A few months ago, on my Winning Investing site, I described an investing strategy of my own device, intended to provide positive returns in almost any market. I called it the Variable Uncorrelated Portfolio.
At that time, I had data showing that the strategy would have produced good returns in the past (+50% from 1/1/09 to 11/27/10), but those sorts of theoretical historical tests often don’t translate to similar future real world results. So, last week, I tabulated more current returns, starting with January of this year.
For the first six months of the year, the portfolio gained around 8% compared to 2% or so for the overall market, at least as measured by the S&P 500. More on those results in a minute, but first some background.
The strategy is based on building a portfolio of uncorrelated assets. Uncorrelated assets are asset classes that don’t necessarily move together, nor do they necessarily move in opposite directions. Hence, they are uncorrelated.
Gold and U.S. stocks are a good example. Gold prices are just a likely to rise or fall in weak or strong stock markets. Same thing for bond prices versus stocks. Sometimes they move together and sometimes they go in opposite directions.
While I came up with this particular implementation, the basic idea of creating a market neutral strategy using uncorrelated assets is not new. My portfolio of uncorrelated assets was inspired by a mutual fund, The Permanent Portfolio Fund (PRPFX) that has outperformed the overall market with much less volatility over the years.
My list of asset classes includes Swiss Francs, precious metals gold and silver, emerging market stocks, European stocks, energy stocks, U.S. stocks, and bonds issued by governments in emerging markets.
Enabled by ETFs
Until recently, it would have been difficult, if not impossible, for individual investors to take positions in such asset classes. However, the proliferation of Exchange-Traded-Funds (ETFs) makes it doable. ETFs have been devised to track just about every asset class that you could think of, and new ETFs are coming on line almost every week.
While many strategies involve holding fixed positions in each asset class, recent research has found that you can improve results by paying attention to market action and avoiding currently weak asset classes.
My strategy takes that approach. You rebalance each month and only buy currently strong assets. The money you would have used to buy the weak asset classes goes into a safe U.S Treasury fund. Thus, instead of being fixed, it’s a variable portfolio of uncorrelated asset classes.
Variable Uncorrelated Portfolio
My uncorrelated portfolio includes eight ETFs. Here’s the list, including the corresponding asset categories.
- Swiss Franc Currency Shares (FXF): Foreign Currency
- SPDR Gold Shares (GLD): Precious Metals
- iShares Silver Trust (SLV): Precious Metals
- iShares MSCI Emerging Markets (EEM): Emerging Markets Stocks
- iShares S&P Europe 350 Index (IEV): European Stocks
- iShares DJ U.S. Oil Equipment & Services (IEZ): U.S. Energy Stocks
- SPDR S&P 500 Index (SPY): U.S. Large-Cap Stocks
- PowerShares Emerging Markets Bond (PCY): Emerging Markets Bonds
Start by allocating equal dollar amounts to each of the eight ETFs. However as already mentioned; you wouldn’t necessarily hold all eight ETFs at any given time. Instead, you only buy the ETFs that are currently trading above their 200-day moving-averages.
A moving average is the average closing price of a stock or fund over a specified period. Stocks or funds trading above their moving averages are said to be in uptrends, and those trading below are in downtrends. I picked the 200-day moving average, which tracks relatively long-term trends, because most of the research that has been reported on this topic was based on the 200-day MA.
Instead of buying the ETFs trading below their moving averages, use the same cash to buy the iShares Barclays 1-3 Year Treasury Bond ETF (SHY). You can use Yahoo (finance.yahoo.com), or many other financial sites to determine whether each ETF is trading above or below its 200-Day MA.
Repeat the process monthly. You don’t have to wait until the first of a month to start. Any day works as long as you are consistent and reallocate your funds on the same date of each month.
2011 Monthly Returns
Here are thus year’s returns by month of the Variable Uncorrelated Portfolio (VUP) compared to the S&P 500.
• January: VUP -0.8 percent, S&P +2.3%
• February: VUP +5.5 percent, S&P +3.5%
• March: VUP 0 +2.8 percent, S&P +0.1%
• April: VUP +7.0 percent, S&P +2.9%
• May: VUP -4.0 percent, S&P -1.1%
• June: VUP -1.9 percent, S&P -1.7%
While the cumulative year-to-date returns look encouraging, we need a much longer track record to declare victory, so don’t put serious money here. Also, there is undoubtedly room for improvement in my selection of asset classes. Tell me if you think you have a better idea.
For more on market neutral strategies, see my Kindle book, Exchange-Traded-Fund Investing: What You Need to Know.