Re-balance Cycle Reminder

The next re-balance time will be on next MondayDecember 24, 2012. You can also find the re-balance calendar of 2012 on ‘Dashboard‘ page once you log in.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Please note that we now list the next re-balance date on every portfolio page.

How to Use Asset Trends and Correlations for Asset Allocation

We released asset trends & correlations page last week. Our newsletter on this new feature has drawn some considerable interests.  This newsletter is a follow up to explain this feature in more details. 

Basic Concepts

Asset Trends — For every asset class such as U.S. (Stocks) Large Cap Blend, a fund (usually is an index mutual fund) is designated as its benchmark index. For example, US Large Cap is represented by Vanguard Large Cap Index Inv (VLACX). We then use the average of the total returns (including dividends and distributions) of past 1, 4, 13, 26,52 weeks as its trend score. The trend score is used to measure the asset class’s recent (intermediate term) return trend.  If you are an expert user, you can input a fund to calculate its trend score. 

Asset Correlations — For any two asset classes, we measure their correlation using their benchmarks’ return series. Notice this is about the (total) returns, not price movement. A correlation is a number from -1 to 1. 1 means perfect correlation, 0 means no correlation and -1 means perfect inverse correlation, i.e. when A has 1% return, B has -1% return or vice versus.  Again, if you are an expert-level subscriber, you can input any two funds to find out their correlation. Correlation calculation is based on past 1 year return history. However, for expert users, you can specify this such as 2 years etc. 

Asset Correlation History — Correlations between two assets or funds can change along the time, sometimes very dramatically. For example, the correlation between Gold and US stocks has changed from -0.52 to 0.48. It is useful and important to understand correlation history. 

Correlations & Diversification In a Portfolio

We all understand that it is important to construct a diversified portfolio. Mathematically, diversification is measured by how much the holdings in a portfolio are correlated. Many beginners mistaken diversification as the number of holdings or take comfort in holding many funds or stocks in a portfolio. However, a real measurement is the pair wise correlations and their overall resulting standard deviation of the portfolio. 

Let’s take a look at the elegant design of the  Permanent Portfolios (or see Four Pillar Based Portfolios): it consists of mainly 4 assets: US stocks, Long Term Treasury Bonds, Gold and Cash.  The following shows how the 3 active assets (stocks, long term bonds and gold) were correlated in the past 5 years. 

It is interesting to see that other than a brief period in 2010, there was always at least one pair had negative correlation. In fact, most of the time, there were two pairs of negative correlation and one pair positive correlation. These negative correlations imply the assets hedge with each other. They work well in the portfolio.  A perfect instance is the financial crisis from late 2008 to early 2009. In the period, permanent portfolio had at least two assets that were negatively correlated, carrying the portfolio through the disaster with relatively low drawdown. 

In addition to the permanent portfolio, Yale endowment manager David Swensen is one of few who propose to use long term Treasury bonds as a hedge in a portfolio. See  David Swensen Six ETF Asset Individual Investor Plan. In mutual funds, First Eagle funds have been very successful in using gold as portfolio hedge. 

In a short term, no one can guarantee all of the assets in a portfolio can hedge with others. This leads to another important and last resort principle in portfolio construction: having an acceptable risk (profile) for a portfolio. To protect a big drop in one day or week or even one month, such as the one in 1987, one can not rely on diversification alone. You have to distinguish between risk and stable assets. Because of the nature of their underlying economic values and markets, bonds, especially US government backed bonds in the recent history, tend to withstand market disaster much better. 

Long Term Expected Returns & Asset Trends In a Portfolio

Expected Returns — as we stated in our previous newsletters, the first step in constructing a good portfolio is to make sure all of the holdings have positive long term expected returns. In fact, the higher, the better. These expected returns will determine the portfolio’s long term expected returns. For example, in the permanent portfolio, US stocks have long term average annual total returns of 7.8% (nominal returns with 2.8% inflation) while 20-year long term US Treasuries have about 4.6%. All are based on Rick Ferri. See the Bogleheads’ excellent wiki page on this subject. Historically, gold also exhibits a similar return like stocks. All of these can help one to derive a ball park average expected returns for your portfolio. 

Asset Trends — asset trends represent an intermediate asset movement trend. They are not expected returns. However, because of the nature of momentum, one can utilize such trends to rotate among an array of diversified assets, further avoiding weak assets that can decline while capturing rising assets to realize intermediate term profits. A similar trend score mechanism is used in our Tactical Asset Allocation. Even if you are not following Tactical Asset Allocation strategy, Asset trends can also give a bird’s eye view on current investment environment by showing a big picture. This can help you for portfolio re-balance, deposit new money or withdraw from a portfolio. 

What to do for an investor: putting it together

MyPlanIQ has tried to provide useful tools for long term investors to manage their investments better.  The following is the check list for portfolio construction:

  • Examine your holdings’s asset allocation
    • Expected returns — these include generic long term returns such as those given by Bogleheads or latest estimated such as those given by John Hussman, or GMO. 
    • Correlations — Look at how each pair of holdings are correlated to correctly understand whether your portfolio is diversified enough.  Use long term and historical correlation data to get a better dynamic picture as correlations can change over times. 
  • Examine your holdings’s fund choices
    • Expenses — index funds such as Vanguard’s sport lowest expense ratios and they are much safe to track an asset class movement. 
    • Diversification — if a fund is an actively managed fund, you want to understand whether the fund is diversified enough. If a fund is overly concentrated, you need to be concerned about its risk. One advantage using MyPlanIQ’s asset allocation strategies is that all strategies have built in fund rotation mechanism to automatically eliminate weak performers. However, you’ll need to be more active to monitor funds in an asset class or the model portfolio you are following. 

Portfolio Performance Update

The following shows how tactical portfolios in our featured ETF plans have performed so far: 

Portfolio Performance Comparison

Ticker/Portfolio Name 1 Week
1Yr AR 1Yr Sharpe 3Yr AR 3Yr Sharpe 5Yr AR 5Yr Sharpe 10Yr AR 10Yr Sharpe
Vanguard ETFs Tactical Asset Allocation Moderate 0.9% 9.5% 10.6% 183.9% 8.3% 76.0% 6.4% 50.8% 10.2% 78.4%
Permanent Global Portfolio ETF Plan Tactical Asset Allocation Moderate 0.3% 3.1% 5.0% 92.6% 7.4% 69.9% 6.4% 52.5% 10.8% 88.2%
Six Core Asset ETFs Tactical Asset Allocation Moderate 0.5% 5.8% 6.2% 115.3% 4.7% 49.8% 6.4% 56.2% 10.1% 83.7%
Retirement Income ETFs Tactical Asset Allocation Moderate 0.8% 6.2% 8.3% 130.6% 9.7% 100.4% 6.5% 58.5% 11.8% 100.2%
MyPlanIQ Diversified Core Allocation ETF Plan Tactical Asset Allocation Moderate 0.8% 7.6% 9.0% 148.2% 6.3% 64.2% 7.3% 64.7% 11.4% 96.2%

*: NOT annualized

**YTD: Year to Date

See the up to date comparison >>

The TAA portfolios have performed reasonably well, given current sluggish investment environment: no assets have shown strong performance trends this year so far. TAA was able to get on stocks (especially US stocks and lately international stocks) and some out performing bonds (such as emerging market bonds). 

Market Overview

Today’s manufacturing ISM report is alarming: At 49.5, the headline PMI print was the lowest since July 2009, the biggest miss to expectations of 51.4 in 5 months, and down from 51.7.  Sub-50 print indicates a contraction in the manufacturing space, usually a precursor to overall recession. We don’t know yet whether the recession predicted by John Hussman and ECRI has finally shown its face. For now, we will monitor our asset trend table on Asset Trends & Correlations or more detailed ones on 360° Market Overview

As weak as the ISM number shows, the market trends table has the most risk on (bullish) case for stocks: international, emerging markets and US stocks rank the highest. US high yield bonds and emerging market bonds, all sitting on the riskiest spectrum in bond segments, are ranked highest among bonds. Whether this is a blip or a sustainable trend remains to be seen.  

We again copy our position statements (from previous newsletters): 

Our position has not changed: We still maintain our cautious attitude to the recent stock market strength. Again, we have not seen any meaningful or substantial structural change in the U.S., European and emerging market economies. However, we will let markets sort this out and will try to take advantage over its irrational behavior if it is possible. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

Latest Articles

How can we improve this newsletter — we value your inputs –Thanks to those who have already contributed — we appreciate it.

Any investment in securities including mutual funds, ETFs, closed end funds, stocks and any other securities could lose money over any period of time. All investments involve risk. Losses may exceed the principal invested. Past performance is not an indicator of future performance. There is no guarantee for future results in your investment and any other actions based on the information provided on the website including, but not limited to, strategies, portfolios, articles, performance data and results of any tools. All rights are reserved and enforced. By accessing the website, you agree not to copy and redistribute the information provided herein without the explicit consent from MyPlanIQ.