It has been now 18 months since our post on “The power of diversification: Portfolios of Logical Invest Strategies”. Back then our main argument for diversification using a robust portfolio of several of our strategies was that “diversification is ‘a rare free lunch’, it is well accepted part of modern financial portfolios, and to stay financially healthy it is important not to skip lunch”.

Several new strategies have been published since then, among them the “NASDAQ 100” strategy, the “Gold-Currency” strategy and our “Hell on Fire”, the 3x leveraged Universal Investment strategy. At the same time, we went through the bumpy start into 2016 and most recently the waves created by the BREXIT referendum.

Does our stated hypothesis of formerly presented portfolios still hold true? How have the individual components performed, and most importantly, have they added value through low correlation? Have new optimum portfolios emerged since then? These are some of the questions we want to shed light on in this new post.

Correlation, still the grand lady of Portfolio Diversification

The year 2015 was without doubt one of the most difficult for momentum based investment strategies like ours: Sideward moving markets without clear trends in all asset classes, heavily event driven movements triggered by central banks, especially in bonds.

The nervousness in markets is clearly visible in below chart depicting the 120 days correlation of some of our strategies to the S&P 500: Our “Sleep Well Bond Rotation (BRS)” had a strong performance late 2014 and early 2015 coupled with strongly negative correlation to equities, thus being a main force for performance and diversification.

However, things changed around mid-2015, when suddenly bonds became strongly correlated to equities, and our Gold-Currency strategy published in December 2015 took over as main diversifier in portfolios with strongly negative correlation to equities.

When equities went very suddenly south early 2016 based on fears of a slow-down and debt issues in China, the S&P 500 lost 7% within the first 6 weeks in the new year. Once again diversification showed to be fundamental to smoothen portfolio volatility and reduce draw-down. Our Bond Rotation gained 3%, while the Gold-Currency strategy increased by 7% in the same 6 weeks period, thus a balanced portfolio was only marginally affected by this turmoil.

In the aftermath of the June 23 BREXIT referendum, the “serial diversification”, e.g. the effect that monthly switches between the “fasted horses” reduce the average correlation profile of our strategies of our strategies, played out quite nicely. While equities took a deep dive only to recover over a 2 weeks period, strategies with bonds as crash protection like the Maximum Yield Rotation Strategy (MYRS) and Universal Investment Strategy (UIS / 3x UIS) jumped by 4.4%, 3.6% (and even 10.5% for the 3x UIS) during June 2016.
Correlation

Optimum Portfolios on the Markowitz Efficient Frontier

We updated our Excel Portfolio Builder and calculated the hypothetical best combinations of our strategies for achieving prominent investor objectives:

  • Maximizing the Sharpe Ratio or the Risk-Benefit balance of the investment
  • Minimizing volatility or keeping it below a certain level which the stomach can handle
  • Reducing Draw-Down, the biggest evil when it is about sticking long-term to a portfolio

Some disclaimers before we start exploring the individual portfolios: This optimization is Markowitz style applied Modern Portfolio Theory looking for portfolio on the Efficient Frontier, that is using past long term median returns and covariance matrix to optimize a portfolio towards the set objective (here maximizing return for given levels of volatility) using secondary constraints (maximum Volatility or DrawDown Level).

Interested readers will see where above emphasis points lead to: Trying to predict future performance based on average past returns from 2009 to 2016 through a mathematical optimization with by nature very volatile covariance matrices might serve as an indication or rough guide for building a diversified portfolio – but not more: It is not to be understood as exact science and does not substitute your own analysis and most importantly “getting comfortable” with putting money into the underlying ETFs.

Another limitation of this exercise is that we did not put a limit on the number of strategies to be employed in the portfolio, that is while in some portfolios only two or three of our strategies receive weights, in other portfolio there are weights assigned to up to all eleven strategies – which clearly will not be a workable option even to our “All Strategies” subscribers.

However, by letting the optimization pick any and all of our strategies you get an indication of where to look for setting priorities in your portfolio, e.g. get a feeling of which strategies to weight higher, and which ones to either eliminate or substitute by other with similar behavior. In a follow-up article – and hopefully backed up by many requests from our readers in the comment section – we will then present some selected portfolio employing a maximum of three strategies for easier handling.

Here a short overview of some prominent portfolio options including the weights of individual underlying strategies. In the following we will dive deeper into some selected strategies, for keeping things easy all options can be found in a separate link displayed at the end.

Heatmap

Volatility minimized or constrained portfolio options:

Minimum Volatility Portfolio:

For most of our readers this combination will not be a surprise. Combining Bond Rotation and Permanent Portfolio with another low-correlation strategy as the Gold-Currency Strategy results in a minimum volatility of only 5.9% but a compound return of close to 14%. This is equity like return with bond like risk at its best.
MinimumVolatility

Maximum Sharpe Portfolio:

This is for sure only a theoretical option for most of our audience, investing in nine individual strategies with up to 30 underlying ETF most probably is too much complexity to replicate this dream Sharpe ratio of 2.86.

However, look at the highest weight strategies to understand the logic behind: Bonds, Gold-Currency, Nasdaq 100, and Permanent Portfolio sum up to 80% of the allocations – this might be a viable option for dedicated DIY investors seeking the “biggest Sharpe bang for the buck”.

MaximimSharpe

Volatility constraint of 15% (Historical average for classical 60/40 Bond Equity portfolio):

This is one of the most popular portfolio scenario requested by readers and also my favorite.  15% volatility is about the level one would expect from a 60/40 Bond Equity portfolio.

The big change to the last post 18 months ago is that now our solver does not suggest any allocation into the Bond Rotation Strategy anymore, but the Gold-Currency strategies takes its role as main diversifier with 27% allocation. Also keep in mind that the bond component of MYRS and UIS act as serial diversifiers for smoothening the ride towards a 40% CAGR with a historical maximum drawdown of only 13%.

MaxCagr_Vol15%

Volatility constraint of 25% (or: why constraints anyway?):

If you are rather the “No risk, no fun” type of investor or have a separate pocket for wild rides without getting sea-sick, then this might be your option. Yet, we do not encourage anybody to put any money into such portfolio that might be needed for living the next 5 years.

Being invested in three times leveraged ETF and the top four NASDAQ 100 stocks is not the investment style we advocate for, but an average 52% CAGR with a Sharpe Ratio above 2.0 is indeed offering a huge profit kick.

MaxCagr_Vol25% 

DrawDown minimized or constrained portfolio options:

We frequently get requests for portfolios which limit the maximum drawdown and implicitly this is also what we´re looking for: Maximizing return while not suffering the hard-to-stomach times when you only see red and start doubting about your portfolio (and the rest of the world ..).

However, keep in mind that drawdowns are a difficult animal to control: Dives from quick and sharp sell-offs are nothing a momentum based rotation strategy with a typical 50-80 days lookback can avoid through any “crash-protection mechanism”. Diversification across different strategies with alternating logic and investment style can only minimize the effects, but never completely off-set. Too much “Diworsification” through bonds or safe heavens slows performance down or can even increase drawdowns in these times where markets are central bank controlled.

Mechanism like stop-loss limits either hurt long-time performance, or even worsen things when you get stopped out during minute-crashes only to see things getting back to normal some instances later. And finally exotic methods like using OTM options normally come at prohibitive costs.

So, while long time volatility constraints work quite well, below constraints on drawdown can already be obsolete by tomorrow after the next central banker makes an unexpected announcement, or any other external shock, therefore take them with a grain of salt.

Maximum 10% DrawDown Constraint:

Even this portfolio has only shown a maximum 10% drawdown in the recent years, we still consider it quite aggressive and not our preferred option. Above 50% in Nasdaq and 20% in 3x leveraged or volatility ETF is quite risky, even if the remaining 28% invested in Gold-Currency balance things a bit.   

MaxDD10

Two times leveraged portfolio options:

For investors with margin accounts here two leveraged options which might be interesting. Using leverage is often mis-understood as betting one’s last shirt and associated with pure gambling.

Here the counter-argument: If you do have access to a margin account, a well-balanced portfolio, know it´s risk profile well and are comfortable sitting-out longer under-water periods, it makes economic sense to achieve a higher return on your own equity – using the currently extremely low interest charged by your broker.

In this case, make sure you remain on the very conservative edge on the volatility side to stay as far as possible from potential margin calls, that is, leverage low volatility locking in higher Sharpe, not looking for higher returns only – like the portfolio proposed below.

Two times leveraged Maximum Sharpe Portfolio:

Below portfolio is consistent with its simple leverage sibling: Bond Rotation and Gold-Currency are the main components, with the rest being split across 8 other strategies. Definitely a complex portfolio which will take quite some time to rebalance, but worth it considering a historical Sharpe ratio above 3.0 resulting from a 52% return at an S&P 500 like 17% volatility level.
Lev2-MaxSharpe

Two times leveraged Minimum Volatility Portfolio:

To be even on the safer side, this two times leveraged portfolio consisting of Bond Rotation, Permanent Portfolio and Gold-Currency has a historical volatility of only 12% and a similar drawdown.

Lev2-MinVola

Summing it up

In conclusion, using either of our Online or Excel based ‘Custom Portfolio Builder’ allows you to set up powerful asset allocation scenarios using our strategies. We hope this post aids you in building your own portfolio using above examples as framework and inspiration.

The evolution from static buy-and-hold portfolios into a multi-level concept of setting up a diversified portfolio of smart individual tactical investment strategies breaks the classical “Efficient Frontier” shifting it more than just a notch towards higher performance at the same level of risk, or less risk at the same performance levels.

Yet, we´re still in the phase where we apply fixed-weight allocations to strategies in order to come up with a buy-and-hold portfolio of now individual strategies. What if we would apply the same switching mechanism we apply in our individual strategies at a portfolio level? Switching to the fastest horses in our stable of strategies once a month? Yes, we know, we´ve been preaching and teasing this ‘new’ approach now for more than a year – but stay tuned, we´re about to launch it! Finally!

Let us know if we can support you in building other portfolios or provide more background information. Please also post in the comment section any specific portfolio combination you’d like to see so we can model the most requested for you.

In anticipation of a vivid discussion,

Alexander