An active 60/40 portfolio

This is part 3 of a series of posts:

  1. A closer look at common asset classes
  2. Variations on 60/40 portfolios
  3. An active 60/40 portfolio

In the previous post we looked at 60/40 portfolios, and their characteristics. While we have been able to improve performance, and reduce volatility, the portfolio still suffered from deep drawdowns. In this post, we will show how these drawbacks can be addressed with the addition of an active component.

Recap

Let us first recap the 60/40 portfolio, built from Vanguard’s Total Stock Market ETF, VTI, and iShares’ 20+ Year Treasury Bond ETF, TLT:

active 60 40 active VTI TLT

While compared to the S&P 500 overall drawdowns have been greatly reduced, and recovery is much faster, investors will still perceive this as a roller coaster ride.

From the post on asset classes, we remember that SPDR Barclays’ 1-3 Month T-Bill ETF, BIL, has cash-like properties, with low but steady returns, and neglectable drawdowns, making BIL a great choice for a safe instrument:

active 60 40 BIL bars

The plan

According to the efficient-market hypothesis, future prices cannot be predicted by analyzing prices from the past. However, it has been observed that the market shows anomalies, leading to the markets being less efficient than expected. One of the most important anomalies is momentum. In finance, momentum describes the tendency of assets to continue a trend established in the past. Assuming momentum exists, we should avoid investing in assets, which have shown a downward trend in the recent past.

With this in mind, we define our active 60/40 portfolio as follows:

  • Calculate the simple 12-month momentum for VTI and TLT.
  • Invest 60% in VTI, if it has positive momentum.
  • Allocate 40% to TLT, if it has positive momentum.
  • Put the remainder in BIL.
  • Re-balance once per month.

A first attempt

With our rules in place, we are now ready to simulate our active 60/40 portfolio. Here is the chart:

active 60 40 active VTI TLT

Wow, this made quite a difference! We make the following observations:

  • Performance has slightly decreased to now 6.3%.
  • Maximum drawdown has greatly decreased to now 12%.
  • Beta has fallen to 0.14.

While it is hard to give up performance, it was well worth it: Our risk-adjusted return has strongly increased, making it much easier to find sleep in turbulent markets. It is our belief that high risk-adjusted returns are much more relevant than maximum absolute performance.

Further improvements

Of course this portfolio can (and should) be further improved. One of the crucial parts is the method calculating momentum. The simple 12-month momentum does not react fast enough to changing markets. Also, assets which have fallen below their historic average have a tendency to perform worse.

Here are some ideas for improving the momentum calculation:

  • Consider momentum to be negative, if it falls below critical historical averages.
  • Calculate momentum on multiple time frames, and blend the results.

By simply adding some more complexity to the method of determining momentum, we can achieve this:

active 60 40 active VTI TLT 2

We note the following differences to the previous portfolio:

  • Our average annual return has increased to 9.2%.
  • The maximum drawdown has shrunken to 8.0%.
  • Our Beta has stayed at 0.14.

This is an overall quite pleasing result. We have good return, combined with low drawdown, and very low market correlation.

But wait – there is one more important observation to make. Let’s have a look at the portfolio’s annual returns:

active 60 40 active VTI TLT 2 bars

As we can see, this portfolio trails the S&P 500 in most years, and still comes out ahead in the long term. This is very much along the lines of The Hare & the Tortoise: The race is not always to the swift. Or in other words: “win more by losing less”. Also, for a portfolio like this, a passive 60/40 portfolio would a much more appropriate benchmark than S&P 500.

Wrap-up

While this is a very simple example, it demonstrates the value and potential of actively managed portfolios. Compared to S&P 500, or passive 60/40 portfolios, we have significantly reduced investment risk, as measured by maximum drawdowns, while at the same time improving average returns. The resulting investment is well diversified and does not add any particular sector or factor risks. Creating and managing the portfolio neither requires fancy math, nor a prohibitive amount of involvement in the markets.

On the flip side, actively managed portfolios have tax implications, depending on the annual turnover, and the resulting holding periods of the investments. The example presented here has a low trading frequency, mostly avoiding short-term capital gains. However, a buy-and-hold strategy is essentially tax-free, while an actively managed portfolio will create taxable events on a regular basis. Therefore, portfolios like this will work best in tax-deferred accounts.

We very much hope that this series of posts provided some valuable insight into the advantages of actively managed investments. At Bertram Solutions, we pride ourselves in doing independent research, and this post is a good example of our approach to analyzing investments.