Friday, 16 January 2015

Model Portfolios - 2014 Return and Risk Performance

2014 was a good year for investors holding any one of a selection of balanced, diversified model portfolios (One-Stop, Lifelong, Simple and Couch Potato, Swensen Seven and Smart Beta, Permanent Portfolio). The lowest return of any portfolio started at 7.5%. But the range extended to more than double, with a 16.0% return in one portfolio. Why the big range and what lessons can we draw, especially considering that all of the portfolios hold a roughly similar breakdown of 40% to 50% fixed income with the remainder equity?

Return vs Risk - The first thing to consider is how much risk the portfolio took on to achieve the return. We computed (using the calculator, which uses Yahoo! Finance data or Morningstar Canada price data e.g. TD Balanced Index Fund, for the portfolio funds) two risk  measures for each portfolio: 1) volatility (standard deviation) of daily returns for the year and, 2) maximum drawdown of fund value from a peak to a trough during the year. These metrics are a kind of "anxiety quotient". The less of each the better. To compare the portfolios, we calculated how much return the portfolio delivered per unit of volatility or drawdown - the higher the ratio, the better.

The Results Table - The best three funds for return, volatility and drawdown are shown in green numbers.
(click on images to enlarge)

Portfolio Return vs Volatility

Portfolio Return vs Maximum Drawdown
Lesson 1) Fund weighting scheme matters as much as asset allocation - The Smart Beta Portfolio delivered the best return by far. It's 16.0% return was 3% ahead of the next best Swensen Seven. The Volatility and Drawdown charts show the Smart Beta to be among the three best on those measures too (the top left corner is the best place to be where the most return for the least volatility or drawdown is achieved). The Swensen Seven differs from the Smart Beta in the choice of ETFs for each asset class - instead of the traditional cap-weighted funds of the Swensen Seven, the Smart Beta uses low volatility, equal-weighted and fundamentally-weighted funds. Compared to the cap-weighted benchmark Canadian equity TSX Composite ETF with symbol XIC, the red-highlighted 2014 return of the fundamentally-weighted fund PXC fell significantly short, but the low volatility fund ZLB more than compensated with its vast out-performance.

In a similar vein, the choice of long term federal government bonds (ZFL's 17.4%) and real return bonds (ZRR's 13.1%) in the Smart Beta, Swensen and Permanent portfolios provided a big return advantage over the broad market bond ETFs such as XBB (8.3%) in all the cap-weighted portfolios.

One year does make an investment lifetime and next year might not see the same all-round out-performance by the Smart Beta ... but it is the result that the research on long term data says to expect, as we reviewed in this post.

Canadian Couch Potato recently reported 2014 returns of a series of cap-weighted model portfolios. This similarity of construction of those portfolios resulted in a much narrower range of returns, only 9.8% to 10.8%. Investors who choose portfolios with different types of ETFs, like the Smart Beta, or others such as the Permanent Portfolio, with its 25% allocation to gold, should expect to diverge appreciably in returns year-to-year.

Lesson 2) Adjusting portfolio weights for volatility looks to be beneficial - Both the Swensen Seven and the Smart Beta, whose weights we adjusted for volatility, had higher returns and good to excellent return vs risk ratios.

The one-stop Tangerine Balanced Fund (mutual fund symbol INI220) and Mawer Balanced Fund (MAW104) performed as well as the Smart Beta on the return vs riskiness measures. The latter is especially interesting since it is actively managed, rather than a passive index fund. It's long term returns look excellent too. Perhaps this is one of the rare actively-managed funds that can and will do better than passive averages. But the passive Tangerine fund has done close to as well in 2014.

Lesson 3) Currency hedging matters - In 2014, when the Canadian dollar fell vs the US dollar, hedging hurt results. The currency-hedged Simple Recipe was clearly the worst on both return-vs-riskiness measures. The unhedged version of the Simple Recipe had a slightly higher return and lower volatility and maximum drawdown. The blue outlined cells in the table show the returns boost to the US-traded and USD-denominated funds in the Smart Beta portfolio. The fall in the Canadian dollar aka rise in USD vs CAD from the start to the end of 2014 provided 9.1% extra return to the three funds with symbols RSP, EFAV and PXH. In the case of PXH, currency turned a net loss in USD into a net gain in CAD. Most of the other portfolios do not hedge their US or international holdings and thus they also received the same returns boost.

Of course, when CAD appreciates, the opposite happens - unhedged foreign holdings' returns are lessened. In the long run, the indications are that hedging does not make a difference without considering costs and in the practical sense, where hedging costs enter the picture, hedging is likely a net negative to returns, as we have discussed in a number of posts under part 6 Asset Allocation and Portfolio Construction of our Guide to Self-Directed Investing.

Lesson 4) Bonds can contribute healthy returns even in a low interest rate environment - The bond component of all the portfolios contributed to the overall attractive portfolio returns as the prevailing low interest rates actually managed to fall (see the charts of various benchmark rates at the Bank of Canada website). When rates fall, bond prices rise and the funds holding the bonds gain in value in addition to receiving the bond interest.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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