Diversification, Style AND Asset Rotation Improve Portfolio Performance without Incurring Extra Risk

10/08/2010 0 comments

In a previous article we compared the results of a highly diversified ETF portfolio with strategic asset allocation that permitted style rotation against strategic asset allocation without style rotation. We did this by restricting the other portfolios to one fund per asset class. We saw that style rotation squeezes out a little more in return for more trading. Putting this together with a “one-click” execution capability that Folio Investing offers offsets some of the effort.

 A snapshot of the results graph is shown above with summary data in the table below.

Annual returns 1 year 3 years 5 years
Folio SAA Moderate 12.43 3.26 8.15
6 SIB ETF SAA Moderate 11.53 2.51 7.89
6 SIB Index SAA Moderate 10.63 1.66 6.72
5 SIB Index SAA Moderate 12.44 2.16 7.00


In this article, we are going to step up to the next level and take the same portfolio and deploy strategic asset allocation – allowing the portfolio to flow with asset momentum and review what additional risk adjusted returns are delivered. 

Strategic Asset Allocation will move funds in asset classes but each asset class will always have the same weighting in the overall portfolio.

Tactical Asset Allocation takes this one step further, enabling asset classes with poor market momentum to be swapped out for another class. Note that fixed income will never be swapped out but may have an increased percentage of the overall portfolio in turbulent times. This approach seeks to limit the downside while participating in the upside.

Intuitively we would expect higher returns offset against more trading activity.
We are going to compare the Folio SAA moderate that delivered the best performance in the SAA category with a tactical asset allocation of the same portfolio and a 6 Asset SIB with both ETF’s and Index funds. This will enable us to compare
  • Tactical versus strategic asset allocation
  • The benefit of multiple ETF’s per class versus a single ETF per class
  • How ETF’s compare against market indices.

 

A snapshot of the results graph is shown above with summary data in the table below.

 Returns Table of the Different Portfolios

Annual returns 1 year 3 years 5 years
Folio SAA Moderate 12.43 3.26 8.15
Folio TAA Moderate 11.74 9.24 11.26
6SIBETF TAA Moderate 9.57 9.62 15.68
6SIBIndex TAA Moderate 8.41 9.22 13.43


The first thing to note is that tactical asset allocation performs better by mitigating downside risk. The strategic asset allocation has performed well as we recover from the sharp drops of recent years but with continuing uncertainty, minimizing downside risk. Again, the benefit of having one-click execution relieves much of the mechanical overhead in pursuing a tactical asset allocation strategy.

 
It is also interesting to note that in this simulation, the best performance comes from the six asset class SIB with fewer fund choices than the Folio portfolio. The reason is that the Folio portfolio used more conservative bond choices that limited the downside but also, slightly reduced the upside. This is a tradeoff that each investor has to make as to whether they want to limit the risk at the cost of a little bit of upside.
 
Finally, both ETF portfolios perform very well against market index funds.
 
Takeaways
  • Tactical Asset Allocation reduces downside risk and that wins in the current uncertain environment
  • ETF’s perform very well against market index funds in both tactical and strategic asset allocation strategies
  • Having a simple and low means of executing the trades is an essential part of a hybrid approach to make it easy on the investor

 

labels:investment,

Symbols:BND,BWX,CIU,CSJ,DBC,DVY,EFA,EFG,EFV,EMB,GLD,HYG,IEF,IEI,IJJ,IJK,LQD,MBB,QQQQ,RWX,SCZ,SHY,TIP,VB,VBK,VBR,VEA,VNQ,VO,VTI,VTV,VUG,VWO,WIP,Portfolio-Building,with,ETFs,Closed-End,Funds,Commodity,ETFs,Currency,ETFs,Developed,Market,ETFs,




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