Since our November site overhaul we have introduced the “Custom Portfolio Builder”, a basic tool to achieve Portfolio Diversification with our strategies. More than 350 investors have since used it to set up their investment portfolio for 2015.

What is the power behind it and how can I maximize the benefit of it?

Understanding Portfolio Diversification

Portfolio Diversification is a cornerstone to successful investing.  In simple form, when measurably diverse assets are combined in a portfolio, the investors portfolio risks are reduced without any sacrifice of returns.  This 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. When one asset is going down while the other is going up, the portfolios risk is reduced without the normal penalty of risk/return trade-offs.  We take advantage of that when our systems dynamically blend things like the S&P 500 and treasury bonds, which often exhibit negative correlation to each other (which is ideal).

Applying Portfolio Diversification to Strategies

Our subscribers can take this a step further.  Our investing algorithms take on a blend of the properties of their underlying assets combined with the “alpha” edges from the investing rules.  The returns of each investing strategy should be thought of as an asset, which are different and unique from the underlying holdings.  So holding a portfolio of strategies functions much like holding a portfolio of assets.  To evaluate the risk profile of the strategy, we examine the history of the returns of those strategies, much like when holding a basket of stocks the historical returns of each stock would be evaluated.

By creating a basket of strategies, if they exhibit diverse returns and risks, we lower the total basket’s portfolio risks, which means improved risk/return benefits for the investor, thus real portfolio diversification.

The best practice recommendation for our subscribers is to consider diversifying a portion of their investing capital across several investing strategies.  The first instinct is to simply pick the top performing historical strategies.  For an advanced investor, smartly thinking about managing risk, it is better to blend in some strategies that have low correlation to other strategies.  For a simple example, sometimes equity stocks are more “in favor”, sometimes government bonds are more “in style”.   Our strategies work the same way, even strategies with great track records will have times when they do not add as much value.  A different strategy, with good history, that uses a different approach and focuses in different asset classes & geography, will often be working well while the first strategy is a bit out of favor.

Our Tools to Help You in Portfolio Diversification

We have recently added a correlation matrix to our ‘portfolio builder’ to provide a further visual aid for composing portfolios. Here are two main factors which explain why both returns and risk improve when blending strategies:

Serial Portfolio Diversification: The nature of our momentum driven strategies, using a horse race analogy, is that they try to always win the race by hopping constantly on the fastest horse, e.g. the early leader might get tired mid-race while a former lagger catches up. Applying this analogy back to the investment world, a strategy switching between globally diversified assets and ‘naturally’ low correlated instruments like treasuries, bonds and commodities will in average benefit from lower correlation to a market index like the S&P500. This is what we call “Serial Diversification”, e.g. the monthly switches reduce the average correlation profile of our strategies.

You can easily see this in below chart which shows the 120 days correlation of some of our strategies versus the S&P 500. During prolonged up-times in the equity markets they positively correlate with the index, while during market corrections  they exhibit low or even negative correlation, thus offering crash protection When the lines are at the top, they strategies were highly correlated with the S&P500, when closer to the bottom, they are negatively correlated.

Portfolio Diversification using ETF strategies

120 day correlation of some of our strategies versus SPY (S&P500)

Cross-Strategy Portfolio Diversification:  When blending our strategies into a fixed weight portfolio you benefit from the less  than 100% correlation between the strategies. The different instruments and algorithms used in each strategy cause it to behave in a unique way in different market environments or regimes.  As an example see below the cross-correlation between the Bond Rotation Strategy and ‘BUG’ Strategy with the Maximum Yield Strategy from the 2011/12 Europe Sovereign Debt Crisis to the end of 2014, including  the turbulences in the second half of 2014.

While the Maximum Yield Strategy had a maximum drawdown of 14% August 2012, the Bond Rotation Strategy and the ‘BUG’ had new highs being up 10% and 6% in the preceding five months.

Portfolio Diversification with low correlation 401k IRA

120 day correlation of Bond Rotation and BUG versus Maximum Yield Rotation Strategy

The correlation matrix in the portfolio Builder shows the correlation between strategies and some common market proxies for the time period from Jan 2008 to Dec 2014. When using it you need to keep in mind that this as somewhat static snapshot, including the worst financial crisis, but also one of the best bull markets in history.

Portfolio Diversification ETF Rotation Strategies 401k IRA

How to apply Portfolio Diversification in practice? Here some example Portfolios:

It is important to note that these portfolios are constructed with perfect hindsight and limited to a 7 year test period during which one of the longest bull-market in the US history occurred. These portfolio have been calculated using non-linear solving techniques and the weights have been rounded to the next full 5%. As such, use them as aid for constructing your own portfolio, but recognize that such perfect conditions will not be met in the future.

Minimum Variance (Volatility) Portfolio: This portfolio with the lowest possible average volatility during the time period of only 5% might be of interest for investors who anticipate turbulences and are looking for stable growth while ‘sleeping well’ at night.

Portfolio Diversification ETF Strategies 401k IRA retirement



Maximum Sharpe Portfolio: With a Sharpe Ratio of above 2.3, this portfolio historically would have given the best Risk/Return profile by using at maximum the correlation profile of the underlying strategies. Depending on the market environment this portfolio has held positions in up to 10 ETF, offering a bond like volatility of 8% with an annual return of above 22%.

Portfolio Diversification ETF Rotation 401k IRA retirement

Highest Annual Return (CAGR) with a bond like 7% volatility: By switching to defensive global sectors or assets during market corrections it achieved a compounded annual return of 16% with a bond like volatility.

Portfolio Diversification ETF Rotation Strategies 401k retirement

Highest Annual Return (CAGR) with a SPY like 15% volatility: This is a typical application of a “risk/return” target portfolio and an example of how investors could use it in practice. Identifying our own risk “appetite” we strive to maximize our return.  The volatility target of 15% is chosen as example. The same could be done for let’s say 8% or 20% target volatility. Note again this is the volatility over the whole period. More advanced techniques with annual or even quarterly volatility targeting will be included in one of the strategies we want to release in the next months.

Portfolio Diversification ETF Rotation Strategies IRA retirement

To set these portfolios into perspective, here an overview of the Risk/Return profile of portfolios, our strategies and the market proxies.

Portfolio Diversification ETF Rotation Strategies 401k IRA retirement

In conclusion, using ourCustom Portfolio Builder allows you to set up powerful asset allocation scenarios using our strategies and achieving Portfolio Diversification. We hope this post aids you in building your own portfolio using above examples as framework and inspiration. As you can observe, very attractive portfolios can be build applying only two or three of our strategies. Or consider our “All Strategies” package, which gives you access to all our 8 current and all future strategies at an annual cost-ratio of 0.4% considering a 250k USD portfolio.

Correlation, especially in such a static view, is just one of the building blocks to a rock-solid portfolio. We have briefly touched here on our current work in progress to more adaptively allocate assets in a single-strategy by using minimum variance optimization – a variation of  the Modern Portfolio Theory.  For further optimizing a portfolio of strategies we are in parallel working on what we call a “meta-strategy” which allows adapting the portfolio more flexibly depending on how strategies behave in different market environments in terms of performance, volatility and correlation.

Let us know if we can support you in building other portfolios or provide more background information.

In anticipation of a vivid discussion,

Alexander Horn