Improve Your 60/40 Portfolio? Decrease Exposure to Stocks and Increase Volatility

If you understand how the dated 60/40 portfolio in conjunction with periodic rebalancing works, you recognize that most of the risk is due to the 60% allocation in stocks losing value during bear markets. This dated approach lost well over 30% in the last bear market, over 30% in previous bear markets and will probably lose more than 30% in the next bear market. But there is a more modern or better version available to investors.

There are two solutions to the 60/40 problem of large losses during bear markets. These solutions capture the same benefits while increasing returns thus adding alpha as well as reducing risk or maximum drawdown. If we can increase returns while decreasing risk, we create a more efficient 60/40 portfolio. This can be done by decreasing the exposure to stocks while increasing their volatility without altering their characteristics.

How does it work? Instead of investing 60% of your money in stocks, invest 20% in stocks that are three times more volatile. This transforms the 60/40 into a 20/80. Let's test how this would have done since July 31, of 2002 through Aug. 31 of this year. We picked this period because during the 14-year period, we witnessed a bull market, then a bear market, and we are currently in another bull market, albeit one that could end any day.

To make a fair comparison, we need to establish a baseline for the dated 60/40 portfolio. For the baseline, we will allocate 60% to the S&P 500 and 40% to Treasury Bonds. Specifically, we will use data on the S&P 500 as our stock proxy and iShares Barclays 7-10 Year Treasury   (IEF) as our bond proxy. The results from this study clearly show why the traditional 60/40 is dated. Let's start with $100,000 and see how the dated 60/40 performed over the 14-year time period.

The Dated 60/40 Portfolio with Periodically Rebalancing

Rebalance Every # of Days

Ending Capital

Maximum Drawdown

     

60

$242,740

33.2%

120

$247,898

32.0%

255

$239,740

30.3%

The above results are typical of what one might expect. There are profits, and there were periods of more than 30% losses during the late 2007 through early 2009 bear market. If you recall, the S&P 500 dropped over 50% and thus the 60% allocation to the S&P 500 had to drop over 30%, regardless of how often you rebalanced. This type of cycle will repeat as long as there are bull and bear markets. An investor can do better.

The following table shows how the 20/80 portfolio would have done over the same 14-year time period. Remember, we got to the 20% allocation to stocks by owning the S&P 500 using three times the leverage. This allowed us to increase our bond allocation from 40% to 80%.

The Modern 20/80 Portfolio With Periodically Rebalancing

Rebalance Every # of Days

Ending Capital

Maximum Drawdown

     

60

$292,447

28.5%

120

$328,205

21.9%

255

$290,040

19.1%

As we can see, the modern version of the 60/40 increases the ending capital and reduces maximum drawdown and is a portfolio that can be implemented by owning just two securities and rebalancing periodically. Why is this modern? Because until the advent and adaptation of leveraged ETFs over the last decade, you could not purchase a security that was correlated with the S&P 500 and had two or three times the daily volatility. However, they are readily available today and have billions of dollars under their management. Most people that invest in these leveraged funds use them as trading vehicles and not how described here. However, it is clear to us that this methodology is superior to the dated 60/40.

One may ask the question, is it better to invest in a two times levered fund ProShares Ultra S&P500  (SSO) than a three times one ProShares UltraPro S&P500  (UPRO) ? Even yet, what about a four times levered fund or a five times? The answer gets a bit complicated because of something called volatility drag. During the 14-year time period studied, had you invested $10,000 in the S&P 500 it would have grown to $24,047. In a two times levered fund it would have grown to $33,871 and in a three times levered fund to $27,687. However, at four times leverage it would have only grown to $12,920 and at five times leverage it would have lost money and only grown to $3,355. This effect is known as volatility drag and is simply a mathematical reality. The reason it happens is because of the mathematics of recovery. As an example, a 20% loss requires a 25% gain to break even. This tells us that there is a wide leverage zone for our modern strategy to work.

This brings us to our second solution. As we can see on the next page, the less you allocate to equities, the more leverage is required. While we like the 20/80 strategy using levered funds, we like an alternative strategy using inverse volatility funds better. We call it the 15/85 solution and our allocation is 15% VelocityShares Daily Inverse VIX ST ETN (XIV) and 85% iShares Barclays 7-10 Year Treasury IEF. We find that XIV is highly correlated to the stock market, is between three to four times more volatile than the stock market and negatively correlated to the bond market, so it fits perfectly in our solution. This lets us reduce stock exposure to 15%, which reduces maximum drawdown. More importantly, XIV gives us the added bonus of exhibiting behavior not seen in the S&P 500. It  increases in value due to the rules that govern how XIV operates. These rules reduce the volatility drag and makes this solution far more elegant and useful. It is the solution we use for our own portfolios. The following table shows the effect of reducing stock exposure while increasing volatility.

Reduce Stock Exposure While Increasing Volatility

Amount of Leverage

Rebalance Every # of Days

Description

Ending Capital

Maximum Draw-down

         

1

60

Dated 60/40

$242,740

33.2%

1

120

Dated 60/40

$247,898

32.0%

1

255

Dated 60/40

$239,740

30.3%

         

2

60

Modern 30/70

$287,128

30.0%

2

120

Modern 30/70

$307,489

26.2%

2

255

Modern 30/70

$282,366

21.5%

         

3

60

Modern 20/80

$292,447

28.5%

3

120

Modern 20/80

$328,205

21.9%

3

255

Modern 20/80

$290,040

19.1%

         

4

60

Modern 15/85

$289,800

27.1%

4

120

Modern 15/85

$339,196

19.5%

4

255

Modern 15/85

$289,860

17.1%

         

5

60

Modern 12/88

$285,766

25.5%

5

120

Modern 12/88

$345,657

18.1%

5

255

Modern 12/88

$285,980

15.2%

Conclusions

  • The main conclusion from this table is that regardless of how often one rebalances, as you decrease the amount of exposure to stocks while increasing the volatility of stocks with the same daily characteristics such as a leveraged Exchange Traded Fund (ETF), the ending capital increases and the maximum drawdown decreases.
  • The second conclusion is that rebalancing can overcome volatility drag. We know that using five times leverage exhibits severe volatility drag as a stand-alone buy and hold investment. As we said before, a $10,000 initial investment would have lost money. However, when paired with bonds and rebalancing, the outcome is unexpected. Instead of performing worse, it still does better than the dated 60/40. It can overcome volatility drag because the moves are so pronounced, it favors rebalancing.
  • The final conclusion is that though most investors gravitate to higher returns at a lower risk, some would be comfortable with the potential of sustaining 30% losses as seen in the dated 60/40. They may want to utilize margin. With two to one margin, and a reasonable margin rate, your portfolio could have grown to over $750,000 or more than a threefold increase.
  • For more info about who we are and what we do, visit FinancialTales.com or SeraCapital.com

This article is commentary by an independent contributor. At the time of publication, the author held positions in the XIV and IEF mentioned.

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