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Regarding alternatives to the standard 60/40 US equity / bond asset allocation, I have reviewed three relatively tame possibilities. The results, based on the addition of various flavors of foreign stocks and fixed income securities, have been less than impressive, although in part because US markets have been in tears in recent years. Let’s take another dive into the possibilities with a more drastic approach with a volatility ETF.
For the uninitiated, theft ETFs are funds that target the volatility of the stock markets as an asset class. The standard approach is to hold VIX futures contracts. The basic idea is that these futures, which are approximations of market volatility (i.e. risk), tend to be negatively correlated with returns and that a strong market correction will therefore be offset by a significant gain of. As such, theft detention is a powerful counterweight to market corrections.
It should be noted from the outset that there are important risks to be taken into account with theft ETFs, in particular in a context of purchase and custody. Considering the upward trend of the stock market over time, VIX ETFs are destined to lose money. The longer you hold these funds, the greater the loss (assuming a buy and hold strategy). The intention (at least according to some traders) is rather to use VIX ETFs on a tactical rather than a strategic basis.
Let’s give up that advice in this test. Why would we do this? The short answer was recently described by a risk manager on the value of a dedicated “convexity strategy†over time. David Dredge, CIO of Singapore-based Convex Strategies, discusses the details in a podcast on Macro Hive, explaining that the standard 60/40 stock / bond mix is ​​a crass tool for managing market risk. Instead, he recommends allocating part of a risk portfolio to long-flight strategies.
To be clear, Dredge does not recommend ETF theft per se and therefore the following does not in any way reflect how its company handles theft for clients. Also note that there are many alternatives to theft ETFs, including options, futures and other derivatives. Suffice it to say, Dredge strategies are more sophisticated than the ones shown below.
That said, the goal here is to seek some perspective on how adding a flight allocation to a 60/40 portfolio changes the risk / reward profile. In practice, you would almost certainly use something other than theft ETFs for a dedicated long allocation in the manner of ideas discussed by Dredge and other risk managers. But as a first approximation of how these strategies can work, it’s easy to test the idea with theft ETFs.
With that in mind, consider how a standard 60/40 portfolio compares to moving various amounts from the bond allocation to the ProShares VIX Mid-Term Futures (NYSE 🙂 ETF.
For the allocation of stocks and benchmark bonds, I use Vanguard Total Stock Market Index Fund ETF (NYSE 🙂 shares and 40% Vanguard Total Bond Market Index Fund ETF (NASDAQ 🙂 shares, with a date starting ten years ago (September 19, 2011). For theft allocations, various degrees of the bond allocation (BND) are moved to VIXM. Concretely, there are three portfolios of 5%, 10% and 20% in VIXM (with corresponding reductions in BND). In all cases, US equities (VTI) remain at a target weight of 60%. Also note that all portfolios are rebalanced to target weights at the end of each calendar year.
Here’s how wealth indices stack up via yield and a few basic risk metrics:
Next, consider a visual performance review over the ten-year window:
Index
Although the Standard 60/40 Portfolio (BMK.60.40) outperforms, the risk management benefits of adding VIXM to the strategy are not negligible. Notably, the Sharpe and Sortino ratios are higher in the three alternative portfolios and the maximum drawdowns are significantly lower. In other words, the reduced return is arguably more than offset by a lower risk. Not too bad when you consider that these alternative strategies don’t require any forecasting or timing skills.
In the real world, these results can be further improved with greater efficiency in derivatives, in part by reducing costs — Morningstar reports that VIXM charges a high expense ratio of 0.87%. Caveats aside, this toy example suggests that a dedicated volatility allocation may work satisfactorily in finding an alternative to the standard 60/40 strategy. Even more so if the easy gains of US stocks and bonds over the past decade shift to a higher risk environment and lower returns, as some analysts predict.
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