Part II Dynamically balanced equity portfolio with a politically corrupt Fed
Origin Process Return Objectives:
150 % of NGDP with 60% risk of SP500.
The “Origin Process”
Axioms of the Origin Process:
1. Return is sourced from the “origin”" of all return: NGDP; 2. NGDP return is increased by assets that use leverage - The Origin Process uses SP500 companies. SP500 companies all use leverage which makes for a higher and riskier return than NGDP; 3.Origin Process does not seek a greater long term return than the SP500, but does seek a lower risk than the SP500; 4.Along with providing a lower ongoing risk than the SP500, the Origin Process also seeks to mitigate the recession or business cycle impact; 5.The Origin Process focus is on knowing NGDP and the business cycle. The Origin Process seeks to reduce risk that does not result in return, strives for simplicity and clarity, uses a small number of assets used, and provide offset to the business cycle downturn; 6. The Origin Process uses the SP500 major sectors with the SPDR suite of sector ETFS, the SP500 ETF SPY; and the long duration US Treasury ETF the TLT. 7. The Origin Process first seeks to mitigate the business cycle risk and then via active portfolio management weight those sectors which in combination provide the optimal use of pairwise correlation with volatility. While return is very difficult to predict, or anticipate, volatility is prescient that results in a useful forward looking view of risk.
3.Mapping the risk management and “insurance” of long maturity US Treasurys.
With the above in mind the rolling returns (6 months) of long US Treasurys and SP500 is graphed. The ability for US Treasurys to offset SP500 declines is shown. And when US Treasurys trade down, it is usually when SP50 trade up. There is no obvious timing ability based on this data to manage the dynamic reweighting.
The volatility of both US Treasurys and SP500 is persistent and thereby does have forward looking information. The volatility of the US Treasurys - here the SP500 SPY ETF and the long US Treasury ETF TLT - is graphed and the volatility of both the SP500 and US Treasurys is similar.
The two volatilities are then considered with the correlation of US Treasurys and SP500, this is quantified by the covariance or the risk of the entire portfolio. If the volatility of both is high and the correlation is greater than 0, or positive, the portfolio covariance is higher as the US Treasury and SP500 are moving together. If the correlation of US Treasurys to Sp500 is negative then the two are moving in opposite, and the covariance or riskiness of the portfolio is low, no matter the volatility of the two assets. The “Origin Process” will look to the nature of the US NGDP growth - the “origin” of return - to in the end allow the portfolio to reach objectives, with the dynamic reweighting of this US Treasury to Sp500 weights.
4.Backtesting to understand the potential return, likely risk and the amount of US Treasurys that were effective in the past.
The dynamic reweighting is based upon volatility staying the same, in a regime for the trade horizon.
Theoretical backtesting is done not to promote or to predict, but only to indicate if the strategy has good potential.The least riskiest combination and the resulting covariance of the two assets is optimized or solved and then that solution of portfolio weights is tracked versus the index - in this case the SP500 cumulative return.
The above backtest for the last ten years to date had the following dynamic reweight solutions:
The summary graph of the above:
The resulting drawdowns, or risk of the above in return per weekly period.
Origin Process uses a series of different time spans of the efficient optimized portfolio solution, mapping out the “efficient frontier”. The current portfolio suggested by the solution and the weights for that portfolio (using the last 5 years of return and risk data). This shows how much return will be lost if one did not do just the highest return asset - in this case the SP500 - and how much risk will be reduced with the lower yielding US Treasurys. In the graph below 6% extra return was foregone to reduce the risk of the portfolio by approximately 50%. Selecting the assets in the portfolio only on expected return would require that is unlikely or impossible, but the ability to forecast risk is doable as risk stays in regimes and is thereby predictable. This is the last 5 years of risk and return data used to solve for the most efficient portfolios of combinations of US Treasurys and the SP500.
The weights of the long US Treasury and the SP500. Two solutions are solved for, the least risky portfolio (red dot above) and the riskier but still an efficient solution deploying extra risk, the tangency portfolio (blue dot above):