Friday, March 17, 2017

Review for a dynamically re-weighted "balanced" ETF sector portfolio - still cash weights

Current Commentary/Analysis For:

## [1] "March 17 2017"

Origin Process Current Review

Paired correlation of the six month run (below) shows the US Treasurys (UST) offset to SP500 and various key SP500 sectors will not be effective as the correlation is staying at 0 or a higher positive value, so our UST weight is 0%. (See the Origin Process rates and yield curve analysis.) Over the last 6 months, with that key Trump equity rally, only finance (XLF) and industrials (XLI) had meaningful and useful, from a portfolio construction point of view, negative correlation.
The SP500 sectors in the 6 month time frontier frame shows the market rally since the election has most of the return from the XLF (finance) ETF sector, which means that active management was not valaue added. Or, in other words, the market return is not based upon portfolio construction but is dependent on the digital of being long or short finance (XLF).
Based on the data for this last rally - six months to date - the “Equal Weighted Portfolio” (EWP) shows (gray box now to the left of the frontier) market return but less risk (see the 6 months frontier below), again showing active management is not additive. The current market is a speculative market, and to apply active portfolio management is naive or likely lacking integrity.
This has been further exacerbated by the recent “State of the Union” address to Congress rally in finance(XLF) which has near singlehanded pulled the market to record highs, around the 2300 level. But again this is almost solely a finance sector (XLF) based market.
Since US Treasurys are “blown” and still too rich to provide a hedge or potential offset to a SP500 and sectors correction, the ability to take equity risk is even further reduced in addition to the speculative nature of this market.
The market is speculative and 88% of the recomended portfolio is cash with 5% in finance and 5% industrials.
The following analysis uses a read of graphing the efficient frontier at various time spans, and then derives the optimized weights of allowed assets - the SP500 major sectors, and an analysis of the market and the asset volatility and an analysis of the correlation between US Treasurys and the SP500.
Using the correlation and the volatility of the assets, a frontier of the optimal portfolios are mapped for 6 months, 1 year, and 3 years.
The 6 months frontier is “swamped” by finance (XLF), but recently outward bowing of the frontier to the left has started. The equal weighted portfolio (EWP) is coming closer the the frontier but is still to the left indicating that active managment has not been useful. If excellent timing was not applied since the election and then after the State of the Union address with the finance sector (XLF), this rally would not have resulted with good risk adjusted returns for the portfolio manager. And since the absence of US Treasury negative correlation which reduces risk taking, and since only 2 sectors are showing in the histograms below, the market is speculative and does not justify the equity bets as per active management. For the most, cash is the best risk qualified return. HOwever the beginning of an outward bowing requires close watch over this market as active management may be shortly useful.
The vertical formation of the 1 year frontier indicate that if the right sector (XLF) was not weighted, sub par returns would have resulted for the last year. The market is speculative and the portfolio has maximum cash weights.
However in the last few weeks the 6 months frontier is developing more of an outward bowing.
The one year efficient frontier graph now has some outward bowing curvature but the EWP to the left of the frontier shows a simply SPY holding would be the best risk reward long equity investment. Large banks are still near or even under book value so a “short” of finance (XLF) is as risky as to be long finance (XLF).
The model will be run daily and the cash position will be reduced when a “normal” outward bowing curve appears, likely first appearing in the the 6 month graph.
The 3 years frontier graph shows the normal efficient frontier shape bowing out allowing return to be maintained yet risk greatly reduced by weighting low correlated sectors.
As the two years and less frontier graphs are in this 3 year graph, by definition, shape, then the weights of assets that are the optimization solution when cash weight is reduced will likely be close to the three years histogram portfolio weights, provided below.
Histograms of the above time periods show the weights for the least risk solution portfolio and the risky solution of the tangent line portfolio.
The first set on 6 months of data shows what sectors are driving the vertical frontier graph given above - finance (XLF) and and surprisingly tech (XLY) is starting to show gven the tech sector low volatility.
6 Months data histogram of weights for the optimized portfolio:
One year of data histogram of weights for the optimized portfolio:
Three years time span, staples (XLS) sector is a keystone weight and finance and tech become drivers of formore return realized but with added risk.
Once the level of speculation drops with a more outward bowing efficient frontierand with the EWP moving to the right of the frontier, the weights deployed as cash is reduced will likely be finance (XLF), tech (XLY) and consumer staples (XLS).
Three years of data histogram of weights for the optimized portfolio:
The above frontiers and optimal weights provided are put through a backtest for the last ten years. This is not forward looking but is plotted to see if there is a coherent structure to the optimized portfolios over time, such that active management is useful.
And good results for active management shows the use of US Treasurys and then reweighing to more optimal equity sector mix can keep pace with the index - the SP500- yet result in about 65% of the index risk (the backtest shows 61% for the last 10 years).
Note that in theory the main tool of reducing risk is the use of US Treasurys (TLT). Since US Treasurys are relatively the same credit quality as SP500, this explains why investors will accept US Treasurys yields of about 1/2 of SP500 yield. That differential is the price for the US Treasury insurance in for those economic downturns.
The “drawdown” of the theoretical backtested portfolio shows that in theory the model recommended weights that would have resulted in 50% of the market loss - the index SP500.
The summary of the above in the backtest plot shows the potential for good risk adjusted returns in comparison to the index, the SP500 with the Origin Process active management. Past returns and certainly not backtesting is no indication of future returns realized, they only frame the analysis of the portfolio process.
A theoretical “what if” test where the backtest is applied to only equity and with no US Treasurys. This shows the usefulness of US Treasurys during major index downturns, or recession. A sector dynamic re-weights into US Treasurys does reduce risk. However US Treasurys are currently several sigmas rich and as the Fed normalizes rates large downward jumps are occurring. Currently no US Treasurys are used in the portfolio. The backtest shows that the use of sector rotation optimization only slightly reduces risk without losing rewards and is smilar to a simply long SPY position. However sector rotation is used as within a short time frame - say under 5 years - risk is reduced an reward maintained via sector rotation.
The backtest for this two asset portfolio, SPY and TLT (long duration US Treasurys) is derived.
Return and correlation is graphed. The offset of US Treasurys is missing as summed up in the rolling 2 months correlation graph. US Treasurys are not providing offset to equity.
The correlation grids are repeated.
This supports the 0% weight of US Treasurys now.
The realized vol for the SP500 is graphed for short dated to long term. The vol shows levels of near historical lows which when combined with the vertical graphs above affirm the max cash weights.
US Treasurys vol is mapped in comparison to SP500 vol. The extraordinary low volatility for both assets classes is shown and that SP500 volatility is two low in relationship to US Treasury vol.