A Well Balanced Wealth Management Investment Strategy
Inflation and deflation are the two most important factors for a well designed wealth management investment strategy. Inflation destroys the long term purchasing power while deflation reduces the effectiveness of the capitalism's basic profit machine. A well designed long term strategy thus needs to have a well balanced hedge in both economic cycles. Harry Browne's permanent portfolio is designed over various major asset classes to tackle this problem. A more actively managed strategy is Doug Roberts' Follow the Fed Strategy. In this article, we will discuss this well balanced strategy ValidFi maintains in some detail.
This strategy is simply based on the fed monetary policy to follow the Fed. Research shows that big caps behave better than small caps when money is tight while small caps outperform big caps when money is easy. Similar relationship is also found in gold and Treasury bonds. Gold is doing better than Treasury bonds when the Fed's money policy is easy, and vice versa. Switching between large and small stocks, gold and Treasury bonds depends on the Fed's monetary policy.
To lower the risk still further, simple intermediate government notes are added to the portfolio. Thus this strategy allocates assets equally among large/small stocks, gold/Treasury bonds and intermediate government notes.
1. Determine whether money is tight or easy
A conservative model portfolio would be simply allocating 1/3 each to large/small cap equity, gold/long term treasury and intermediate treasury notes.
The strategy adjusts portfolios every month according to the money status.
The following table compares the performance between the conservative portfolio and the permanent portfolio (PRPFX) from 1/1/1997 to 11/27/2009.
Doug Roberts' strategy is one of those well balanced long term strategies adopted by wealth managers to preserve capital and purchasing power while achieving reasonable growth. At the moment, the strategy decides that "money is easy" (which is obviously true) and invests in both small cap and gold.
This strategy is simply based on the fed monetary policy to follow the Fed. Research shows that big caps behave better than small caps when money is tight while small caps outperform big caps when money is easy. Similar relationship is also found in gold and Treasury bonds. Gold is doing better than Treasury bonds when the Fed's money policy is easy, and vice versa. Switching between large and small stocks, gold and Treasury bonds depends on the Fed's monetary policy.
To lower the risk still further, simple intermediate government notes are added to the portfolio. Thus this strategy allocates assets equally among large/small stocks, gold/Treasury bonds and intermediate government notes.
1. Determine whether money is tight or easy
- The indicator we use is T-bill -12 month value minus Inflation - 12 month value, as described in the Barrons' articles. If the former is larger than the latter, then Fed's money policy is tight.
- The T-bill - 12m is the trailing 12 - month compound return using the last twelve monthly T - bill's values.
- Similarly the Inflation -12m measures the trailing 12-month compound return using the last 12- month inflation values. Inflation is calculated as the change in CPI index between this month and last month divided by last month's CPI index.
- We can also compare the above indicator value with the 64-day simple moving average value of the indicator. If the former is larger than the latter, then the Fed's tight, and vice versa.
A conservative model portfolio would be simply allocating 1/3 each to large/small cap equity, gold/long term treasury and intermediate treasury notes.
- If money is tight, the portfolio is composed of:
- 33.33% in large stocks
- 33.33% in Treasury bonds
- 33.33% in intermediate treasury notes
- 33.33% in large stocks
- If money is easy, the portfolio is made up of:
- 33.33% in small stocks
- 33.33% in gold
- 33.33% in intermediate treasury notes
- 33.33% in small stocks
The strategy adjusts portfolios every month according to the money status.
- If short-term T-bill rate remains higher/lower than inflation, no adjustment is made to the portfolio because money remains tight/easy.
- Similarly, if the indicator value stays above/below 0, or it's higher/lower than the 64-day simple moving average value of the indicator, no adjustment needs to be done to the portfolio.
- However, if the money status changes, for example, money is tight right now while it was easy last time, investors must adjust the portfolio accordingly. In this case, portfolios should be switched to the other type so that investors can achieve higher returns while remaining lower risks.
The following table compares the performance between the conservative portfolio and the permanent portfolio (PRPFX) from 1/1/1997 to 11/27/2009.
| Last 1 Years | Last 3 Years | Last 5 Years | Since 1/1/97 to 11/27/09 | |
| Roberts Portfolio Annualized Return | 22.3% | 7.4% | 9.4% | 9.9% |
| PRPFX Annualized Return | 28.7% | 7.3% | 8.5% | 8.46% |
| Roberts Portfolio Sharpe Ratio | 1.7 | 0.5 | 0.68 | 0.77 |
| PRPFX Sharpe Ratio | 1.66 | 0.41 | 0.54 | 0.65 |
Doug Roberts' strategy is one of those well balanced long term strategies adopted by wealth managers to preserve capital and purchasing power while achieving reasonable growth. At the moment, the strategy decides that "money is easy" (which is obviously true) and invests in both small cap and gold.
Labels: GLD, IEF, IWM, NAESX, Portfolio_5667, PRPFX, SPY, Strategy_582, TLT, VFINX, VFITX, VUSTX
6 Comments:
Nice article. The Permanent Portfolio has really stood out as a solid performer especially considering that it appears to have a static allocation structure. This Fed based model appears to allow for some improvement with the tradeoff of more active management.
I've just begun to look around the ValidFi site and have already found some great stuff. The one thing that seems a bit off are the Sharpe ratios: they are consistently several orders of magnitude too high. It is nice to have all this material compiled in one location. I look forward to revisiting.
eric
Hi Eric,
Thank you for your encouraging comments.
Strategies with those high Sharpe ratios were at first surprising to us too. But upon closer examination, you will find out they are indeed correct. One thing we should point out is that some of those strategies could not be practically replicated exactly as they are right now: for example, the high yield bond timing strategy using Vanguard High Yield Bond fund VWEHX could NOT be used as it is as there is no way Vanguard would allow frequent short term trading on VWEHX. On the other hand, people could use this as a proxy to trade high yield bond ETFs such as JNK or HYG.
We would appreciate very much if you indeed find some strategies/portfolios with incorrect Sharpes and point them out to us.
Thanks,
John
Thanks for the reply. I'm basing the Sharpe ratio on what Hulbert defines. You can find this (it sounds like you probably subscribe) in the Long Term Performance Ratings Footnotes section of the Long Term issue that comes out biannually, footnote 2. Here it is: "The numerator of this Ratio is the portfolio's average monthly return less the average monthly return of 90-day T. Bills over the same period. The denominator is the standard deviation of the portfolio's monthly returns." Looking at the risk adjusted returns in Hulbert usually shows a positive or negative number less than 1. That's what got me wondering when I looked at your Sharpe ratios. I am using Google Chrome; could there be an issue with compatibility in interpreting the number correctly? Anyway, if there is an alternate method of calculating Sharpe ratios or I've got it wrong, sorry about that, but you may consider moving over to the way Hulbert does it regardless. The benefit could be significant. Hulbert has such an extensive historical dataset that being able to readily compare Sharpe ratios between your site and his would be very useful and would allow for integrating his data and findings with yours. The same goes for his Risk, Total Return, and Correlation statistics, too. There seems to be a lot of potential here.
Like I said, sorry if I'm misinterpreting it.
Eric
Hi Eric,
We use (annualized return - annualized return of T-bill)/(daily standard deviation * sqrt(252)) to calculate Sharpe. This would represent the annualized Sharpe ratio. Since we are using daily data to calculate standard deviation (and then annualize it), I would argue our ratio should be more accurate (as it has more samples). However, this number should be close to the monthly Sharpe ratio from Hulbert and Morningstar. We are familiar with both.
Maybe we should switch to monthly to make it more apple to apple.
On a separate note, some of our portfolios indeed have high Sharpes and this is indeed due to their superior risk-adjusted returns. You could look at some of those closely (standard deviation and max. drawdown etc.) to see whether that is the case.
Some of these strategies are intuitive and time proven and they do point to that human based are not necessary the best.
Cheers,
John
I recently came accross your blog and have been reading along. I thought I would leave my first comment. I dont know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.
Alena
http://grantfoundation.net
One thing I noticed on the portfolio descriptions: the Sharpe ratios are given as percents. Does this mean you are taking the result of the calculation and multiplying it by 100? If so, that may be why you display numbers for Sharpe ratios that appear orders of magnitude different from what others show.
I have gotten a lot out of what you've done so far and look forward to what you'll be doing in the future. Btw, who are you guys and what got you started on this? I'd guess there's a technical/analytical background in there somewhere.
Ooops, better get back to Christmas with everybody else...Merry Christmas.
Eric
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