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Summary Portfolios using QQQ and bond mutual funds achieved high returns with low risk from 1999 to 2015. The parameters of the mean-variance optimization (MVO) algorithm can be easily adapted to the risk tolerance of the investors. MVO strategy is very robust, and it may continue to perform well in the future. The idea of writing this article came from a comment by Varan, a frequent contributor on Seeking Alpha. Varan suggested that I investigate the performance of a portfolio using the PowerShares QQQ Trust ETF (NASDAQ: QQQ ) during the 2000 to 2003 period. Since two funds in the portfolio, the iShares 1-3 Year Treasury Bond ETF (NYSEARCA: SHY ) and the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ), were created in July 2002, Varan suggested that I use two mutual funds with similar holdings, the Vanguard Long Term Treasury Fund (MUTF: VUSTX ) and the Fidelity Limited Term Government Fund (MUTF: FFXSX ). In the articles on the simple ETF portfolio the simulations did not cover the 2000-03 bear market when QQQ had a maximum drawdown of -82.96%. We frequently hear investors saying that tactical asset allocation using bond funds will not work anymore because everybody expects a secular bond bear market. So, it is relevant to ask how tactical asset allocation worked using an asset that suffered a severe bear market. In that respect, QQQ is a prime example, having suffered such deep and prolonged losses during the 2000-03 bear market. It has taken twelve years for QQQ to recover and reach the level it had at its top in March 2000. The new portfolio is made up of the following four assets: SPDR S&P MidCap 400 ETF (NYSEARCA: MDY ) PowerShares QQQ Trust ETF Vanguard Long Term Treasury Fund Fidelity Limited Term Government Fund Basic information about the funds was extracted from Yahoo Finance and marketwatch.com and it is shown in table 1. Table 1. Symbol Inception Date Net Assets Yield% Category MDY 5/04/1995 14.23B 1.41% Mid-Cap Blend QQQ 3/03/1999 36.93B 0.96% Large Growth VUSTX 5/19/1986 3.27B 2.75% Long Term Treasury Bond FFXSX 11/10/1986 385M 0.68% Short Term Treasury Bond The data for the study were downloaded from Yahoo Finance on the Historical Prices menu for MDY, QQQ, VUSTX, and FFXSX. We use the daily price data adjusted for dividend payments. For the adaptive allocation strategy, the portfolio is managed as dictated by the Mean-Variance Optimization (MVO) algorithm developed on the Modern Portfolio Theory (Markowitz). The allocation is rebalanced monthly at market closing of the first trading day of the month. The optimization algorithm seeks to maximize the return under a constraint on the portfolio risk determined as the standard deviation of daily returns. The portfolios are optimized for three levels of risk: LOW, MID and HIGH. The corresponding annual volatility targets are 5%, 10% and 15% respectively. In Table 2 we show the performance of the strategy applied monthly from June 1999 to September 2015. Table 2. Performance of MVO algorithm applied monthly versus 100% in QQQ. TotRet% CAGR% VOL% maxDD% Sharpe Sortino 2015 return LOW risk 268.91 8.32 5.51 -5.51 1.51 2.19 3.60% MID risk 553.49 12.18 10.3 -10.55 1.18 1.68 3.10% HIGH risk 824.31 14.59 15.11 -16.12 0.97 1.36 -0.24% QQQ 124.69 5.08 29.43 -82.96 0.17 0.23 -1.22% In table 2 we see that all MVO portfolios had stellar performance over the 16 years of this study, even though QQQ had a very rocky ride. Also, notice that the realized volatilities of the MVO strategies are well correlated with the maximum drawdown and the realized annual returns. The 2015 returns column reports the results during 2015 to the end of September. It shows that all MVO strategies performed better than QQQ. The LOW and MID risk portfolios achieved a positive return of over 3% while QQQ lost 1.33%. The HIGH risk portfolio lost a minute 0.24%. The equity curves for all portfolios are shown in Figure 1. (click to enlarge) Figure 1. Equity curves of the portfolios with MVO monthly optimization versus QQQ over the whole time interval from June 1999 to September 2015. Source: All charts in this article are based on calculations using the adjusted daily closing share prices of securities. In figure 2 we show the equity curves during a shorter period that includes the 2000-03 bear market, specifically, we show the June 1999 to December 2003 interval. During the first nine months there was a steep increase in QQQ price followed by a three year bear market. We also included a nine month period of recovery. (click to enlarge) Figure 2. Equity curves of the portfolios with MVO monthly optimization versus QQQ over the time interval from June 1999 to December 2003. We see that all MVO portfolios increased at a slow pace during the bear market. The HIGH risk portfolio was basically flat from March 2000 to March 2003, while the LOW and MID risk portfolios achieved small but steady gains. The details of their performance are given in table 3. Table 3. Returns of QQQ and MVO portfolios during the 2000-03 bear market. Time Interval QQQ LOW_Risk MID_Risk HIGH_Risk 6/10/1999-3/28/2000 123.95% 13.32% 23.93% 53.15% 3/29/2000-3/11/2003 -79.79% 26.21% 22.72% 6.65% 3/12/2003-12/31/2003 53.25% 10.59% 17.86% 34.09% In figure 3 we show the equity curves of the MVO portfolio during the 2008-09 bear market. We included nine months of recovery from April to December 2009. (click to enlarge) Figure 3. Equity curves of the portfolios with MVO monthly optimization versus QQQ over the time interval from October 2007 to December 2009. In figure 3 we see that QQQ suffered a large loss from October 2007 to March 2009. During the same interval, the HIGH risk portfolio lost 8.40%, the MID portfolio was flat, and the LOW risk portfolio gained 7.29%. The exact numbers are given in table 4. Table 4. Returns of QQQ and MVO portfolios during the 2008-09 bear market. Time Interval QQQ LOW_Risk MID_Risk HIGH_Risk 10/1/2007-3/09/2009 -50.27 7.29 0.37 -8.40 3/10/2009-12/31/2009 78.72 8.71 19.35 42.54 Finally, in figure 4 we show the equity curves from September 2014 to September 2015. (click to enlarge) Figure 4. Equity curves of the portfolios with MVO monthly optimization versus QQQ over the time interval from September 2014 to September 2015. In figure 4 we see that QQQ as well as all the MVO portfolios were very volatile, but their equity was bound in a narrow range. Still, the LOW and MID risk portfolios outperformed by realizing modest gains. The exact gains and losses are given in table 5. Table 5. Returns of QQQ and MVO portfolios during the latest one year and the first nine months of 2015. Time Interval QQQ LOW_Risk MID_Risk HIGH_Risk 9/30/2014-9/30/2015 3.63 8.18 9.17 3.58 12/31/2014-9/30/2015 -1.22 3.60 3.10 -0.24 To give the reader more insight into how the MVO strategy succeeds in making gains even when an asset of the portfolio suffers extremely large losses, we present in the following three figures the monthly allocations during the period from June 1999 to December 2003. We decided to display the allocations over a short time interval in order to get graphs that are easy to read. (click to enlarge) Figure 5. Monthly allocations of the portfolios LOW risk strategy over the 2000-03 bear market. In figure 5 we see that the LOW risk strategy allocated, on average, over 60% of the money to the short term bond fund. QQQ was not allocated any funds between March 2000 and November 2002. The long term bond fund was allocated substantial funds during the bear market. (click to enlarge) Figure 6. Monthly allocations of the portfolios MID risk strategy over the 2000-03 bear market. The MID risk strategy allocated more funds to the long term bond fund than to the short term during the bear market. Again, QQQ was allocated the smallest amount of funds during the bear market. (click to enlarge) Figure 7. Monthly allocations of the portfolios HIGH risk strategy over the 2000-03 bear market. The HIGH risk portfolio allocated very little money to the short term bonds. During the bear market most money went alternately to the long term bonds and the mid cap MDY. QQQ was still not allocated any significant funds from April 2000 to November 2002. In table 6 we show the October 2015 allocations for all the strategies. Table 6. Current allocations for October 2015. MDY QQQ FFXSX VUSTX LOW risk 0% 0% 70% 30% MID risk 0% 0% 31% 69% HIGH risk 0% 0% 0% 100% Conclusion The Mean-Variance Optimization strategy applied to a well-constructed portfolio of stocks and bonds performs quite satisfactorily during deep bear markets. It also offers a very simple mechanism of adaptation to the risk tolerance of the investors by trading off risk and returns. The illustrations of this article give us confidence that MVO strategy is very robust, and it may continue to perform well in the future. Additional disclosure: The article was written for educational purposes and should not be considered as specific investment advice. Scalper1 News
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