Go Long: Beyond the 60 40 Portfolio

Kyle Birmingham
Investment Strategy & Product Marketing
January 20, 2022
Investing

Traditional portfolio advice for regular folks goes something like this: invest for the long-term, buy some stocks and bonds, be diversified, something, something, something. And, if you don’t know where to start, look at a 60 40 portfolio. 

As a finance professional, I’ve been guilty of spouting these platitudes, always caveated with “this is not financial advice!” To be fair, the 60 40 is the Toyota Camry of portfolios. Reliable and will likely get you where you’re going. And, in the context of the financial services industry, it sort of makes sense. Brokerage accounts can be clunky, investors have to remember to rebalance back to target weights, and regular trading can lead to emotional decision making (we talked about that last week).

It’s generic advice, but investors can customize it by scaling the equity portion up and down depending on their time horizon and risk tolerance (you know when you’re going to die and how much risk you're comfortable with, right?).

The pervasive thinking in our industry is to simplify so that investors will have less to screw up. We at Composer love simplicity. It’s part of our ethos. However, we take umbrage with the idea that things should be made simple, or suboptimal, because the system is clunky. What if there was a better system? What if simple could be powerful and personalized?

Let’s look at our trusty old 60 40 portfolio.

Here we use VTI and AGG to build a two-ETF portfolio. 

60% equity and 40% bond split

Looking at the statistics you can see why it's a bellwether of portfolio construction.

Data is from January 20th 2019 through January 19th 2022

Over the last 3 years, a 60 40 portfolio has returned ~15% annually with a standard deviation of ~13.5%, a much smoother ride than the S&P 500, represented here by SPY, which returned ~22% annually with a standard deviation of ~22%. That’s the game of investing we’ve all been taught. Higher risk = higher return. 

But like with all rules of life there are exceptions and nuances. Two examples that jump to mind: 

  • Diversification can reduce risk while maintaining return
  • Regular rebalancing can improve risk adjusted returns [1]

With Composer, thousands of ETFs and stocks can be combined with systematic trading logic to create infinite possibilities. Investors can capture diversification and rebalancing benefits through automated trading.

For the set-it-and-forget-it types, Composer can automatically rebalance your 60 40 portfolio, capturing the benefits of rebalancing without the need for reminders or spreadsheets. And, unlike robo-advisors, you’re in control. Composer provides transparency, flexibility, and data so you can set your portfolio up the right way for you. Maybe not an economic free lunch but perhaps 50% off a side of French fries.

And, Composer is much more powerful than that. Above, we talked about how the 60 40 is popular because it's diversified and easy to implement within the current investment management infrastructure. But what could you do if you weren’t confined to that infrastructure? What other ways could you balance risk and returns? 

Let’s take a look at an example.

One of the biggest challenges in building a portfolio is managing volatility, or risk. Volatility is the dispersion of returns for a market index, security, or portfolio, which we often measure using standard deviation. 

So why should you and your portfolio care about volatility? Higher volatility means greater risk, and as investors, we definitely care about downside risk. Further, spikes in volatility are often associated with market declines. For example, take a look at the VIX [2] index and the S&P 500 in March 2020 when COVID-19 first disrupted global markets. As volatility, represented by the VIX, increased significantly the S&P 500 dropped 34% and fell into a bear market [3].

Data from FRED which is short for Federal Reserve Economic Data

Investors can protect themselves from this inverse relationship by adding strategies to their portfolio that do well when volatility is increasing. These types of strategies are called “long volatility” and usually run counter to stocks and riskier bonds which perform poorly during volatility spikes. Traditionally, long volatility strategies have been implemented through options and futures contracts; unfortunately, options can be complicated and require margin accounts and futures contracts can be expensive to continually roll forward. The good news is that investors can now access some of the benefits of long volatility through ETFs that perform well during volatility spikes.

Here, we build a long volatility strategy using four assets: international government bonds, US government bonds, and going long the Yen and short the Australian dollar, representing the YEN/AUD exchange rate. We select these assets because they demonstrated a high correlation with the VIX index during volatility spikes from 2006 to 2021. And while these assets do not have a direct link to volatility like options or futures contracts, they should provide an easier to implement, lower cost hedge in our portfolio. Note: we use leveraged ETFs to capture this exchange rate position [4].

Intuitively, the position in U.S. and international government bonds makes sense for volatility protection. During periods of uncertainty, government bonds are seen as a safe place to park money as investors reduce risk in their portfolios. The YEN/AUD exchange rate is less intuitive, so we will need to see how it performs in our backtest.

[Update: For the saved symphony, we replaced YEN/AUD with a bullish dollar ETF (UUP) due to low trading volume for YCL and CROC]

Adding a dynamic hedge through Composer can augment the risk return profile of a portfolio.

You can check out the symphony here; save it to your editor for further testing and refining.

This symphony invests in VTI while looking at the weekly volatility of the market. If the weekly standard deviation of VTI is greater than its two-week average, the symphony shifts 30% of the portfolio into our long volatility strategy. The trading logic is based on volatility clustering, where past volatility is predictive of near-term future volatility. Said differently, volatility is more likely to follow volatility and calm is more likely to follow calm.

Taking a look at the three-year backtest, the dynamically hedged portfolio has a higher Sharpe ratio and annualized return than the 60 40 portfolio. In particular, the symphony performed well during the 2020 COVID crash (max drawdown ~26% vs. 34% for SPY). Looking at the longest time period we have data for - August 1st 2012 through January 19th 2020 - the long vol symphony and the 60 40 portfolio have similar Sharpe ratios, but the long vol strategy returns ~4% more annually.

Data is from January 20th 2019 through January 19th 2022

This symphony was created using 5 ETFs and the rebalance frequency was set to weekly. That’s it. And to me, this is the beauty of Composer. The platform lets you experiment with new ideas, quickly giving you feedback through backtests. The research and economic rationale behind the strategy make sense and the backtest performs inline with what I would expect. Now I can implement the strategy live on Composer, monitoring and refining the assets and logic as needed. 

It is incredibly difficult to beat the market. However, we at Composer believe it should be easier to build portfolios that take advantage of the huge opportunity set available to investors. Don’t be constrained by what legacy providers offer. Build portfolios that meet your needs and that take advantage of the financial tools available to you. I personally can’t wait to see what you build. Get started here.


Disclosures

Certain information contained in here has been obtained from third-party sources. While taken from sources believed to be reliable, Composer has not independently verified such information and makes no representations about the accuracy of the information or its appropriateness for a given situation. In addition, this content may include third-party advertisements; Composer has not reviewed such advertisements and does not endorse any advertising content contained therein.

This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisers as to those matters. References to any securities or digital assets are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Furthermore, this content is not directed at nor intended for use by any investors or prospective investors, and may not under any circumstances be relied upon when making a decision to invest in any strategy managed by Composer. Any investments referred to, or described are not representative of all investments in strategies managed by Composer, and there can be no assurance that the investments will be profitable or that other investments made in the future will have similar characteristics or results.

Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others. Please see Composer's Legal Page for additional important information.

[1] While almost everyone believes in the benefits of regular rebalancing, the impact on returns can be tricky to estimate and depend on the time period and assets you are rebalancing. Check out an interesting article on the topic here

[2] The VIX Index is used as a barometer for market uncertainty, providing market participants and observers with a measure of constant, 30-day expected volatility of the broad U.S. stock market. Learn more here.

[3] From highs on February 19th 202 to lows on March 23rd 2020, the S&P 500 fell 34%. https://www.cnbc.com/2021/03/16/one-year-ago-stocks-dropped-12percent-in-a-single-day-what-investors-have-learned-since-then.html

[4] A few caveats. The long volatility symphony is backtested over a 3 year period. And while back-tested long volatility strategies have demonstrated benefits over longer periods, performance may look different in the future. Further, there is increased risk using leveraged ETFs. Please review the prospectus, risks, and return expectations for each product before investing in leveraged products. Backtest data does not include transaction costs or expense ratios.

Important Disclosures

Investing in securities involves risks, including the risk of loss, including principal. Composer Technologies Inc., is an SEC Registered RIA. The SEC has not approved this message.

Certain information contained in here has been obtained from third-party sources. While taken from sources believed to be reliable, Composer has not independently verified such information and makes no representations about the accuracy of the information or its appropriateness for a given situation. In addition, this content may include third-party advertisements; Composer has not reviewed such advertisements and does not endorse any advertising content contained therein.

This content is provided for informational purposes only, as it was prepared without regard to any specific objectives, or financial circumstances, and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisers as to those matters. References to any securities or digital assets are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Furthermore, this content is not intended as a recommendation to purchase or sell any security and performance of certain hypothetical scenarios described herein is not necessarily indicative of actual results. Any investments referred to, or described are not representative of all investments in strategies managed by Composer, and there can be no assurance that the investments will be profitable or that other investments made in the future will have similar characteristics or results.

Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others. Please see Composer's Legal Page for additional important information.
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With any investment, your capital is at risk. The value of your portfolio with Composer can go down as well as up. Past performance is no guarantee of future results.

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