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Does we see the same pattern of portfolio volatility reduction when we equalize the volatility / risk contribution of the holdings?
The answer is an unequivocal YES. In each portfolio, when we adjusted the asset allocation percentages to get closer to an equal share of risk from each ETF holding, there was a marked reduction in both the annualized portfolio volatility and the daily Value at Risk (VaR - a measure of how much the portfolio could lose in any given day taking into account its past volatility over the specified time period of 1-, 2-, 5-years). For instance, the Swensen Seven portfolio's annualized volatility for the past year goes down from 5.2% to 4.4% after adjustment and its VaR declines from 0.8% to 0.6%. Risk is not decreased by half but it it's still an appreciable difference.
The volatility reduction applies for any and all time periods we tested - the past year, two years, five years, maximum data available. Equalizing volatility contributions of holdings is a consistent and reliable way to reduce volatility of a portfolio.
It's encouraging that the reduction improvement was least for the Smart Beta portfolio, which we had built by guesstimating equalized volatility contributions. Our guesstimate helped a lot but we did not have the benefit of the InvestSpy.com calculator when writing that post so we can see the usefulness of the tool.
Which portfolio got the biggest volatility reduction?
The Simple Recipe gained the most - it had the largest reduction in both risk measures, e.g. its trailing one-year annualized volatility went down from 4.5 to 2.9% and VaR from 0.7 to 0.4%. Not only was its reduction the largest, it had the lowest absolute volatility after the adjustment e.g. the 2.9% volatility is against 4.4% for the Swensen and 3.6% for the Smart Beta.
Does that mean the adjusted Simple Recipe is the best?
It's certainly a strong plus in its favour but we notice that the method to achieve the reduction was to boost the allocation to fixed income (the bond ETF with symbol XBB) at the expense of equity. The Swensen Seven also improved by increasing fixed income, though by not nearly as much, while the Smart Beta did not touch the fixed income allocation. Instead it moved money from volatile ETFs RSP, EFAV and PXH to more stable ZLB and ZRE. A higher bond allocation is not the only way to reduce portfolio risk.
After adjustment both the Swensen Seven (45% allocation) and Smart Beta (40% allocation) have an allocation to fixed income significantly less than Simple Recipe's 75%. That leaves more in higher returning (on an expected basis at least) equities. Yet Smart Beta's one- and two-year volatility is not that much higher than Simple Recipe's. Our point in the original post linked above about the Smart Beta portfolio was that it could well offer an improvement over traditional portfolios through a more balanced structure and more efficient ETFs. The balance for different economic growth, market, crisis, inflation and currency environments of the Swensen Seven and the Smart Beta is retained while the Simple Recipe is decidedly unbalanced towards fixed income. Volatility risk reduction has come at a cost. If future bond returns are weak because of rising interest rates, the unbalanced Simple Recipe could lag considerably.
We believe the trade-off looks favourable to Smart Beta but every investor must decide for him or her self.
Every portfolio is more stable than any of its components, even compared to the ultra stable bond ETFs
It's not much of a surprise to most investors to see in our comparison table that equities on their own, such as ETFs SPY, VTI, XIU and XIC are much more volatile than portfolios that include them along with more stable fixed income ETFs. But some may not realize that even that most stable holding, the broad Canadian bond market ETF XBB is more, not less, volatile than the Simple Recipe portfolio which includes equities along with it. That's right, the portfolio is less volatile than any of its parts. It's not magic or illusion. Why? This occurs through the operation of negatively correlated holdings that move in opposite directions (one zigs while the other zags as the popular expression goes, though both go up in the long term). The overall average ride is smoother. The slide below from this presentation based on the Booth & Cleary Corporate Finance textbook shows how this works.
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This screenshot of the InvestSpy results for the trailing one-year performance of the adjusted Smart Beta shows the desirable negative correlations amongst the various ETFs.
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Bottom Line
Adding ETFs to a portfolio that produce positive returns and are un- or negatively-correlated with other holdings, such as the bond funds and ZLB in the Smart Beta portfolio, adds greatly to return reward vs volatility risk performance.
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.
4 comments:
Very interesting analysis, thanks ! My investment approach is based on the the same principles but I use an even simpler approach with only 3 ETF: ZLB, ZCM and one based on a momentum strategy.
In my analysis, I didn't find any significant value add to diversify beyond that like Smart Beta with REIT and other geographies.
I'd be interested to get your point of view or analysis on this.
Rick Ferri's take on RSP. http://www.rickferri.com/blog/investments/no-free-lunch-from-equal-weight-sp-500/
Notwithstanding Mr Ferri's brief analysis, many others who have examined the equal weight index have found it be more return vs risk efficient than a cap-weight. In fact cap-weight has been found to be inefficient compared to other wefighting schemes like fundamental and minimum variance. Jacques Lussier's new book Successful Investing cites a series of such studies. The EDHEC-Risk Institute has lots of papers on the subject e.g. see here http://www.edhec-risk.com/latest_news/featured_analysis/RISKArticle.2012-01-20.4937?newsletter=yes and here http://www.edhec-risk.com/indexes/equity_index_research. A quote from the latter page: "Four main weighting schemes are analysed: efficient indices, fundamental indices, minimum-volatility indices, and equal-weighted indices. Empirical results for US and Developed World data on these indices show that the average returns of all four alternative index construction methods are superior to those of cap-weighted equity indices in both universes and that, by several measures of risk-adjusted performance, they are likewise superior"
As they say, let the debate continue.
Anon1, re the three ETFs, my guess would be that in a short time period of a few years, a subset of asset classes may well do the job but when the economic environment changes drastically to a new set of growth vs inflation circumstances, that's when the other asset classes start to be useful.
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