ValidFi News and Articles

The concept of core satellite portfolio construction has been adopted for several years by many investment and wealth managers. The EDHEC has collected several papers detailing this concept. ValidFi has maintained a so called Simple Core Satellite Portoflios strategy to show case this concept. In this article, we will discuss the effectiveness of combining simple timing and passive allocation to achieve better risk adjusted returns.

The key idea behind the core satellite portfolios is that, while the traditional passive (buy and hold) strategic asset allocation is suited for long term investment, the short term or intermediate term risk is too much for an ordinary investor to bear with. A portfolio with over 20% peak to trough drawdown (i.e. loss) is probably the maximum for many investors. On the other hand, an actively managed portfolio, while reducing short term risks, could suffer from a stream of short term loss. For example, a moving average based equity portfolio buys into the stock market when the stock market index such as S&P 500 index SPY rises above its 200 days moving average and sells out of the market when the index drops below the 200 days moving average. This strategy works well to protect capital during severe market downturns such as 2008's but it could suffer from loss when markets whip saw in a side way fashion. Furthermore, it could forgo a significant portion of profits when markets rise from depressed low levels. The following table illustrates correlations between the two strategies:

	Early Bull	Late Bull	Bear	Side Way
Passive Buy and Hold	Good	Good	Bad	OK
Moving Average Timing	Miss	Good	Good	Bad

Apparently, these two strategies complement to each other in various market or economic cycles. Furthermore, both strategies have exhibited good long term average returns. Combining these two strategies in a portfolio should be able to maintain the long term return while reducing the risk or smoothing out the return curve.

We employed ValidFi's portfolio tool to construct core satellite portfolios based on the above two strategies. The following are three such portfolios that ValidFi now lively monitors.

	Buy and Hold Equity	Fixed Income (Total Bond Market Index)	200 Days Simple Moving Average Equity (Satellite)
75% Stocks and 25% Bonds Buy and Hold	75%	25%	0%
30% Stocks and 40% Bonds and 30% Satellite Timing Equity	30%	40%	30%
25% Stocks and 25% Bonds and 50% Satellite Timing Equity	25%	25%	50%

The first two columns combined represent the core part of a portfolio and the last column represents the satellite (actively managed) part of a portfolio. For the stock investment, Vanguard 500 index VFINX (ETF equivalent SPY) is used and for the fixed income part, Vanguard Totoal Bond Market Index VBMFX (ETF equivalent AGG) is used.

The following table shows the characteristics of the portfolios from a period 6/30/1988 to 12/7/2009.

	Last 1 Years	Last 3 Years	Last 5 Years	Since 6/30/1988
Annualized Return 75% Stocks and 25% Bonds Buy and Hold	24.3%	-1.98%	2.42%	8.2%
Annualized Return 30% Stocks and 40% Bonds and 30% Satellite Timing Equity	19%	4.3%	5.7%	8.9%
Annualized Return 25% Stocks and 25% Bonds and 50% Satellite Timing Equity	20.3%	5.4%	6.7%	9.5%
Max. Drawdown 75% Stocks and 25% Bonds Buy and Hold	20.8%	42.4%	42.4%	42.4%
Max. Drawdown 30% Stocks and 40% Bonds and 30% Satellite Timing Equity	8.75%	17.7%	17.7%	17.7%
Max. Drawdown 25% Stocks and 25% Bonds and 50% Satellite Timing Equity	7.2%	16.3%	16.3%	16.3%

It is evident that core satellite portfolios not only enhanced returns (from 0.7% to 1.3% annually) but also reduced the maximum drawdown (risk) dramatically. The buy and hold portfolio had gut wrenching 42% maximum drawdown which, we suspect, very few investors had stomachs to tolerate. 

The above is a simple example to utilize ValidFi's portfolio platform to construct, study and monitor composite portfolios. For investors who desire to have more diversification over various assets and strategies, such a platform could be handy.

Labels: AGG, Portfolio_7355, Portfolio_7357, Portfolio_7359, SPY, Strategy_374, VBMFX, VFINX, VTI

Mark Hulbert recently published a story on marketwatch.com: Hybrid Halloween Indicators. The original Halloween indicator (or sometimes called "sell in May and go away") has been studied extensively. In his story, Hulbert mentioned a research paper published in 2002 in his article. The paper found that most stock markets around the globe indeed exhibited such abnormality: "sell in  early May and buy in late October" could achieve excessive risk adjusted return.
The improved strategy proposed by Sy Harding (detailed description could be found here and here) issued a buy signal on Friday Oct. 16, 2009. This strategy uses MACD to further pinpoint the buy/sell dates around April and October time frames. It is pertinent to compare such a strategy with the original strategy as well as with the buy and hold strategy at this time.
The "original" strategy dictates that one sell on April 26th and buy on October 16th. The following table compared the performance of the three strategies from 7/1/1971 to 10/16/2009. All of them use Wilshire 5000 total return index as the proxy to the stock market investment and use 13 week treasury bill as the cash when they are out of the stock market.

	Since 1971	Last 5 Years	Last 3 Years	Last 1 Year
AR (%) Original	7.769	2.544	-1.938	-7.138
AR (%) Improved	8.236	2.696	1.364	3.777
AR (%) Wilshire 5000	6.733	0.693	-6.55	17.488
Sharpe (%) Original	28.915	3.211	-15.331	-20.388
Sharpe (%) Improved	38.481	5.097	-1.172	14.826
Sharpe (%) Wilshire 5000	16.064	-5.257	-27.383	45.033
Max. Drawdown (%) Original	35.107	35.107	35.107	32.114
Max. Drawdown (%) Improved	33.073	33.073	33.073	27.306
Max. Drawdown (%) Wilshire 5000	56.645	56.645	56.645	32.13

From the table, one could see that the "improved" strategy does the best in terms of overall return and risk. Overall, one could clearly see that both "original" and "improved" strategies have outperformed the buy and hold strategy.



From the above graph, we could see that the "improved" strategy waited till the end of 2008 to get into the stock market, thus sidestepping some loss that the "original" strategy incurred during the October to December time frame. Unfortunately, both of them suffered a great deal from the March steep decline.  This is a clear reminder that such strategies are not fool proof and they are still subject to stock market's big swing.
Given the steep run-up of the stock market so far, a favorable seasonality backdrop should be treated just as a backdrop: one should not blindly follow the strategy alone but instead, taking such a statistical evidence into consideration during your portfolio management such as portfolio rebalancing.

Labels: ^DWC, IWM, NAESX, Portfolio_3444, Portfolio_6869, SPY, Strategy_480, VFINX, VTI, VTSMX