Tag Archives: modern

U.S. Stocks Rise 2.1% For The Week, But Don’t Lament Being Diversified

The Standard & Poor’s 500 stock index rose 2.1% last week, lifted by better-than-expected earnings reports from tech giants Amazon (NASDAQ: AMZN ), Microsoft (NASDAQ: MSFT ) and Alphabet (NASDAQ: GOOG ) (NASDAQ: GOOGL ). When trading closed on Friday, the S&P 500 stock index had erased all of the losses sustained since the correction of late August-early September, when the index declined by as much as 13.4% from its high. The U.S. bull market, now over six years old, last week was going strong. Ironically, however, all this good news about U.S. stocks can be a little frustrating to diversified investors because it makes prudent, diversified investors look like laggards versus the S&P 500. So now’s a good time to remember that diversified investors won’t ever perform as well as a hot asset class or as bad as the worst asset class. (click to enlarge) This chart illustrates how the S&P 500 outperformed a broad range of 13 assets classes in the five years ended September 30, 2015. The index of U.S. blue-chip, publicly-held companies gained 87%, a very strong gain for a five-year period. The S&P 500 was driven higher because the U.S. economy rebounded more strongly from the global debt crisis and the Great Recession. The return on the S&P 500 was significantly better than most of the other asset classes in this diverse group of 13 types of investments. It would be natural to lament not concentrating your portfolio on U.S. stocks instead of building a diverse group or asset classes. It’s frustrating not performing as well as the S&P 500. However, that’s not how strategically investing for the long run and using Modern Portfolio Theory works. Being diversified means, by definition, not placing your entire portfolio in any single asset class. You diversify because no one can be certain that the next five years will be as good for American stocks as the last five years. Owning a broad range of asset classes means you won’t ever perform as well as the No. 1 asset class. But it also assures your portfolio won’t perform as poorly as the worst asset class that you hold. Diversification and rebalancing periodically, which is the core of Modern Portfolio Theory, provides a strategic course of moderation. The idea is to avoid the big swings of being concentrated in one or two asset classes. Concentrating a portfolio in U.S. stocks could have given you bigger gains, but it can also work against you and land you with larger losses when stocks are out of favor, and can make it more difficult to stay the course when stocks are knocked down in a correction or bear market. So don’t kick yourself if all your money was not riding on U.S. stocks the past five years. While past performance is not a guarantee of your future results, it is also true that a long-term investment strategy cannot fairly be measured against short-term trends.

FFFEX: Need A Target Date Fund? Keep Looking

Summary FFFEX offers investors a high expense ratio to go with a needlessly complex portfolio. By incorporating an enormous volume of other mutual funds the target date fund incorporates a higher expense ratio with suboptimal holdings. If the fund needs exposure to the total US market, they can ditch the complicated combination of funds and just use FSTVX. The bond holdings of FFFEX are suboptimal. Since the portfolio is so heavy on equity, the bond holdings should emphasize long term treasury securities. Lately I have been doing some research on target date retirement funds. Despite the concept of a target date retirement fund being fairly simple, the investment options appear to vary quite dramatically in quality. Some of the funds have dramatically more complex holdings consisting with a high volume of various funds while others use only a few funds and yet achieve excellent diversification. My goal is help investors recognize which funds are the most useful tools for planning for retirement. In this article I’m focusing on the Fidelity Freedom® 2030 Fund (MUTF: FFFEX ). What do funds like FFFEX do? They establish a portfolio based on a hypothetical start to retirement period. The portfolios are generally going to be designed under Modern Portfolio Theory so the goal is to maximize the expected return relative to the amount of risk the portfolio takes on. As investors are approaching retirement it is assumed that their risk tolerance will be decreasing and thus the holdings of the fund should become more conservative over time. That won’t be the case for every investor, but it is a reasonable starting place for creating a retirement option when each investor cannot be surveyed about their own unique risk tolerances. Therefore, the holdings of FFFEX should be more aggressive now than they would be 3 years from now, but at all points we would expect the fund to be more conservative than a fund designed for investors that are expected to retire 5 years later. What Must Investors Know? The most important things to know about the funds are the expenses and either the individual holdings or the volatility of the portfolio as a whole. Regardless of the planned retirement date, high expense ratios are a problem. Depending on the individual, they may wish to modify their portfolio to be more or less aggressive than the holdings of FFFEX. Expense Ratio The expense ratio of Fidelity Freedom® 2030 is .74%. That expense ratio is simply too high. Investors using a target date fund need to keep an eye on those expenses. It is possible to create a very efficient portfolio using only a few funds. Ideally the funds selected for building the portfolio would be selected for offering excellent diversified exposure at very low expense ratios. At the most simplistic level, an investor is looking for domestic equity, international equity, domestic bonds, and international bonds. If any of those had to be left out, the international bond allocation is the least important. In my opinion, there is no need to use both growth and value indexes. There is no need to individually use large, medium, and small-cap allocations. For instance, the Fidelity Spartan® Total Market Index (MUTF: FSTVX ) has a net expense ratio of .05% and offers exposure to the vast majority of the U.S. market. If you were building a target date fund from Fidelity funds, you could simply use FSTVX and eliminate all other domestic equity funds. This method would provide investors with a low expense ratio on the underlying domestic equity position and excellent diversification. That is precisely why I am including FSTVX as a holding in my portfolio. The Vanguard Target Retirement 2030 Fund (MUTF: VTHRX ) has an expense ratio of .17%. Just so investors have a healthy comparison of how much it costs to run a very efficient target retirement fund, the Vanguard expense ratio gives a pretty clear indication. Holdings / Composition The following chart demonstrates the holdings of Fidelity Freedom® 2030: If you were making a target date fund, how many allocations would you need? Hopefully it wouldn’t be that many. Note that the holdings chart above simply showed the equity funds. There is simply no need for a portfolio to be this complex. The list below shows the bond portfolios: A Major Problem When you look at the equity portfolio, it is very complex. When you look at the bond portfolio, it is quite simple. The issue I’m noticing is that the portfolio is not holding any allocations specifically to treasury securities. There is one allocation to investment grade bonds, but that is it. This portfolio suffers from almost every sector allocation having positive correlation with the other sector allocations. When investors give up the negative beta of long term treasuries it is extremely difficult to be on the efficient frontier. When you combine missing out on the benefits of negative beta with having a very high expense ratio, you have a very poor choice for a retirement fund. Looking Deeper Since there is only one bond fund that is has an allocation greater than 4%, I decided to look deeper into that holding. The Fidelity® Series Investment Grade Bond Fund (MUTF: FSIGX ) is closed to new investors, has an expense ratio of .45%, and has a fairly weak allocation to treasuries as demonstrated by the following chart: (click to enlarge) Treasury securities are making up 20.4% of the portfolio. The resulting portfolio clearly deviates quite dramatically from the selected index fund. When I used Invest Spy to run a regression on FSIGX, the negative beta was only -.08. Fidelity has other long term bond funds like the Fidelity Spartan® Long Term Trust Bond Index Fund (MUTF: FLBAX ) which have dramatically lower betas. How much lower is the beta for FLBAX? It is around -.46. Simply put, FLBAX belongs in most Fidelity target date funds because it offers a great negative correlation to equity holdings. Of course, allocating money to FLBAX may be less profitable since it only has a .1% expense ratio. Volatility An investor may choose to use FFFEX in an employer sponsored account (if their employer has it on the approved list) while creating their own portfolio in separate accounts. Since I can’t predict what investors will choose to combine with the fund, I analyze it as being an entire portfolio. (click to enlarge) When we look at the volatility on FFFEX, it is only moderately lower than the volatility on the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). For a fund that has the option to include long term treasuries, international diversification, and in general has an enormous combination of underlying funds, it is very disappointing that the target date fund for investors that are only 15 years from retirement has demonstrated almost as much volatility without offering even close to as much in the way of returns. Granted, the S&P 500 has thoroughly defeated international markets over the last several years. Having weaker returns is perfectly acceptable for FFFEX; the problem is that it also had a similar max drawdown. If the fund included a substantial position in FLBAX, that max drawdown would not have been near as bad. I’ve demonstrated a combination of FFFEX with a 20% allocation to FLBAX: (click to enlarge) Even though FLBAX also has a huge max drawdown, the extremely negative beta results in the max drawdown events occurring at different times for each funds and the combined portfolio has a max drawdown of only 9.4%. For the investor that is only 15 years out from retirement (20 years from when the sample period began), having a max drawdown of 9.4% sounds much better than 17.5%. Of course, investors should not rely on historical results as predicting future results. The example is simply to demonstrate that a portfolio of domestic equities and long term treasuries has been capable of maintaining fairly low portfolio volatility due to the historical negative correlation of the two asset classes. Conclusion When an investor takes on an expense ratio that is even .3% higher and pays that ratio for 20 years, they are looking at losing 6% of the value of the portfolio without accounting for compounding. If investors account for the benefits of compounding and assume annual returns are positive, the potential value lost is even greater than 6%. FFFEX is an expensive option for investors looking for a simple “set it and forget it” retirement plan from their employer sponsored retirement accounts. The volatility of the fund is not a problem and the total exposures are not unreasonable. The problem comes down to two issues. One is that the fund has needlessly complicated the portfolio holdings and the other is that the expense ratio is simply too high when compared to similar products offered by competitors. There are some great funds offered by Fidelity and I have positions in a few of them. Unfortunately, this fund just falls short of the mark. To improve the allocations within the fund, the managers should dramatically simplify the portfolio and use low expense funds for allocations to each core section. Those sections would be domestic equity, international equity, treasuries, and international bonds. Having a small allocation to junk bonds would be fine as well.

Simple ETF Portfolio Performance With Monthly Reallocation By Mean-Variance-Optimization

Summary The simple ETF portfolio with monthly reallocation performed better than the equal weight portfolio in 2015. The low and mid risk portfolios had good positive returns, while the high risk portfolio had a very small loss. Even the high risk portfolio performed better than the equal weight portfolio. The simple ETF portfolio was introduced in an article published in August 2015. Since then the markets suffered a mini crash and a correction associated with high volatility and very negative market sentiment. Investors all over the world moved large amount of money out of the stock market and into other “perceived safer” asset classes such as bonds. It is appropriate, therefore, to ask ourselves how an adaptive strategy is dealing with this kind of market environment. In this article we analyze the performance of the simple ETF portfolio, emphasizing its results during the latest period of high market turbulence. For completeness, we will review the historical performance of the portfolio since January 2003, but will discuss in more detail its performance during the first nine months of 2015. The portfolio is made up of the following four ETFs: SPDR S&P MidCap 400 ETF (NYSEARCA: MDY ) PowerShares QQQ Trust ETF (NASDAQ: QQQ ) iShares 1-3 Year Treasury Bond ETF (NYSEARCA: SHY ) iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) 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 SHY 7/22/2002 13.11B 0.48% Short Term Treasury Bond TLT 7/22/2002 6.41B 2.62% Long Term Treasury Bond The data for the study were downloaded from Yahoo Finance on the Historical Prices menu for MDY, QQQ, SHY and TLT. 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 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 January 2003 to September 2015. Table 2. Performance of MVO algorithm applied monthly versus an equal weight portfolio. TotRet% CAGR% VOL% maxDD% Sharpe Sortino 2015 return LOW risk 167.65 8.03 5.60 -5.59 1.43 1.99 3.16% MID risk 399.09 13.45 10.61 -10.34 1.27 1.68 3.60% HIGH risk 697.85 17.70 16.40 -17.18 1.08 1.52 -0.33% Equal weight 204.71 9.14 9.58 -24.50 0.95 1.29 -1.33% Please notice that the realized volatilities are well correlated with the target values. In fact, the realized volatilities are just slightly greater that the target values. Also, as expected, the realized annual returns are also well correlated to the volatility targets. All the values in the CAGR% column are a little greater than the realized volatilities in the VOL% column. The 2015 returns column shows that all MVO strategies performed better than the equal weight portfolio. The LOW and MID risk portfolios achieved a positive return of over 3% while the equal weight portfolio lost 1.33%. The HIGH risk portfolio lost a minute 0.33%. 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 and equal weight allocation. Source: All charts in this article are based on calculations using the adjusted daily closing share prices of securities. We see in figure 1 that the equity of the LOW risk portfolio had a constant, very stable, rate of increase over the entire time of the simulation. It was almost unaffected by any market event. By contrast, the equity of the equal weight strategy with rebalancing shows the highest variability and the highest loss during the 2008-09 crises. The equal weight strategy worked quite well during long bullish periods of the market such as during 2003-07 and 2009-14. The MID and HIGH risk strategies worked extremely well during the 2009-14 period with a very brief periods of mild correction in 2011. All strategies show a flattening of their equity curves during 2015. In Figures 2, 3 and 4 we show the time allocation for all MVO strategies from January 2014 to September 2015. We decided to display the allocations over a shorter most recent time interval in order to get graphs that are easy to read. (click to enlarge) Figure 2. In figure 2 we see that the LOW risk strategy allocated, on average, over 60% of the money to the bond funds. About 30% to 40% was allocated alternately to QQQ or MDY. (click to enlarge) Figure 3. In figure 3 we see that in 2014 the money was allocated alternately between TLT and QQQ. The first half of 2015 the allocation went to MDY and TLT. In July and August of 2015 the money was allocated to QQQ and SHY, switching all to TLT and SHY in September and October. (click to enlarge) Figure 4. In figure 4 we see that the HIGH risk strategy allocates the money to a single asset at any time. Since January 2014 it simply alternated between QQQ and TLT. This strategy worked very well most of the time, but in the first nine months of 2015 it suffered a very small loss. In table 4 we show the current allocations for all the strategies. Table 3. Current allocations for October 2015. MDY QQQ SHY TLT LOW risk 0% 0% 69% 31% MID risk 0% 0% 35% 65% HIGH risk 0% 0% 0% 100% As seen in table 3 all portfolios are invested only in bond funds, regardless of risk level. The low risk portfolio in mostly invested in the short term, while the high risk is 100% in long term treasuries. Conclusion The simple ETF portfolio with monthly reallocation performed better than the equal weight portfolio in 2015.The low and mid risk portfolios had good positive returns, while the high risk portfolio had a very small loss. Additional disclosure: The article was written for educational purposes and should not be considered as specific investment advice.