ValidFi News and Articles

Recent market volatility marked the first serious drop since November last year. It is timely to review how smart investors have prepared and reacted to such a change. The following analysis is based on ValidFi's real time asset allocation analysis tool for mutual funds.

First, let's take a look at several best performing moderate asset allocation funds in the last 3 years.

The following are beta (asset exposure) changes of the stock market (using Vanguard Total Stock Market Index VTSMX as the proxy) for moderate allocation funds Janus Balance (JABAX), FPA Crescent (FPACX), Waddell & Reed Asset Strategy (WYASX) and Ivy Asset Strategy (WASYX). Notice also the beta reduction does not mean the manager actually makes a physical asset reduction in his portfolio. It could mean that his portfolio has been positioned defensively (such as more heavily in defensive sectors such as consumer staples). Same is true for beta increase also.









Taking into account S&P 500 index (SPY)'s 2% year to date drop, one could see that all of these funds have reduced their exposure to equity somewhat. Notice further that other than FPACX, the other three funds reduced their exposure right at the beginning of year. Such a move apparently reveals the year end asset rebalancing. It seems to be very prudent and timely to make such reductions (or a rebalancing act). Also, notice both Waddell & Reed and Ivy made drastic reductions on days 1/14 and 1/15.
On the other hand, if we look at funds with under exposure going to the new year, such as Vanguard Wellesley Income (VWINX) and GMO Benchmark-Free Allocation (GBMFX), these funds actually increased their equity exposures during this correction period:





Currently, ValidFi's Guru Asset Allocation Clone with Diversified Bonds portfolio has the following asset mix: 25% short term bond allocation (SHY and CSJ), 7.41% high yield bond (HYG or JNK) and the rest is in stocks (SPY, EFA, EEM), REIT (IYR or ICF) and gold GLD.



All in all, from the above, we could infer that smart money managers do not expect a drastic stock market melt down (at least at this moment) while they are making timely move to adjust their asset exposure to the right mix. One should definitely reduce equity exposure if he/she has over exposure to this asset. On the other hand, for those whose equity exposure has been under the target allocation,  it might be prudent to gradually increase the allocation.

Labels: CSJ, EEM, EFA, GLD, HYG, ICF, IYR, JNK, SHY, SPY, TLT

In our previous article, we alluded that in a diversified portfolio, putting a long term timing indicator such as 10 month simple moving average on risky assets such as stocks, commodities could effectively reduce risk (i.e. big loss) while improving return. Investors are in a heightened state of anxiety these days as equity markets are consistently at a level where some analysts find them over valued (such as John Hussman's recent analysis or Robert Shiller's Cyclically Adjusted 10 Year PE ratio (Price to Earnings Ratio). Using a long term timing indicator to safe guard these portions of a portfolio is an effective way to do so.

In the international stock asset, investors could utilize today's diverse array of country ETFs to get an exposure. The following is the list of country ETFs used in this strategy:

• The Netherlands (EWN)
  
• Germany (EWG)
  
• France (EWQ)
  
• Switzerland (EWL)
  
• Italy (EWI)
  
• United Kingdom (EWU)
  
• Belgium (EWK)
  
• Austria (EWO)
  
• Singapore (EWS)
  
• Hong Kong (EWH)
  
• Japan (EWJ)
  
• Canada (EWC)
  
• South Africa (EZA)

The portfolio has equally weighted amount on each country ETF. A 10 month Simple Moving Average (SMA) is used for each ETF. The strategy checks the SMA indicators at the end of each week and does the necessary transactions. Furthermore, the portfolio is rebalanced every year.

The following table illustrates the performance of this portfolio from  5/18/2009 to 12/18/2009.

	Last 5 Years	Last 3 Years	Last 1 Years	Up To Date	2004	2005	2006	2007	2008	2009
Annualized Return(%)	11.749	7.969	20.542	13.414	19.892	9.477	21.57	11.594	-6.249	20.541
Sharpe Ratio(%)	70.258	43.454	109.953	84.593	186.162	69.757	134.478	47.291	-195.092	108.191
Standard Deviation(%)	14.011	15.175	18.597	13.697	10.319	10.475	13.589	18.123	3.679	18.9
Draw Down(%)	16.916	16.916	9.694	16.916	3.938	7.902	15.169	10.354	6.529	9.694

This portfolio compares favorably with the unguarded EFA which has the following performance (2004 is a full year data) while Up To Date being from 5/18/2004 to 12/18/2009.

	Last 5 Years	Last 3 Years	Last 1 Years	Up To Date	2004	2005	2006	2007	2008	2009
AR(%)	3.33	-7.032	28.904	6.21	18.93	13.322	25.806	9.951	-42.126	24.844
Sharpe Ratio(%)	5.051	-24.366	89.625	16.4	123.536	103.547	162.686	44.417	-92.86	79.664
Standard Deviation(%)	28.199	34.513	32.145	26.7	14.541	11.664	14.933	18.337	47.084	32.209
Draw Down(%)	61.761	61.761	30.238	61.761	9.806	7.192	15.755	11.576	54.496	30.238

Users could modify this portfolio to allow addition of recently introduced country ETFs such as emerging or new country ETFs including EWZ (Brazil), FXI (China), INP (India, an ETN or INDY, an ETF). RSX (Russia), TUR (Turkey), THD (Thailand),  South Korea (EWY), PLND (Poland) and VNM (Vietnam), or even regional ETFs such as EPP (pacific), AFK (Africa), GAF (Africa and Middle East), VGK or IEV (Europe).  Moreover, users could change the country weights. It is very encouraging to see that there are some many country ETFs available for investors to get a diversified exposure. Certainly cautions should be taken for those with very little liquidity.

Labels: EFA, epp, ewc, ewg, ewh, ewi, ewj, ewk, ewl, ewn, ewo, ewq, ews, ewu, ewy, ewz, eza, fxi, rsx, vgk

John Hussman's weekly comment on 12/14/2009: Any virtue of stocks here is decidedly speculative. Stocks are overvalued to a level from which uninspiring returns have always followed. That fact is true regardless of whether or not the economy is in a sustainable recovery. More detailed here. Hussman has been negative since September this year. Recently, however, he has adopted a slight speculative stance on US stock market through call option exposure. Based on his commentary and our estimate here, the stock exposure beta of Hussman Strategic Growth Fund HSGFX is less than 10%. The following are some key points from his above commentary.

• S&P historical return: Using Barsky-Delong model, to achieve annual real return of 4.2%, the S&P would need to be at 810. Or putting it the other way, Hussman stated that "the conclusion is not that stocks must decline immediately, but rather, that long-term total returns for the S&P 500 are likely to be less than 4.2% after inflation." "Alternatively, on the assumption that future growth rates match what we've observed over the past two decades and indeed over most of the past century, an expected long-term total return of 10% for the S&P 500 (what investors generally carry in their heads as the 'typical'long-term return on stocks) would currently be consistent with an index level of 672".
  
• 'Second wave' concerns begin to appear: Hussman has been warning that the second wave of housing credit crunching (the mortgage reset) is approaching the peak at this moment. He quoted Meredith Whitney's interview on CNBC which was very negative on the outlook of 2010: "which is so disturbing on so many levels to have so many Americans be kicked out of the financial system, and the consequence both political and economic of that is a real issue you can't get around. It's never happened before in this country or in the modern economy. The biggest trend in 2010 will be seeing who gets kicked out of the banking system."

So the question is whether the banks could withstand the upcoming credit loss, even with their newly raised equity from public markets this year. Furthermore, with the bailout in effect, how much the banks could shift the loss to the government, i.e. tax payers. Based on the 'stealth stimulus' theory reported by Wall Street Journal, consumers are foreclosing homes and freeing their cash flow to 'stimulate' the economy. Thus consumers -> banks -> taxpayers flow will do a 'stealth' wealth redistribution with 'banks' being intact!

Any way you put it, we are definitely at a situation with many potential landmines. The best approach at this moment is to rebalance your portfolio's asset allocation back to a risk level you could tolerate (remember 2008?) and then stick to the strategies/plans you have chosen.

Labels: AGG, IWM, NAESX, SPY, VBMFX, VFINX

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

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

• 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.

2. Portfolios
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
    
  
  
  
• 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
  
  

3.  Switching frequency
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.

We have found that using the 64-day simple moving average performs much better than  simply basing on whether the indicator's value is positive or negative.

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

What? Are you Madoff? These days, anything related to 'low risk' or 'steady' returns generates skepticism. It is very understandable and perfectly reasonable for investors to have such a feeling, given what have happened in the financial industries.

However, if an investor does follow sound and safe investment principles consistently and disciplinarily, yes, Virginia, there is a hope! In the following, we will show how one could achieve a 10% return in the past 9 years by simply incorporating Buffett or Shiller long term stock market timing indicators in your investing.
The idea is simply that, when the stock market is significantly undervalued, one should fully invest in the stock market; when the stock market is significantly overvalued, one should sell the stocks and fully invest in bonds using some fixed income strategies. The proxy to invest in stock market is Wilshire 500 total return index while the strategies for fixed income investment are Alpha Dynamics for Multi Sector Bonds. This strategy evaluates 32 multi-sector bond mutual funds every quarter based on their trailing one year's Alphas and then select top 3 three funds for next quarter investment. The quarterly rebalancing frequency allows investors to avoid the short term redemption fee charged by brokerages or fund companies. It switches to Cash (13 week treasury bill) when none of the funds has positive 1 year alpha.

The following table illustrates the performances for the two portfolios from 12/31/2000 to 11/20/2009.

	Annualized Return	Standard Deviation	Maximum Drawdown
Buffett Indicator based Bond as Cash	12.73%	1.21	11%
Shiller Indicator based Bond As Cash	10.38%	11.1%	20%
Wilshire 5000 Total Return	-0.58%	22.2%	56.6%

A portfolio with much longer history (from 12/31/1990 to 11/20/2009) using Shiller's metric and alpha based high yield bond fund quarterly switch strategy shows a similar result (9.75% annualized return).

The above are just some of examples to show that if one is patient enough and avoids the hype in a long term period, he/she will be rewarded with  low risk reasonable returns.

Labels: ^DWC, BWX, CFT, EEM, EFA, IWM, MDY, Portfolio_6961, Portfolio_7145, Portfolio_7259, Portfolio_7261, SPY, Strategy_613, Strategy_629, Strategy_638, TLT, VFINX, VTSMX

John Hussman, manager of Hussman Strategy Growth Fund (HSGFX) proposed price to peak 10 year average earnings as a long term stock market valuation gauge. Compared with the normal one year price to earning ratio, Price to Peak Earnings would eliminate short term noise. This is similar to Shiller's Cyclically Adjusted Price Earning ratio (CAPE10) and Warren Buffett's stock market GNP/GDP metric. In his weekly commentary on Dec 5, 2005, titled as 'Earnings Revert to the Mean, Stocks Will Struggle', he proposed a simplistic method: "buy when Price to Peak Earnings is lower than 15 and sell when it exceeds 19.5". John Hussman has been using this as the valuation yardstick to manage the Hussman Strategic Growth Fund HSGFX.
It is interesting to examine how effective using such a metric as a long term stock market timing indicator. Similar to the Warren Buffett's stock market GNP/GDP metric and Shiller's CAPE, the following strategy characterizes the stock market valuation into the following five categories based on the ratio of the current Peak PEs to the long term average Peak PEs:

• Significantly Overvalued (SO): such as if the ratio >= 150%
  
• Modestly Overvalued (MO): such as if   117% <=  ratio < 150%
  
• Fairly Valued (FV): such as if 83% <= ratio < 117%
  
• Modestly Undervalued (MU): such as if 67% <= ratio < 83%
  
• Significantly Undervalued (SU): such as if ratio < 67%

These five categories are determined by four valuation parameters (such as 150%, 117%, 83% and 67% in the above). At each rebalancing (adjusting) period (such as weekly or monthly), the strategy decides at what region the US stock market valuation is and then does the following rebalancing:

• SO: 0% in stock, 100% in cash.
  
• MO: 25% in stock, 75% in cash.
  
• FV: 50% in stock, 50% in cash
  
• MU: 75% in stock, 25% in cash
  
• SU: 100% in stock, 0% in cash

The stock market exposure is through buying Wilshire 5000 total return index (^DWC) or it could be set by users. Users could adjust the valuation parameters to get an effect like only buying at significantly undervalued (SU) level and selling at significantly overvalued (SO) level. Some of model portfolios of this strategy are:

• SO: >=150%, MO: [117%, 150%), FV: [83%, 117%), MU: [67%, 83%), SU: <67%
  
• SO: >=150%, MO, FV, MU: [67%, 150%), SU: <67%

A model portfolio called P Hussman Peak PE Market Timing Strategy Buy 15 Sell 19.5 Weekly is also maintained to live monitor the strategy suggested in 'Earnings Revert to the Mean, Stocks Will Struggle'.
The following table compares the performance of the three long term stock market indicators. All of the portfolios are based on 'buy at significantly undervalued and sell at significantly overvalued' strategy.

	12/31/1970 to 11/13/2009
Buffet GNP Metric Annualized Return	9.74%
Shiller CAPE10 Annualized Return	6.9%
Hussman Peak PE Annualized Return	8.02%
Wiilshire 5000 Total Return Annualized Return	6.9%
Buffet GNP Metric Sharpe Ratio	0.53
Shiller CAPE10 Sharpe Ratio	0.25
Hussman Peak PE Sharpe Ratio	0.33
Wilshire 5000 Total Return Sharpe Ratio	0.15

All of the strategies have achieved better returns and much higher Sharpe ratios compared with Wilshire 5000 total return index.

On Friday 11/13/2009, Both Buffett and Hussman metrics indicated the market was fairly valued: Buffet Total Stock Market Valuation to GNP ratio was 78.6% while Hussman's Peak PE10 to the long term Peak PE10 average was 1.04 (current peak PE 10 was 12.4 and the long term average was 11.9). Shiller CAPE10 to its long term average indicates the market was 22% overvalued.  It should be noted that John Hussman has been very cautious recently, pointing out the uniqueness of the current economic situation. Interested readers should read his latest weekly commentary here.

Labels: ^DWC, BWX, CFT, EEM, EFA, IWM, MDY, Portfolio_7145, SPY, Strategy_613, Strategy_629, Strategy_638, TLT, VFINX, VTSMX