As Investors we ask ourselves a number of important questions when we set up our portfolios:
- What investment model/strategy shall I use?
- Strategic Asset Allocation (SAA) Plan;
- How shall I allocate funds and how much risk am I prepared to take?
- What risk adjusted return am I comfortable with (Sharpe Ratio)?
- I’ve been told that diversification is good – but how much is necessary and can I have too much?
In this “Mini-Series” of Posts I will use the simple Swensen 6 portfolio as the basis to address these questions. I have chosen this portfolio since it is a simple portfolio that should be familiar to regular readers of the ITA Wealth Management Blog. Furthermore, using fewer than 10 ETFs to construct a portfolio eliminates the need to perform a cluster analysis to ensure diversification and thus keeps analysis/portfolio management to a minimum.
As a reminder, the Swensen 6 portfolio, as described by Lowell in his July 31, 2014 Post (https://itawealth.com/2014/07/31/swensen-six-ivy-10-portfolios/) can be represented by the following allocation of assets/ETFs:
- Domestic Equities – 30% – VTI (Swensen does not recommend particular ETFs. These are Lowell’s recommendations.)
- Foreign Developed Equities – 15% – VEU (This ETF contains emerging market stocks. Another option is to use VEA.)
- Emerging Market Equities – 5% – VWO
- Real Estate – 20% – VNQ
- U.S. Treasury Bonds – 15% – TLT
- U.S. Treasury Inflation-Protected Securities – 15% – TIP
In order to compare performance of “Swensen” portfolios to a suitable index/fund I will use the Vanguard Target Retirement 2025 Fund (VTTVX) as my benchmark. Vanguard considers VTTVX to be a suitable Buy and Hold vehicle for someone retiring in about 10 years’ time (2021-2025) and is considered a moderate risk Fund.
VTTVX is a composite Equity/Bond fund that holds approximately 70% Equities and 30% Bonds with both Equities and Bonds being split between Domestic (US) and International (Developed and Emerging Markets) holdings. Thus, the main differences between VTTVX and a “Swensen” portfolio are that a) VTTVX holds International Bonds, whereas “Swensen” does not, and b) “Swensen” includes Real Estate holdings that VTTVX does not.
The VTTVX benchmark is essentially a periodically adjusted portfolio based on a 70/30 Equity/Bond SAA Plan. So let’s first look at the ~8 year performance of a “Swensen 6” portfolio a) as a “passive” Buy and Hold portfolio and b) as a monthly (33 day) adjusted (to the SAA Plan weightings identified above) portfolio:
Let’s compare key performance parameters for these 3 portfolios:
We note that:
- “Swensen” portfolios perform somewhat better than the VTTVX benchmark in terms of Compound Annual Growth Rate (CAGR), risk-adjusted return (Sharpe Ratio) and (lower) Maximum Draw Down (MDD);
- Monthly adjustment of the “Swensen” portfolio results in a higher CAGR at the expense of volatility (risk), risk-adjusted return and MDD;
- Maximum Draw Down (MDD) is probably unacceptable for all Buy and Hold (BH) and pseudo BH (i.e. periodic adjustment to SAA Plan) portfolios.
- The “Swensen 6 Buy_Hold” strategy generates the “best” performance based on volatility (risk), risk-adjusted return (Sharpe) and lowest MDD – at the expense of absolute return (CAGR).
The likely reason for the better performance of the “Swensen” portfolios (particularly in the 2010-2012 period) is the inclusion of REITs in the portfolio asset mix.
The above are minimum-attention portfolios – annual or quarterly adjustments could probably be applied to management strategy without significantly affecting comparative performance.
Maximum Draw Down (MDD) is the big problem with the above portfolios even if (with hindsight) we have the nerve to stay with our plan and can generate an acceptable (?) ~7% annual return over an 8 year period. In Part 2 I will look at how we can reduce risk, both MDD and volatility, by adding a level of Risk Management to our selected investment strategy. Members who have read my Feynman Study Posts know that I consider Risk Management to be the most important consideration of any investment strategy. If we lose 50% in a bear market we have to make 100% on the remaining balance to recover to our original portfolio value – this usually takes a significant period of time – far longer than it takes us to lose the money.