Three Permanent Portfolios for the Long-Run

Last week different tactical approaches (momentum, moving average) to the Permanent Portfolio were detailed here. Harry Browne proposed a “Permanent Portfolio” allocation in his 1998 Fail-Safe Investing: Lifelong Financial Security in 30 Minutes.  The portfolio is an equal-weight portfolio of stocks, long-term bonds, cash, and gold. One approach to replicate the Permanent Portfolio is to hold a stock, long-term bond, cash, and gold position.

Another alternative is to hold a mutual fund or ETF that replicates the entire Permanent Portfolio strategy.  Two “one-stop” options presently exist,  the Permanent Portfolio Mutual Fund (PRPFX) and the Global X Permanent ETF (PERM).

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PRPFX invests 20% of its assets in Gold, 5% of its assets in Silver, 10% of its assets in Swiss franc assets, 15% of its assets in Stocks of U.S. and foreign real estate and natural resource companies, 15% of its assets in Aggressive growth stocks, and 35% of its assets in Dollar assets. This allocation is similar to the one proposed by Browne, but does differ in its allocation weightings and its exposure to real estate, silver, natural resource companies, and the Swiss franc.

In February Global X Funds launched the Permanent ETF (PERM). This ETF seeks to replicate, net of expenses, the Solactive Permanent Index. The index tracks the performance of four asset class categories that are designed to perform differently across different economic environments. They include stocks, U.S. Treasury bonds (long-term), U.S. Treasury bills and bonds (short-term), and gold and silver.

Since its inception in February, PERM has failed to gather significant assets, with total assets currently listed at less than $15 million. It also has thin volume, with average daily volume less than 15,000 shares and its current expense ratio is .49%. The thin volume makes trading more difficult than more widely held ETFs and could lead to larger bid-ask spreads.

In March I compared the early performance of PERM to an equal-weight portfolio of four ETFs: SPY (SPDR S&P 500 ETF), TLT (iShares Barclays 20+ Year Treasury), SHY (iShares Barclays 1-3 Year Treasury Bond Fund), and GLD (SPDR Gold Trust). Below is an update to the two portfolio’s relative performance. Portfolio A is 100% invested in PERM while Portfolio B uses the four ETF allocation. Returns include dividends (PERM has yet to pay a dividend), data courtesy of ETF Replay:

Since its inception PERM has under-performed a 4 ETF strategy.  The 4 ETF strategy has no exposure to silver, while PERM maintains exposure to silver. As you can below, silver (using the ETF SLV as a proxy) has underperformed gold since February 7th (PERM’s inception date). Date courtesy of Yahoo Finance:

Thus, part of the short-term underperformance of PERM could be related to its silver exposure. The performance difference between gold and silver will fluctuate in the long-term, and at times PERM’s silver exposure could aid its performance.

The expense ratio of PERM is also worth considering when evaluating performance. The expense ratio of .49% compares to the SPY expense ratio of .09%, TLT expense ratio of .15%, GLD expense ratio of .40%, and SHY expense ratio of 15%. In an equal weight portfolio these expense ratios average  .20%. However, additional commissions could be generated when each ETF is bought or sold, while a single Permanent allocation to PERM only creates one transaction.

PRPFX is another viable alternative for investors looking for a Permanent Portfolio strategy. However, as detailed above this mutual fund’s allocation strays further than the Harry Browne allocation. Its performance since February in relation to PERM:

PRPFX has an expense ratio of .84%, higher than its ETF counterpart. However, it may offer an alternative allocation preferred by some investors.

The three Permanent Portfolios detailed here all share similar strategies.  However, as we can see, even small (or in the case of PRPFX, moderate) differences in allocations and expense ratios can lead to differences in performance over a relatively short time period. For the long-term investor, identifying these differences and then allocating accordingly will  impact returns in the long run.


Monday Readings

AlphaClone updated their blog with the newest institutional transactions for the 2nd quarter. For some background on how I have applied their strategies, click here for my 2010 article.

The Trend is Your Fickle Friend – John Hussman

Bankstas in the Age of Money – Vanity Fair

Dividends: In Search of Safety & Growth – MRB Partners, courtesy of Mebane Faber’s new Idea Farm project

The Danger in Dividend Stocks – Barron’s

Boomers are Breaking the Deal (pdf) – John Mauldin

Paulson’s and Soros’ GLD Blunder – IndexUniverse


Tactical Applications of the Permanent Portfolio

Harry Browne proposed a “Permanent Portfolio” allocation in his 1998 Fail-Safe Investing: Lifelong Financial Security in 30 Minutes.  Browne proposed an equal-weight portfolio of stocks, long-term bonds, cash, and gold. One of the major appeals of the portfolio is its simplicity and the low correlation between the assets. Today an investor could create this portfolio using as little as four ETFs: SPY (SPDR S&P 500 ETF), TLT (iShares Barclays 20+ Year Treasury), SHY (iShares Barclays 1-3 Year Treasury Bond Fund), and GLD (SPDR Gold Trust). Holding four low-cost ETFs and re-balancing periodically can help minimize trading costs and potential tax implications while also providing diversity.

Top 50 Trending Stocks

In February 2012 I back-tested the Permanent ETF Portfolio (SPY, TLT, SHY, and GLD) and some minor variations of the portfolio, with the results available here. The conclusion reached then was “the portfolio has had relatively low drawdown and volatility with recent returns outpacing equity markets. The 10 month moving average system lowered the volatility of the portfolio…but had slightly lower overall returns than simply buying and holding the portfolio.” The moving average system also results in higher trading costs and potential tax implications.

Today we will re-examine the same strategies detailed in February as well as additional tactical applications of the Permanent Portfolio. The time-frame for all tests is January 3rd 2005 to August 23rd, 2012. All tests were conducted using ETF Replay.

First, buying the ETF version of the Permanent Portfolio on January 3rd, 2005 with no re-balance has resulted in the following returns:

If we bought the portfolio and re-balanced annually, total returns decreased slightly versus the “no re-balance” portfolio but volatility decreased, resulting in a higher sharpe ratio and lower max drawdown:

The 10 month simple moving average system has been popularized in recent years by Mebane Faber in The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets. For the tests below when an ETF in the portfolio was below its 10 month moving average at month-end, the position was sold and held in “cash” (SHY was used as a substitute for cash). When it closed the month above its 10 month moving average, the ETF was purchased at the stated allocation.

The performance for the 10 month moving average system within the 4 ETF permanent portfolio is below. GLD did not have adequate trading history at the start of 2005 to generate a 10 month moving average, so the results are slightly skewed until GLD generated a signal in mid 2006.

The moving average system has resulted in lower total returns but lower volatility, resulting in a slightly higher sharpe ratio than the first two strategies. However, this comes at potentially higher trading costs and tax implications. There were 37 trades since 2005 using the 10 month moving average, which equates to roughly 5 trades per year. When compared to an annual re-balance strategy that potentially requires 4 year end trades, the moving average system still has relatively low turnover for an active strategy.

A potential momentum strategy for the Permanent Portfolio is to purchase the top 1 or 2 ETFs of the 4 based on relative strength.  For the tests below the ETF with the top 6 month relative strength is purchased and held for a month. The returns when purchasing the top 1 ETF each month are below:

The returns for the top 1 ETF strategy has resulted in substantially higher volatility and comparable returns to a buy-and-hold strategy. In addition, the strategy had 61 trades since 2005.

However, the historical results for purchasing the top 2 ETFs are much more promising:

A relative strength system that purchased the top 2 ETFs has resulted in substantially higher returns versus the top 1 system. The strategy resulted in 50 trades or an average of  6-7 trades per year.

Additional strategies an investor could use would be to allocate a percentage of funds to each strategy. For example, if we allocate 50% of a portfolio to the 10 month moving average system and 50% to the 6 month top 2 relative strength system, the results are below:

As you can see, returns and the sharpe ratio were better than buy-and-hold but again it comes at higher turnover.

Below is a table comparing the various strategies tested above:

System Total Return % Volatility % CAGR % Sharpe Max Drawdown %
Buy and Hold 107.70 9.30 10.00 0.76 -16.71
Buy and Hold, Annual Rebalance 102.00 7.70 9.60 0.85 -14.03
10 Month SMA 89.70 6.70 8.70 0.87 -7.1
6 Month Relative Strength Top 1 111.20 19.00 10.30 0.46 -24.3
6 Month Relative Strength Top 2 213.90 12.40 16.10 1.04 -14.2
Combined Systems (10 month SMA + top 2) 145 9.3 12.4 1.01 -10.7

Simple tactical approaches like the ones detailed above offer viable alternatives to investors nervous about buying-and-holding the portfolio over the long run. For example, someone may be nervous about the direction of long-term rates and the potential for losses in TLT in the coming years.  A simple moving average system and relative strength system could help reduce exposure to asset classes when they display weakness.

These systems come at potentially higher trading costs and tax implications. Also, a systematic approach can be difficult for some investors to follow –  we may allow the outside “noise” to interfere with the signals of our investment system.  In doing so, we can actually hurt our long-term returns when compared to the original system or a buy-and-hold approach.

Key takeaways are threefold, 1) Buying and holding the Permanent Portfolio the past 8 years has resulted in strong risk-adjusted returns 2) Tactical approaches have offered slightly higher risk-adjusted returns and in some cases total returns, but with higher trading costs, 3) There is no guarantee any of the systems detailed above will perform well in the future. For example, a rise in long-term interest rates coupled with an equity market malaise or a collapse in the price of gold combined with either of the two could impact the strategy’s ability to outperform in the future.

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GLD and SPY Signals

The MarketClub ETF Portfolio/strategy created earlier this year has been quiet this summer as all four ETFs were on either a neutral or short (sell) signal. At its core, the service is a trend-following trading system. The strategy I created tracks MarketClub’s Trade Triangle buy/sell signals on four ETFs – USO, SPY, FXE, and GLD. For background on the portfolio please see my initial article on the portfolio here.

This portfolio should be looked at more as a collection of trades, rather than a comprehensive portfolio. The reason the “portfolio” has been so quiet this summer is the four ETFs tend to be highly correlated, so when one is on a signal, the other ETFs have a high probability of sharing the same signal. This is not a fault of the signals, but in my choice of ETFs. I may add some uncorrelated ETFs, such as TLT, in the near future in order to increase the number of signals and offer a better overall representation of potential applications of the signals.

MarketClub is a sponsor of Scott’s Investments, but these trades/tests are conducted in near real-time (I typically don’t have time during the day to publish the trades, so I post them in the evening).  My objective is to track and test, out-of-sample, the effectiveness of their trade signals.

Two long trades have been signaled on GLD and SPY in the past week.  A monthly trade triangle was triggered today (8/23) for GLD at 162.18.  SPY had a monthly trade triangle signal last week (8/16) at 141.66.  My blog update regarding the SPY signal is tardy, but I will track the portfolio using the 8/16 signal price.

The MarketClub chart for GLD is below:

The MarketClub chart for SPY is below:

To track the historical performance and current trade performance click on the “Marketclub ETF Portfolio” on the right hand side of Scott’s Investments.

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Thursday Investment Articles

Below are some worthwhile investment articles for this week:

Chris Vermeulen posted a video yesterday with some potential trade setups and trade education

From Mebane Faber: Buffett’s Alpha,  What Will Be Obvious 20 Years From Now, and his new Global Value paper.

Confidence and Enthusiasm – John Hussman

Doug Kass: Topping Out

Why Does Wall Street Always Win? Simon Johnson

PIMCO is Positioning for a Housing Recovery

Is Germany Entering a Recession? John Mauldin

Dance of Fireflies – David Kotok

Permanent Portfolio Shakedown Part 1 – Advisor Perspectives

The Trend is Our Friend: Risk Parity, Momentum and Trend Following in Global Asset Allocation – SSRN

Investing in the Second Lost Decade: A Book Review

Equity investors suffered through a difficult decade in the 2000s, with many investors seeing little or no returns for the greater part of the decade. Martin Pring, Joe Turner, and Tom Kopas co-authored Investing in the Second Lost Decade: A Survival Guide for Keeping Your Profits Up When the Market Is Down to guide us through the next lost decade of 2010-2020. The primary argument is that we are in a secular, or long-term, bear market for equities that began in 2000, and since most secular trends last for 20 years or more this bear market should continue for the rest of this decade.

The book’s these is told through a fictitious couple, the Smiths, who retired in 2000 and who face the challenge of needing income from their retirement savings while navigating the challenges of an equity bear market and low interest rates that are set to rise. Very few assumptions about the reader are made in the book, so if you are unfamiliar with the term “secular” or business cycles, these are explained in detail.

Are there still opportunities for profit in a secular bear market or should investors simply park their money in cash and wait it out? According to Pring, Turner and Kopas investors can hope to profit in secular bear markets. but they must be nimble and use cyclical trends to rotate between assets. Buy-and-hold works well in secular bull markets, with shallow drawdowns and an otherwise rising tide lifting all boats. However, secular bear markets are a more challenging environment – drawdowns can be more severe and downtrends can last for extended periods of time, resulting in lower overall returns, especially for the buy-and-hold investor.

Not only do the authors argue we are in an equity secular bear market but they also see interest rates rising in the near future and the potential for an increase in inflation (which, if we did decide to park our money in cash would quickly reduce our purchasin gpower). For fixed-income investors, rising rates lead to lower fixed-income prices leading to capital losses. With equities in a long-term bear market and interest rates set to rise, readers may at this point find themselves despondent.

The authors argue there is hope – commodities should serve as a hedge against rising inflation and help offset some of the losses investors could experience in other asset classes. They also present a strategy for rotating among major asset classes – cash, bonds, equities, and commodities – based on shorter-term cyclical trends that are based on the business cycle and typically last 4-6 years.

Cyclical trends exist within longer-term secular markets, thus even if we are in a 20 year (or more) equity bear market, asset classes including equities can have shorter-term bullish phases. The authors present a system comprised of simple indicators for indentifying cyclical trends, potentially providing readers an edge on when to over or under-weight equities, bonds, commodities, and cash.

One of the drawbacks of the book is the attempt to reach a multitude of audiences, leaving the book at times drifting between the perceived knowledge base of the reader. Novice investors might relate to the Smiths and will find the secular/cyclical explanations useful. However, the technical trend indicators and data points used to recognize market trends and then implement a trading strategy could be overwhelming for some investors. More experienced investors may find parts of the book slow, but the indicators used to identify cyclical trends are useful information. The appendix is also a must-read, with several indicators and strategies present in-depth for those wishing to manage their own tactical cyclical investment strategy.

Investing in the Second Lost Decade makes an important argument with monumental implications – that we are in the middle of a secular bear market. Their argument has implications for all investors in all asset classes as profits will be harder to attain during a secular bear. However, success is possible if investors have the knowledge and tools to recognize shorter-term cyclical trends.

Author’s note: If you are going to order this book I will receive a small commission from Amazon (and you will pay no more because of that) if you order through our website

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Weekend Readings

Apple vs LinkedIn – Technical Traders

The Power of Effective Diversification – Portfolioist

Simple But Not Easy: The Case for Quantitative Value (white paper)- Greenbackd

Why Hedge Funds Destroy Investor Wealth – Advisor Perspectives

Random Europe (pdf) – John Mauldin

Financial Markets, Politics, and the New Reality (pdf) – John Mauldin’s Outside the Box

Kass: Dreaded Triple Top Approaching? The Street

Monday Investment Readings

Below are some investment related articles I am reading this week:

Gold Mining Stocks Continue to Disappoint, but Not for Long – Chris Vermeulen

Repeal of Glass-Steagall: Not a cause, but a multiplier – Barry Ritholtz

And Then There is Disaster C (pdf) – John Mauldin

Reports of the Death of Equities Have Been Greatly Exaggerated – GMO

Turnkey Analyst’s Holy Grail of Quantitative Investing Part 1 of 4 here, Part 2 of 4 here.

Corn – David Kotok

Begging for Trouble – John Hussman

Market Volume: Summer Doldrums or Something Else?, Advisor Perspectives

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High Yield Momentum Portfolio, August Update

Once per month I update a high yield dividend stock momentum portfolio on Scott’s Investments.  The portfolio is comprised of the highest yielding stocks in the S&P 500 with high price momentum.

The portfolio is a simple quantitative strategy and begins by screening the S&P 500 for stocks yielding greater than 4%. The results are then ranked by their 6 month returns.  The top stocks are then added to a hypothetical portfolio and tracked publicly on Scott’s Investments.  This month there were 49 results, six less than last month.

Now you can follow me on Stocktwits and Twitter!

Per a previous article, the highest momentum, high-yield stocks have historically out-performed lower yielding, lower momentum stocks.  The screen is more of a trading strategy and less of a passive income strategy, although the dividends do play an essential component in the overall returns. Thus, turnover could be high and the strategy is not for everyone but I have added one modification to the strategy to minimize turnover.

In order to limit turnover stocks with yields that have fallen below 4% due to share price appreciation will remain in the portfolio. Stocks will only be sold when yield falls below 4% due to dividend cuts or when the six-month performance would otherwise lag the top 10-11 stocks in the screen. .

Click here for MarketClub’s Top 50 Trending Stocks

The portfolio has turnover in three positions for August. Kimco Realty (KIM), FirstEnergy (FE), and Lorillard (LO) are all being sold. FE lost 6.47% in its brief one month stint in the portfolio. KIM was closed at a 9.72% gain in 4 months and LO for a .69% gain in eight months. Individual security returns exclude dividends.

The proceeds were used to purchase positions in DTE Energy (DTE), CenturyLink (CTL), and Frontier Communications (FTR). DTE currently yields 4.12%, CTL 6.82%, and FTR 8.49%.

The High Yield Momentum Portfolio was designed to be fully invested at all times regardless of market conditions. However, as part of a larger portfolio there may be additional steps an investor can take to reduce risk and diversify strategies.  For example, the Ivy Portfolio uses a 10 month moving average to dictate an invested or cash position (signals are updated daily at Scott’s Investments). An investor could hedge long positions by shorting (or purchasing an inverse ETF) an equity market index such as the S&P 500 when it trades below a long-term moving average.

Below are the top 15 high yield momentum stocks as of August 9th.  Keep in mind that only 10 stocks are held in the portfolio, the current holdings can be viewed on the right-hand side of Scott’s Investments and in the second table below.

Since inception the portfolio is up 9.27% including dividends. Returns exclude commissions, taxes, and are hypothetical:

Data source: Finviz

Ticker Company Trend Dividend Yield Performance (Half Year) Price
T AT&T, Inc. Analysis 4.73% 27.46% 37.23
MO Altria Group Inc. Analysis 4.72% 21.61% 34.72
FTR Frontier Communications Corporation Analysis 8.49% 19.85% 4.71
VZ Verizon Communications Inc. Analysis 4.51% 19.81% 44.34
FII Federated Investors, Inc. Analysis 4.69% 18.20% 20.46
CTL CenturyLink, Inc. Analysis 6.82% 16.17% 42.54
RAI Reynolds American Inc. Analysis 5.20% 16.03% 45.39
CINF Cincinnati Financial Corp. Analysis 4.22% 13.87% 38.18
DTE DTE Energy Co. Analysis 4.12% 13.28% 60.22
TEG Integrys Energy Group, Inc. Analysis 4.63% 13.25% 58.8
PCG PG&E Corp. Analysis 4.01% 12.27% 45.39
AEE Ameren Corporation Analysis 4.65% 11.89% 34.43
AEP American Electric Power Co., Inc. Analysis 4.33% 11.52% 43.37
HCP HCP, Inc. Analysis 4.39% 11.28% 45.57
CMS CMS Energy Corp. Analysis 4.05% 11.26% 23.72

Current positions including the new updates:

Position Shares Purchase Price Purchase Date Cost Basis Current Value Percentage Gain/Loss Excluding Dividends
MO 312 31.79 5/11/2012 $9,918.48 $10,832.64 9.22%
VZ 236 44.9 7/11/2012 $10,596.40 $10,464.24 -1.25%
CINF 312 34.45 2/10/2012 $10,748.40 $11,912.16 10.83%
FTR 2349 4.71 8/9/2012 $11,063.79 $11,063.79 0.00%
FII 529 20.89 3/12/2012 $11,050.81 $10,823.34 -2.06%
T 295 33.59 5/11/2012 $9,909.05 $10,982.85 10.84%
RAI 231 45.7 7/11/2012 $10,556.70 $10,485.09 -0.68%
CTL 260 42.54 8/9/2012 $11,060.40 $11,060.40 0.00%
PCG 233 45.06 6/11/2012 $10,498.98 $10,575.87 0.73%
DTE 183 60.22 8/9/2012 $11,020.26 $11,020.26 0.00%
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