Darwin Portfolio Review – 26 October 2021

Dead Horse Point, Moab, Utah

The review date for the Darwin portfolio was 26 October and I did review/adjust the portfolio on that date – I’ve just been a little bit slow in writing this post.

On 26 October my workbook was looking like this:

suggesting the allocations shown on the bottom row for the ETFs comprising my “core” holdings.

As a reminder, the Darwin is a “core” portfolio of five diversified assets, that are held at all times, with the allocations adjusted periodically (every 20 trading days) based on estimated risk as measured by the (annualized) 21-day volatility. It is a portfolio based on Risk Parity – or an attempt to target the risk contribution from each asset to a desired level. For this particular portfolio I have chosen to set the volatility (risk) target to 10% for all five assets (relatively aggressive). This means that, if all assets were perfectly correlated, the maximum portfolio risk might be 50% (5 x 10%). However, since we have a diversified portfolio of weakly correlated assets the actual portfolio volatility will be significantly less than this since when one asset zigs others zag by different amounts.

Based on my holdings on 26 October, the suggested allocations required me to sell 2 shares of VTI (US Equities) and to buy 2 shares of TLT (US Long-Term Treasuries) and 3 shares of GLD (Gold) to rebalance the portfolio:

Note also that I am holding this portfolio in a margin account and have chosen to allow up to 25% leverage on the account. Thus, my cash holdings after making these adjustments was a ~$2,500 debit and the portfolio was showing an annualized Internal Rate of Return of 7.23% (after 4 months of operation – so not a reliable estimation of future returns).

Performance to date looks like this:

or, in a slightly clearer “stacked allocation” format:

thus, we have recovered a little from the draw-down that we were looking at a month ago.

You will note from the first two screenshots above that I have made some changes in the workbook. At ITA Wealth we remind readers, quite often, that no single investment strategy/system works well under all market conditions and that system diversification is an important part of total portfolio construction. As an example I am therefore adding a totally new “system” to the Darwin Portfolio. This “system” has absolutely nothing to do with “core” portfolio construction or “momentum” systems as available in the Kipling workbook.

The system is “simple” in that it will hold only one ETF (either VIXY or SVXY) at any time and is purely a play on volatility. When prices go down/crash due to uncertainty or unpredictable events, volatility tends to spike higher – so we would like to be long volatility at that time so as to diversify/hedge our risk (losses on equity holdings). Conversely, when volatility is high, following some unexpected event (e.g. Covid-19 pandemic scare in 2020) and investors learn to relax a little following the event, then equity prices recover, volatility tends to drop and we would prefer to be short (sell) volatility. Thus, volatility becomes a diversifier and potential hedge against “Black Swan” events. I say “potential” because these events tend to occur quickly and are not easy to catch/predict – especially for investors that might only want to check their portfolios on a monthly basis. Thus, this strategy really requires a daily check (but not a lot of time/effort).

Broad market volatility is often measured by the VIX (S&P 500 Volatility Index) – but, unfortunately, the VIX cannot be traded directly – it’s just an index like the SPX Index (that can only be traded through the SPY ETF that is designed to track the SPX). However, volatility can be traded in the futures markets through VIX futures. But we probably don’t want to have to open a futures trading account – so, there’s an app for that (or at least an ETF) and we can trade VIXY (for long volatility exposure) or SVXY (for short volatility exposure). Because these ETFs are priced based on futures prices things get a little complicated – and our “simple” system is not quite as simple as it might sound. I will try to explain the strategy in a future post but, since it is a little complicated, I won’t do that here and anyone that might have an interest should just follow my future Darwin posts to get a feel for performance. I will warn at the outset that one can get slapped hard if not paying attention – so it’s only for serious investors with the necessary discipline to pay relatively close attention to the markets.

Because of the risks associated with the strategy it is important to size allocations to the strategy very carefully – and I’m still working on what that might mean. Since the Darwin portfolio is small (~$10k) and I’m only looking to diversify risk on this “core” portfolio I am comfortable allocating ~$1.000 (1%) to the strategy at this point in time. I have therefore purchased 16 shares of SVXY (short volatility) as my volatility diversifier.

Since I don’t have cash in this account to purchase the shares I will be using margin – this means that I am upping my leverage to ~35%. Note: I am not advocating that investors should use leverage/margin – it’s just that this is a small marginable account and it’s convenient (and I’m comfortable) doing this at this level. No matter which way this portfolio goes from here it should be a good example of the benefits and/or dangers of using leverage.

Unless we see any Black Swans in the near future we’ll check on progress at next month’s review. If I get a signal to change (go long volatility) in this period I’ll report in the comment section (so sign up for notifications of future comments if interested).

David