Managing Portfolio Risk: The Ulcer Index

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Includes: CSHTX, HWDIX, PALL, PUI, VWIAX, WFCMX, WPSGX, YACKX
by: Charles Bolin
Summary

This article is intended for readers who want to manage risk in portfolios by making small changes monthly or quarterly to their portfolios if required.

Funds and Lipper Categories are ranked using Ulcer Index (risk), Martin Ratio (risk adjusted returns), Returns compared to Peers, and three month trend, among others from Mutual Fund Observer.

Several charts of current risks are highlighted.

Definitions

From Mutual Fund Observer Definitions:

ULCER Index: It measures both magnitude and duration of drawdowns in value. A fund with high Ulcer Index means it has experienced deep or extended declines, or both.

Martin Ratio: Like Sharpe and Sortino, it measures excess return, but relative to its typical drawdown. Martin excels at identifying funds that have delivered superior returns while mitigating drawdowns.

Beginning with the End in Mind

For this article, I select seven funds that have good risk adjusted returns to be in the February Model Portfolio. Below are the results for the past 13 months compared to the Vanguard Wellesley Income Fund (VWIAX). I use the past 13 months to reflect that investors are rotating into more conservative investments, and the Vanguard Wellesley Income Fund because it is a great conservative Mixed Asset Fund.

Source: Portfolio Visualizer

Introduction

Mutual Fund Observer (MFO) is used to rank funds and Lipper Categories based on risk, higher risk adjusted returns, Return versus Peers, and three month momentum, among other criteria. The Best Lipper Categories for Bond, Municipal Bond, Alternative, Mixed Asset, US Equity, Global Equity, International Equity, Sector Equity, and Commodity sub categories are summarized. I prefer to describe the risks and rewards of the funds and let readers decide how these funds may fit into their portfolios.

The list of funds is further refined to 15 funds that are used in Portfolio Visualizer to maximize return with a minimum equity exposure of 25% following Benjamin Graham's guidelines. Seven of these funds are selected to be in the February Model Portfolio which maximizes return for 5% volatility.

Top Lipper Categories

Below are the Top Ranked Lipper Categories. Generally, the further down the table you look, the higher the risk. The metrics shown below are the averages for the funds that I selected from MFO metrics.

CATEGORY Risk Rating Martin Sharpe Ulcer
BOND
1) International Income 1.0 5.0 27.4 1.5 0.1
2) Global Income 1.0 5.0 23.6 0.8 0.1
3) Short Invest Grade Debt 1.0 4.5 12.4 0.4 0.1
4) Multi-Sector Income 1.0 5.0 7.0 0.6 0.1
5) U.S. Mortgage 1.0 4.3 5.5 0.5 0.2
MUNICIPAL BOND
1) Muni Short-Intmdt Debt 1.0 3.0 1.3 0.2 0.3
2) Muni General & Insrd Debt 1.0 4.0 3.4 0.6 0.5
ALTERNATIVE
1) Alt. Multi-Strategy 2.0 5.0 1.2 0.3 1.2
2) Alt. Global Macro 2.0 5.0 0.5 0.1 1.4
MIXED ASSET
1) Mxd-Ast Target Today 1.7 5.0 (0.9) (0.3) 1.3
2) Flexible Portfolio 3.0 4.0 (0.8) (0.3) 3.7
US EQUITY
1) Small-Cap Core 4.0 5.0 0.4 0.1 3.9
2) Multi-Cap Core 4.0 4.5 0.0 (0.0) 4.6
3) Mid-Cap Core 4.0 4.7 0.1 (0.0) 4.6
4) Large-Cap Value 3.3 5.0 (0.1) (0.1) 3.9
GLOBAL EQUITY
1) Global Small-/Mid-Cap 3.0 5.0 (0.0) (0.0) 3.3
2) Global Multi-Cap Core 3.0 5.0 (0.4) (0.1) 3.4
INTERNATIONAL EQUITY
1) Intern Large-Cap Growth 4.0 5.0 (0.3) (0.1) 5.0
2) Intern Multi-Cap Growth 3.5 5.0 (1.2) (0.5) 5.1
SECTOR EQUITY
1) Global Real Estate 4.0 4.5 1.2 0.3 3.5
2) Global Financial Services 2.0 5.0 0.8 0.3 1.8
3) Utility 3.0 5.0 7.3 1.2 1.7
4) Real Estate 4.0 3.0 1.5 0.4 4.4
COMMODITY
1) Com Precious Metals 5.0 5.0 4.6 1.4 6.2

Source: Created by Author based on Mutual Fund Observer data.

Top Funds for Top Lipper Categories

I list funds separately for Vanguard, Fidelity, Exchange Traded Funds, and all other mutual funds because readers (and myself) may have preferences or limitations in their choices.

CATEGORY ETF VANGUARD FIDELITY OTHER
BOND
1) International Income VTABX
2) Global Income HOLD HWDIX
3) Short Invest Grade Debt SPSB VFSTX FYBTX RUSIX
4) Multi-Sector Income CSHTX
5) U.S. Mortgage LMBS FMSFX BATAX
MUNICIPAL BOND
1) Muni Short-Intmdt Debt VMLTX FSTFX OWMBX
2) Muni General & Insrd Debt FMB VWAHX FHIGX WFCMX
ALTERNATIVE
1) Alt. Multi-Strategy DRRIX
2) Alt. Global Macro DVRIX
MIXED ASSET
1) Mxd-Ast Target Today VTINX FIKFX JRFOX
2) Flexible Portfolio INKM FAYZX MBEAX
US EQUITY
1) Small-Cap Core SMDV QRSVX
2) Multi-Cap Core SPLV VTCLX FFSMX MRFOX
3) Mid-Cap Core XMLV FMCSX IVOIX
4) Large-Cap Value MGV FSDIX YACKX
GLOBAL EQUITY
1) Global Small-/Mid-Cap VMNVX
2) Global Multi-Cap Core ACWV MVGIX
INTERNATIONAL EQUITY
1) Intern Large-Cap Growth HEWC
2) Intern Multi-Cap Growth EFAV LLINX
SECTOR EQUITY
1) Global Real Estate FFR MGLIX
2) Global Financial Services PGF
3) Utility PUI FSUTX
4) Real Estate SRET
COMMODITY
1) Com Precious Metals PALL

Source: Created by Author based on Mutual Fund Observer data.

Top Funds - Narrowing Down the List

Below are the funds with the highest risk adjusted returns compared to the risk. Most notable are the low risk, higher risk adjusted returns of the bond funds.

Source: Created by Author using data from Mutual Fund Observer

These are the funds that made the short list to be evaluated in Portfolio Visualizer. Defensive funds such as utilities, real estate, dividend, large cap value, low volatility funds dominate the list, along with bonds.

Symbol Fund Ulcer Martin 3 Mo Trend
PUI Invesco DWA Utilities Momentum 1.9 8.5 2.4
MGLIX MFS Global Real Estate I 3.3 1.6 5.1
VTABX Vanguard Total International Bond Index 0.1 27.4 1.1
PALL Aberdeen Standard Physical Palladium 6.2 4.6 8.9
SRET Global X SuperDividend REIT 4.4 1.5 4.8
HWDIX Hartford World Bond I 0.1 23.6 1.0
RUSIX RBC Ultra-Short Fixed Income I 0.0 40.1 0.7
XMLV Invesco S&P MidCap Low Volatility 3.1 1.5 2.0
WFCMX Wells Fargo CoreBuilder Shares 0.3 7.4 1.0
WPSGX AB Concentrated Growth Adv 4.5 0.9 3.6
MRFOX Marshfield Concentrated Opportunity 3.4 1.0 2.9
CSHTX AB Taxable Multi-Sector Income 0.1 7.0 0.7
PGF Invesco Financial Preferred ETF 1.8 0.8 2.7
LMBS First Trust Low Duration Opportunities 0.0 7.6 0.4
YACKX AMG Yacktman I 2.7 1.1 1.7

Source: Created by Author using data from Mutual Fund Observer

Model Portfolio Based on Top Funds

Of the 15 top funds, I enter a maximum constraint into Portfolio Visualizer according to my own risk tolerance. I limit sector and commodity funds to 5% allocation per fund.

I consider the list below to be a starting point for further research and not a recommended portfolio. The one fund that I would scrutinize closely is PALL (palladium). I own a gold ETF, but have not researched palladium before. Stocks are 82% large cap and 15% mid cap. Bonds are 70% higher than "A" rating and in the short to intermediate range.

Symbol Allocation Morningstar Rating Great Owl Return Stdev Max Drawdown Sharpe Sortino
PUI 5% 4 No 11.5% 12.9% -9.1% 0.8 1.3
PALL 5% Yes 23.5% 19.0% -12.6% 1.1 2.1
HWDIX 15% 4 No 4.4% 1.7% -0.3% 1.5 5.1
WFCMX 20% 5 Yes 3.2% 2.4% -1.0% 0.6 1.0
WPSGX 15% 4 No 11.2% 17.1% -12.4% 0.6 1.0
CSHTX 20% 3 Yes 2.3% 0.9% -0.4% 0.5 0.9
YACKX 20% 5 Yes 7.4% 9.8% -4.9% 0.6 1.0
Portfolio Performance
Max Rtn @ 5% Vol 6.9% 4.9% -1.6% 1.0 2.0
VWIAX 0.8% 6.0% -3.5% -0.2 -0.3

Source: Created By Author. Morningstar rating is from Morningstar, Great Owl is from Mutual Fund Observer, Metrics are from Portfolio Visualizer

Category Weight
US Stocks 30.1%
Intl Stocks 3.7%
US Bonds 38.0%
Intl Bonds 17.4%
Other 5.2%
Cash 5.7%

Source: Created by Author using data from Portfolio Visualizer

Review of Previous Model Portfolios and Baseline Funds

Each month, I create a Model Portfolio around different themes. The returns over the past year have been higher than Bench Mark Funds, as well as the Sortino Ratio (Risk Adjusted Returns). I started using Mutual Fund Observer in November.

Bench Mark Funds Rtn 3 Mon Rtn 12 Mon Max Drawdown Sortino
Vanguard Wellesley 1.8% 4.2% -3.5% -0.25
iShares Core Cons Allc 1.6% 2.0% -4.1% -0.45
Vanguard Wellington -0.5% 4.5% -6.8% -0.07
S&P 500 -3.0% 7.0% -13.5% 0.19
Portfolio Theme Month
Managing Risk Feb-19 2.7% 10.4% -1.7% 1.80
Low Risk Jan-19 1.9% 7.1% -2.7% 0.52
Great Owl ETF Dec-18 0.8% 5.9% -3.4% 0.46
Great Owl Nov-18 0.8% 4.9% -3.1% 0.28
Employer Plans Oct-18 0.8% 5.3% -6.8% 0.25
Full Cycle Sep-18 0.4% 6.1% -3.8% 0.58
Bear Market Aug-18 0.3% 8.4% -6.9% 0.56
Max Rtn for Target Vol Jul-18 -0.7% 8.4% -8.0% 0.68
Late Stage Jun-18 -0.5% 7.6% -5.6% 0.47
Reducing Risk May-18 -0.9% 3.5% -8.2% 0.00

Source: Returns are from Morningstar and draw down, Sortino are from Portfolio Visualizer

Risks

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 Economic Policy Uncertainty Index. The level of risk is moderate, but the momentum is concerning.

Source: Created by the Author based on data from the St. Louis Fed Reserve

The Yield Curve is flat and portions of it inverted which suggests a higher, longer term risk of recession.

Source: Created by the Author based on data from the St. Louis Fed Reserve

Below is the valuation Indicator which is composited from market capitalization to GDP, Tobin Q Ratio, Cyclically Adjusted Price to Earnings Ratio, Price to Profits for the US Economy, and relationship of dividends to 10 year treasuries. Valuations are not as high as prior to the Technology Bubble, but are higher than prior to the Financial Crisis.

Source: Created by the Author based on data from the St. Louis Fed Reserve

Price to Earnings per share can be influenced by short term lagging trends, accounting rules and share buybacks; however, it is worth looking at. Note that EPS are often high prior to a recession, as well as P/E ratios that appear to be lower prior to a recession. Note also how high EPS are now due to the temporary tax cuts. It is not sustainable in my opinion.

Source: Created by the Author

Summary

My strategy for the past year has been to reduce risk while the market is high. I use dips to assess what is likely to do better in the next bear market. While I do not own any of the funds in the February Model Portfolio, I own many funds in similar Lipper Categories as those shown in this article, and my personal allocation is similar to the Model Portfolio.

Disclosure: I am/we are long VTABX, VWIAX, SPLV, VTINX, FIKFX, VMNVX, FSUTX. 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.