Introduction
The simple ETF portfolio was introduced and analyzed in a couple of Seeking Alpha articles published in August 2015 and April 2016. In those articles, the portfolio was managed with a Tactical Adaptive Allocation strategy. The implementation of the strategy required the use of an expensive software package, or a not-so-reliable and hard to use Excel spreadsheet. To overcome those difficulties and make the strategy more accessible to individual investors, we looked into using the Portfolio Visualizer [PV], a free software application available since 2013.
The portfolio is made up of the following four ETFs:
- SPDR S&P MidCap 400 ETF Trust (NYSEARCA:MDY)
- Power Shares QQQ Trust, Series 1 (NYSEARCA:QQQ)
- I-Shares 1-3 Year Treasury Bond (NYSEARCA: SHY)
- I-Shares 20+Year Treasury Bond (NYSEARCA:TLT)
Portfolio Visualizer has three portfolio allocation strategies based on price momentum: Relative Strength, Dual Momentum, and Adaptive Allocation. Either one may be used with very similar results. In this paper we show an example based on the Relative Strength strategy. Here is the PV link to the model portfolio.
The strategy has a simple rule: rank the four assets by their total returns over the last 3 calendar months, and invest all the funds to the best performing asset. The trades are executed at the market closing of the last trading day of the month.
Backtest results
The simulation is done over 16 years, from January 2003 to December 2018, based on the availability of the market data. In the article, only a small fraction of the results is presented and discussed. The interested reader can see all the results on the model’s PV link.
Here are some performance metrics of the strategy: Compounded Annualized Growth Rate [CAGR] is 15.58%, the maximum drawdown [MaxDD] is -16.39%, the worst year is -2.04%, and the Sharpe Ratio is 1.02.
For comparison, a portfolio invested equally in the four assets, and rebalance annually had the following results:[CAGR] is 8.72%, the maximum drawdown [MaxDD] is -19.46%, the worst year is -9.41%, and the Sharpe Ratio is 0.99
The graphs of the equities of the two portfolios are shown in the figure below.
Figure 1. Model Portfolio Growth
Source: All the figures in this article were generated by the PV application.
Figure 2. Model Portfolio annual returns
Here are a few observations drawn from the annual returns graph.
- The momentum strategy had 3 years with negative returns: 2005, 2015, 2016.
- The equal weight strategy had 2 years with negative returns: 2008, 2018.
- The momentum strategy underperformed in 5 years: 2004, 2005, 2012, 2015, 2016.
Application for retirement accounts
In this section we analyze how this portfolio would have performed if it was applied mechanically by an investor in retirement. We assume that the investor started with $100,000 in January 2003, and decided to withdraw 8.0 % (adjusted for inflation) of the portfolio balance at the end of each year.
We compare the momentum strategy with the equal weight, rebalance annually, and a benchmark represented by SPY, the S&P500 ETF. The graphs of the balance of those portfolios are shown in the figure below.
Figure 3. Portfolio Growth with a 8% annual withdrawal
From the graphs we can see that the equal weight portfolio ends up with almost the same balance as the market benchmark. The advantage of the equal weight portfolio over the SP500 is that it achieved the same returns with much lower volatility of the balance. That resulted in an almost constant annual cash withdrawal.
The momentum portfolio shows a much higher balance than the benchmark over the whole period of time. That investor was able to withdraw much larger amounts of cash, particularly over the period from 2008 to 2018.
To better appreciate the differences in performance we show some numbers in the table below.
Timing Portfolio | Equal Weight | S&P 500 ETF | |
Starting balance - 1/2003 | $100,000 | $100,000 | $100,000 |
Balance - 12/2003 | $137,406 | $112,422 | $117,922 |
Withdrawal in Dec. 2003 | ($11,948) | ($9,776) | ($10,254) |
Balance - 12/2008 | $127,729 | $90,755 | $69,418 |
Withdrawal in Dec. 2008 | ($11,107) | ($7,892) | ($6,036) |
Final Balance - 12/2018 | $267,241 | $100,292 | $102,455 |
Withdrawal in Dec. 2018 | ($23,238) | ($8,721) | ($8,909) |
The outperformance of the portfolio with monthly reallocation over the benchmark is striking. The investor in the SP500 was hit hard in 2008, but as one can see in the balance graph, it slowly recovered by 2014. The equal weight portfolio suffered mild losses in 2008 and it quickly recovered by 2010.
One observation from the table: The withdrawals in 2018 were done at a rate of 8.72% to account for inflation.
Implications for investors
Going forward, for a long time horizon of at least 5 years, the simple portfolio will, most likely, outperform the US equity market. The outperformance will be significant during equity bear markets and during some deep corrections. That result was true in 2008, 2011, and 2018. This behavior is explained by switching the money to one of the bond funds, TLT or SHY. Because SHY invests in very short duration bonds, the portfolio is expected to perform well in markets with rising interest rates.
The simple portfolio can be easily applied with minimum effort. On the last trading day of each month, the investor has to rank the four assets by their total return over the last three months and allocate all the money to the asset with the highest return.
To apply the simple portfolio successfully, the investor needs to exercise patience and to accept that there may be periods when the strategy underperforms. Based on the observed behavior of the strategy, we expect that any underperformance will be minor. The worst year in the 2003 - 2018 period was a return of -2.04%. Again, the losses are small because the strategy invests in SHY or TLT during market corrections.
Conclusions
Starting in 2003 until now, a retired investor would have been able to withdraw steadily at a rate of 8%, adjusted for inflation, without decreasing the balance of his investment in the SP500 index. That is much higher than what most people would expect. Obviously, 2003 was a favorable year to start withdrawing from a retirement account. In the period from 2003 to 2018, the worst year to start would have been 2007.
Starting in 2007 the SP500 portfolio would sustain a rate of withdrawal of only 6.5% . The rate is 7.5% for the equal weight portfolio, and an amazing 14% for the momentum allocation portfolio.
One should not expect that the performance of the US market and of the portfolios presented in this paper will continue in the near future. Therefore, a retired person should not expect to be able to withdraw cash at 8% and higher from investments. But in hindsight, we see that those withdrawals were possible even over a period in which the equities suffered major losses in a bear market.
Also, the fact that the momentum allocation underperformed in 5 out of 16 years did not make the strategy unprofitable over the long run. Periodical underperformance of the strategy is unavoidable and it should be accepted.
An obvious solution to mitigate the impact of underperformance periods is to allocate only a portion of the money to a single strategy. For this portfolio, the volatility of the returns can be decreased by investing - as an example, 50% into the momentum strategy, and the other 50% into the equal weight portfolio. One can vary the ratio 50/50 to 60/40, or 40/60, or any other ratio to reflect one’s expectations.
Additional disclosure: The article was written for educational purposes and should not be considered as specific investment advice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.