Exposures
|Max Sharpe||Max RTN @ 4.5 Vol||Risk Parity||Model Port.||Min Var.||Min Drawdown||Max Divers.||VWIAX|
|3 Yr Return||4.9%||6.2%||3.6%||5.3%||3.3%||4.0%||4.7%||4.9%|
|US Market Correlation||0.8||0.9||0.6||0.8||0.5||1.9||0.7||0.8|
|Under 1 Yr||2.8%||2.9%||3.7%||3.4%||4.8%||2.9%||4.6%||6.0%|
Source: Portfolio Visualizer
Below is the result of Rolling Optimization to maximize the return at 4% volatility compared to the January Model Portfolio (Provided Portfolio). The importance of Rolling Optimization is that it changes allocations according to market conditions. This strategy would have produced returns of 13% in 2017 and 1.8% in 2018.
Source: Portfolio Visualizer
The allocation "drift" is shown below as optimization is performed quarterly with the constraints provided earlier.
Source: Portfolio Visualizer
STEP 4: VALIDATION, VALIDATION, VALIDATION
I used the Martin Ratio from Mutual Fund Observer, Morningstar, and my personal preferences to reduce the 62 funds down to 13 to be in the January Hypothetical Million Dollar Model Portfolio. As of January 11th, the portfolio would have returned 1.2% over the past 12 months. It would have returned 1.4% over the past three months compared to -0.3 for the Vanguard Wellesley Income Fund and -4.4% for the S&P 500. According to Morningstar X-Ray Premium Service, the portfolio has 34% equities with a large cap value style. Bonds are moderate to high quality in the moderate term range. The sectors are overweighted in consumer defensive and utilities and under-weighted in energy and technology. The average expense ratio is 0.28%.
|Vanguard Total Intl Bd Idx Admiral||VTABX||10%||4600||21.68||99,728|
|SPDR Barclays Inter Term Trs||ITE||10%||1600||59.41||95,056|
|Wells Fargo CoreBuilder Shares||WFCMX||10%||8500||11.81||100,385|
|Capital Group Core Municipal||CCMPX||5%||4800||10.3||49,440|
|Fidelity Freedom Index Income Inv||FIKFX||7%||6000||11.61||69,660|
|Schwab Monthly Income Max Payout||SWLRX||10%||10000||9.68||96,800|
|AMG Yacktman I||YACKX||10%||5300||19.28||102,184|
|Pacer Trendpilot US Mid Cap ETF||PTMC||10%||3200||30.86||98,752|
|Invesco S&P 500 Low Volatility ETF||SPLV||10%||2200||47.23||103,906|
|iShares Edge MSCI Min Vol Global||ACWV||10%||1300||82.7||107,510|
|Fidelity Select Utilities||FSUTX||2%||200||81.44||16,288|
|Pacer Trendpilot 100 ETF||PTNQ||4%||1200||32.67||39,204|
|Schwab Health Care||SWHFX||2%||900||23.51||21,159|
The Efficient Frontier compares the return against the volatility as measured by standard deviation. Below is the Efficient Frontier for the 13 funds selected for the January portfolio from July 2015 to December 2018 and for 2018 alone which included a mild correction.
Source: Portfolio Visualizer
The following allocations are shown for varying standard deviations on the Efficient Frontier. If one is willing to accept more volatility, then he can own less FIKFX (Income), ITE (Intermediate Treasuries), and CCMPX (Municipals) and add YACKF (Large Value), PTMC (Trendpilot Mid-Cap) and SPLV (S&P 500 Low Volatility).
Source: Portfolio Visualizer
STEP 5: MARKET TRENDS - Is the Water Hot?
While being a medium term investor, it is important to keep an eye on market trends. Below is a technical indicator for the S&P 500, the Moving Average Convergence Divergence, which uses exponential moving averages to identify short-term momentum trends. It is currently bullish for short-term trends.
The following chart shows the S&P 500 (SPY), relative strength, and William's R. I suspect that recovery will continue further.
FUND SPOTLIGHT - Pacer Trendpilot US Mid Cap ETF
Each month, I show a little extra research on one or two funds. These are funds that I want to know more about, but may not own or purchase. This month, I look at Pacer U.S. 450 Trendpilot ETF (PTMC) which passed my Mutual Fund Observer screen and has a Morningstar Rating of 5. It has a 3-year standard deviation of 8.5 compared to 11 for the S&P 500. There are $690M in assets under management, and the expense ratio is 0.62%. It's 3-year return has been 10.8% with a maximum drawdown of -8%. Over the past three years, it has 79% upside capture and 47% downside capture ratios.
According to the Prospectus, PTMC follows the Pacer Trendpilot US Mid Cap Index:
The Index uses an objective, rules-based methodology to implement a systematic trend-following strategy that directs exposure (I) 100% to the S&P MidCap 400® Index (the “S&P MidCap 400”), (II) 50% to the S&P MidCap 400 and 50% to 3-Month US Treasury bills, or (III) 100% to 3-Month US Treasury bills, depending on the relative performance of the S&P MidCap 400 Total Return Index (“S&P MidCap 400 TR”) and its 200-business day historical simple moving average (the “200-day moving average”).
The strategy is likely to result in higher taxes because of the high turnover rate. The fund is currently all in short-term investments.
The other Trend Pilot ETF in the January Model Portfolio is Pacer 100 Trendpilot ETF (PTNQ) which is a large cap fund. Its three-year standard deviation is 13. PTMC has lost 3% over the past 3 months while PTNQ has gained nearly 4% over the same time period.
My investment strategy is self-regulating in two regards. First, in a defensive mode, I use a target volatility less than Vanguard Wellesley, and as volatility has risen, I have a measurable method for reducing equity exposure. Second, my objective is to be 25% in equities (down from 35% currently) prior to a bear market. As the markets fall in a bear market, equities will have to be added to maintain a minimum equity exposure of 25%. Buy low, sell high.
As for comparing low-risk strategies in preparation for a bear market, Risk Parity, Minimum Variance, Minimum Drawdown, Maximum Diversification each have equity exposures of 15% which is less than the 25% guidance from Benjamin Graham that I follow. My preference is to use Maximizing Return at a target volatility appropriate for the business cycle. I will accept a higher volatility in earlier stages of the business cycle when risks are lower. I also use Maximum Sharpe Ratio as a comparison each month.
Disclosure: I am/we are long VTABX, YAFFX, SPLV, VWIAX. 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 an engineer with an MBA nearing retirement and not an economist nor an investment professional. The information provided is for educational purposes and should not be considered as advice. Investors should do their due diligence research and/or use an investment professional.