Low Volatility Index

[NewPPer]

I've recently read an interesting article on the idea of Low Volatility Indexing and wanted to know what the Permanent Portfolio advocates think about it.

Here's the article: http://howtoinvestonline.blogspot.com/2 ... ising.html

And here's a performance chart from stockcharts.com: http://stockcharts.com/freecharts/perf. ... I,SPY,SPLV

The basic idea seems simple enough, but I wonder how it will play out in practice. Perhaps this would be something to put in a VP instead of in the PP itself? 

For the S&P 500 this is what the blurb says:

The PowerShares S&P 500® Low Volatility Portfolio (Fund) is based on the S&P 500® Low Volatility Index (Index). The Fund will invest at least 90% of its total assets in common stocks that comprise the Index. The Index is compiled, maintained and calculated by Standard & Poor's and consists of the 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months. Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time.

Interested in the views of others on this new indexing option.

Thanks,
New PPer

[MediumTex]

For the PP you would basically want the opposite of this approach.

The PP seeks maximum volatility in each of its 4 assets.

[craigr]

Also using past volatility measures is driving by using the rear view mirror. The past does not predict the future.

[alvinroast]

This is turning out to be my biggest problem area of the PP. I've in the process of shifting assets into a PP for the last couple of months. I really thought the tough part would be the LTT bonds given the both the low interest rates and the moral hazard of loaning money to an unworthy debtor.

Now that I've jumped into the LTT I realize that none of my stock portfolio of Preferred Stocks/Util/Consumer Staples belongs in the PP. For now I am considering that my VP while I pare it back, but it certainly feels strange to have high yielding conservative positions in the variable account. I was imagining that as the high risk speculative account. I still feel pretty good about the non-correlation with the PP positions, but after moving to low volatility positions I feel like I'm back to square one. I just keep telling myself it was good enough for Harry Browne...

[MediumTex]

This is turning out to be my biggest problem area of the PP. I've in the process of shifting assets into a PP for the last couple of months. I really thought the tough part would be the LTT bonds given the both the low interest rates and the moral hazard of loaning money to an unworthy debtor.

Now that I've jumped into the LTT I realize that none of my stock portfolio of Preferred Stocks/Util/Consumer Staples belongs in the PP. For now I am considering that my VP while I pare it back, but it certainly feels strange to have high yielding conservative positions in the variable account. I was imagining that as the high risk speculative account. I still feel pretty good about the non-correlation with the PP positions, but after moving to low volatility positions I feel like I'm back to square one. I just keep telling myself it was good enough for Harry Browne...

Here is an interesting idea:

You could build a VP that consisted solely of PP tweaks.

Stocks: dividend paying blue chips and utilities
Bonds: 10 year average duration corporate bonds
Gold: TIPS
Cash: CDs at FDIC insured institutions

It would be fun to watch this portfolio in comparison to the PP and see how the two performed in relation to one another.

[NewPPer]

Tex, Craig, Clive,

I agree with all your comments, and I agree that this type of index wouldn't work as well in a PP. The article states that the likely performance would be the following: "lower gains than the market index during strong bull markets (such as the tech bubble) - this is the big trade-off ... in periods lasting several years... higher gains in the long term as the advantage of not losing during downturns more than makes up for the gain shortfall during strong bull markets"

In the PP during the downturns you would be making it up in other areas (gold or LTTs) and would be potentially be rebalancing at much lower stock prices, therefore the downturn protection isn't worth the trade-off for the big bull markets.

However, this leads me to Tex's comment on volatility. You stated that "The PP seeks maximum volatility in each of its 4 assets." Why then are small cap stocks not advocated over large cap?

I'm Canadian so I'll use a Canadian example as well as a US one, but in the following chart we see that the TSX Completion Index, which contains mid-cap and small-cap stocks, does better than the TSX 60 or the TSX Composite. We see that the highs are higher (2003-2007) and the lows are worse (2008). http://stockcharts.com/freecharts/perf. ... O%2CXIU.TO

We see the same effect in the US comparing Vanguard's VTI (Total Stock Market) to VB (Small Cap) http://stockcharts.com/freecharts/perf.html?VTI,VB

So if we are trying to maximize volatility why wouldn't we put the more volatile small-cap indexes in our PP stock allocation than a more general total market index? One obvious answer is simplicity, which I fully accept (for example I recently implemented a Canadian PP for my mother and gave her the standard TSX Composite index ETF which she understands instead of confusing her with terms like small-cap, value, growth, fundamental indexes, etc..). But for those who accept the premise and rationale of the PP (which after reading this blog, a lot of the forum, and Fail-Safe Investing, and Why the Best Laid Investment Plans Usually Go Wrong I completely do) why wouldn't the stock allocation of a savvy PPer be more volatile?

Back to discussion about this low-volatility index, I feel that it might have a spot in the VP for someone who wants to put "money he can afford to lose" into stocks, but somewhat more defensively. If it does indeed provide lower volatility and good returns it seems like a good play. All that being said the current ETF offerings are very young so perhaps it would be wise to give it time.

Thanks for the responses guys,
New PPer


 

[craigr]

However, this leads me to Tex's comment on volatility. You stated that "The PP seeks maximum volatility in each of its 4 assets." Why then are small cap stocks not advocated over large cap?

They're not consistently more volatile on the upside. There have been protracted periods where they lagged the markets vs. Large caps on the downside. So volatility cuts both ways.

Overall in theory you are correct, but in actual practice the total stock market funds are probably the most efficient way to capture maximum market returns. Not to mention that in the past many small cap funds were easily 2-3X as expensive as large cap funds plus had much worse tax efficiency. So even if you had maximum gains, you had these other costs to consider nipping at the heels.

At some point you just reach a point of "good enough" and for me that is the simplicity of a broad based index fund. It's the fund you can own and not have any regrets.

I'm Canadian so I'll use a Canadian example as well as a US one, but in the following chart we see that the TSX Completion Index, which contains mid-cap and small-cap stocks, does better than the TSX 60 or the TSX Composite. We see that the highs are higher (2003-2007) and the lows are worse (2008). http://stockcharts.com/freecharts/perf. ... O%2CXIU.TO

In the US if you go back to the 1990s though you'll see large caps beat small cap stocks. Same thing happened from 1980-1990. So it's all time dependent.

why wouldn't the stock allocation of a savvy PPer be more volatile?

Browne's ideas was that the volatility of stocks as a measure of Beta (volatility vs. the S&P 500) would be consistent going forward. So he tried to pick more volatile funds based on the same ideas as bonds and gold. He was wrong. What happened is that high beta funds would turn low beta going forward. Again past does not predict the future. The best solution (which he advocated later) was to just buy the S&P 500 index. But today the Total Stock Market index is even better as it includes small and mid caps all in one package.

BUT, if you wanted to mix in some Small Cap Value into the stocks and used a low cost passive index to do it I don't see any real problem. Just don't turn it into market timing and beware of the potential tracking error if small caps lag the large caps for many years (which happens).

Back to discussion about this low-volatility index, I feel that it might have a spot in the VP for someone who wants to put "money he can afford to lose" into stocks, but somewhat more defensively. If it does indeed provide lower volatility and good returns it seems like a good play. All that being said the current ETF offerings are very young so perhaps it would be wise to give it time.

These new products come and go like a summer breeze. You may find in two years the product doesn't have enough customers so they shut it down. This is why I just recommend people stick to really big well established funds. You'll likely get better and more stable performance.

But if it's a VP play, then go for it. Just be sure it's money you can afford to lose.

[alvinroast]

This is turning out to be my biggest problem area of the PP. I've in the process of shifting assets into a PP for the last couple of months. I really thought the tough part would be the LTT bonds given the both the low interest rates and the moral hazard of loaning money to an unworthy debtor.

Now that I've jumped into the LTT I realize that none of my stock portfolio of Preferred Stocks/Util/Consumer Staples belongs in the PP. For now I am considering that my VP while I pare it back, but it certainly feels strange to have high yielding conservative positions in the variable account. I was imagining that as the high risk speculative account. I still feel pretty good about the non-correlation with the PP positions, but after moving to low volatility positions I feel like I'm back to square one. I just keep telling myself it was good enough for Harry Browne...

Here is an interesting idea:

You could build a VP that consisted solely of PP tweaks.

Stocks: dividend paying blue chips and utilities
Bonds: 10 year average duration corporate bonds
Gold: TIPS
Cash: CDs at FDIC insured institutions

It would be fun to watch this portfolio in comparison to the PP and see how the two performed in relation to one another.

Thanks MT. I may just do that since I'm half way there already. If we replace TIPS with Silver and FDIC insured CDs with Australian bank accounts I'm basically there already. It is after all in the VP at this point. At the end of a year when it underperforms against my PP maybe I'll learn to live without a VP.

[Alanw]

alvinroast,
If you want a comparison on how a more volatile stock portion of the PP would work, check the Paul Boyer Mad Money Machine site.  He follows the HBPP principal except the stock portion contains SCV and EM. The graphs will show you how this compares to the original HBPP.

[alvinroast]

Thanks Alanw

The 2011 chart  seems like a strong statement for not adding EM to the mix right now. I could still definitely see including small value in the stock portfolio though.

I plan to hold back on most of the international stocks until I have a definite plan for where I want to move to.

[MachineGhost]

The PowerShares S&P 500® Low Volatility Portfolio (Fund) is based on the S&P 500® Low Volatility Index (Index). The Fund will invest at least 90% of its total assets in common stocks that comprise the Index. The Index is compiled, maintained and calculated by Standard & Poor's and consists of the 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months. Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time.

I'm not sure this is going to work.  Low volatility outperforms if it is relative to the entire stock universe.

MG

[stone]

Thanks Alanw

The 2011 chart  seems like a strong statement for not adding EM to the mix right now. I could still definitely see including small value in the stock portfolio though.

I plan to hold back on most of the international stocks until I have a definite plan for where I want to move to.

My (sort of) PP does have the stock part split into three (CTY, BRSC, TEM). Paul Boyer's chart doesn't have any rebalancing in it yet.  I was adding to my PP through the year and the EM stock part (TEM) actually has come out as the holding that has given the greatest gains so far (more than LTT or gold). I realize that this is a weird result because the account has three times as much in it now as it did a year ago but it does indicate that volatile stocks can work in the PP.

[stone]

Here is an interesting idea:
You could build a VP that consisted solely of PP tweaks.

Stocks: dividend paying blue chips and utilities
Bonds: 10 year average duration corporate bonds
Gold: TIPS
Cash: CDs at FDIC insured institutions

It would be fun to watch this portfolio in comparison to the PP and see how the two performed in relation to one another.

That "Personal Asset Trust" PNL seems a little bit like that. It has gold, US TIPs, some Singapore treasuries,  US, UK and Swiss blue chip defensive stocks.

http://www.trustnet.com/Factsheets/Fact ... PNL&univ=T
          1y      3y      5y    12m-24m 24m-36m 36m-48m 48m-60m
  NAV  +15.0 +51.4 +41.0    +13.2      +16.4    -5.7      -1.3
 
With TIPs I guess there is a world of difference between long dated and short dated TIPs. The UK 40year index linked gilt TR8F is very volatile. It has been gyrating as much as gold and LTT over the past year but not consistently in lock step with either of them.

[alvinroast]

Stocks: dividend paying blue chips and utilities
Bonds: 10 year average duration corporate bonds
Gold: TIPS
Cash: CDs at FDIC insured institutions

Corporate bonds have a higher risk of default. Overall whilst paying a higher yield, the periodic defaults will knock those gains back to being not too dissimilar to having held safer treasury's. 25% in 10 year and 25% in CD's wouldn't be dissimilar to holding 50% in 5 year.

MT's above allocation is light on domestic currency hedge, allocating stocks to international is one way to address that.

25% international stocks, 25% TIPS, 50% 5 year Treasury isn't too adrift from a Larry Swedroe Fat Tail Minimisation (FTM) allocation. Best I can tell the FTM and PP have very similar risk and rewards over the longer term, but do at times deviate from each other over shorter periods of time. Holding equal amounts of both reduces the overall volatility (risk) without affecting rewards.

Indicative yearly total gains stat's (1926 to 2008 inclusive)


   Pearson Correlation 0.38

A LTT/STT barbell within a PP isn't that different overall compared to holding mid-duration, which in turn isn't that different to holding 5 year constant roll (or a ladder).

I'd suggest an alternative of a 50% allocation to a PP comprised of 25% international stocks, 25% gold, 50% 5 year T and a 50% allocation to 30% international small cap value, 70% TIPS. Which combined amounts to

12.5% international stocks
12.5% gold
25% 5 year T
15% international small cap value
35% TIPS

Combining the 12.5% and 15% stocks together, perhaps into an overall allocation of

13.75% international value
13.75% international small
12.5% gold
25% 5 year T
35% TIPS

Since asset weightings will be different soon after having bought due to price fluctuations, rounding to

15% IV
15% IS
10% Gold
30% 5 Year T
30% TIPS

Rolling 30 year real (after inflation) annualised % gains

Thanks for the analysis Clive.

I have really appreciated Swedroe's focus on non-correlation. I was leaning toward his version since my wife is not a fan of gold. I really couldn't stand not owning gold so I took another look at HBPP. Seeing them together really makes me feel better about the Swedroe/Brown mishmash I have while in the transition to HBPP. Since the other holdings are quite conservative I'm going to sleep well tonight. I really like cutting the Std. Dev. as much as possible right now.

I'm going to review both tomorrow and see if I'm missing anything. One thing I wonder about is what happens if the US stock market takes off and Intl doesn't. Since Lg Cap US stocks are growing fastest in the Intl markets, that may not be likely of course. I'm also not a big fan of TIPS and currently have a LTT/STT barbell (using EDV).

Then again the perfect is the enemy of the good.

Thanks again for the insights.

[TK3]

I found the pp through two sources: the large post on the Bogelheads forum and by running all of the standard lazy portfolio's though Geoff Consodine's Monte Carlo simulator.  I have found his writing about diversification very enlightning, and wanted to share this article with the group.

http://advisorperspectives.com/newslett ... wbeta3.php

When I review the PP historical returns, for some reason I always want to stop and review the years when stocks fall off the table.  Perhaps it is just how we are trained to look at the market every day, or to use the market as a proxy for investment success.  Great reading!!