Muscular Investing

Double the Gain of the Morningstar Bucket Portfolio - part 4

Brian Livingston

Brian Livingston


Lazy Portfolios such as Morningstar’s generally ignore asset classes other than stocks, bonds, and REITs. Alternative assets, when combined with a Momentum Rule, give you diversification benefits that produce massive improvements in gains.

 


This is Part 4. Parts 1, 2, and 3 appeared on Nov. 6, 8, and 13, 2018.

We’ve seen earlier in this column that a Lazy Portfolio promoted by Morningstar Inc. — known as the Bucket Portfolio — greatly improves its annualized return to 12.4% instead of 8.7%, with the addition of a single step. That tweak would have given you double the gain after 4½ years and 4.6 times the gain after 45 years in simulations.

The enhancement is called the Momentum Rule. This is the statistical principle that asset classes with the greatest gains in the past 3 to 12 months tend to continue going up in the following one month.

But I repeat that this is not a recommendation to follow the Bucket Portfolio with actual money! There are much better portfolios for long-term traders, as we’ll see shortly. First, it’s important for us to illustrate why Lazy Portfolios can’t provide market-like returns — but crash nearly as badly as the US equity market — and how momentum overcomes the problem.

The diagram above shows nine major asset classes that are now available in index mutual funds or exchange-traded funds (ETFs). Lazy Portfolios — investing strategies that never change the percentages allocated to their holdings — almost entirely avoid commodity funds (primarily energy) and precious metals (most importantly, gold). I analyzed ten Lazy Portfolios for my new book, Muscular Portfolios. Commodities and gold were included in only two of these static strategies. Even in those two cases, the alternative asset classes made up only 5% to 8% of the holdings.

That omission hurts Lazy Portfolios. As we can see above, a commodity fund has a low 44% correlation to the S&P 500. Gold ETFs have almost no correlation at all. Low-correlation assets can greatly help a portfolio when equity markets around the world are going to hell in a handbasket.

Correlated assets crash together, low-correlation assets do not

Why would we want low-correlation assets? For one thing, ETFs with a low correlation to equities can go up even when the S&P 500 is crashing down. We can see this in the graph below. Pundits often say, “When the US stock market crashes, everything crashes,” but that isn’t true! During the horrendous financial crisis of 2007–2009, Treasury bond funds and gold funds retained their value or rose the entire time. Meanwhile, commodity ETFs actually rose 66% for the first eight months of the period, by which time the S&P 500 was already down more than 20%.



The commodity decline in the latter 15 months of the crash (the dotted line in the graph) shows why a Momentum Rule is needed. As people around the world realized in mid-2008 that a severe global recession had begun, the bottom dropped out of demand for commodities of all kinds, such as oil, copper, and other industrial materials. By the end of the bear market, commodities ETFs were 28% lower than at the beginning of the bear.

You can’t simply make up a theory like, “When the S&P 500 crashes, move all your money into commodities.” Instead, Muscular Portfolios use a Momentum Rule to determine which asset classes have the best odds. Don’t fall in love with any asset class — let the numbers show you what’s going up and what’s going down.

The two most powerful strategies revealed in the book Muscular Portfolios generated annualized returns of 14.3% and 16.2% in 1973–2015, as modeled by the Quant simulator (see Part 3). That’s far above the 12.4% return the “enhanced” Bucket Portfolio offered after it was improved with a Momentum Rule. At the right moments, the Muscular Portfolios moved into bonds, commodities, and precious metals — something a Lazy Portfolio can never do.

In addition, the two Muscular Portfolios kept their losses in the financial crisis as low as 18% and 21%. That’s well under the 25% to 30% “behavioral pain point” that’s been shown to compel many investors to liquidate in fear. (For an explanation of the pain point, see my summary page.)

Commodities and gold aren’t asset classes you’d want to hold all the time. For one thing, they generate no earnings and careen in price due to widely fluctuating global supply and demand. As one example, the physical-gold ETF known as GLD closed on Nov. 14, 2018 at virtually the same price it did on Apr. 27, 2010. That’s no growth for 8½ years! But when equities are collapsing, commodities and precious metals may be shining.

The long-term future of long-term trading

It won’t be too many more years — perhaps one more bear market will do the trick — before investors widely realize that Lazy Portfolios don’t deliver market-like returns but still crash almost as badly as buy-and-hold equity strategies. It only took a couple of decades for most people to figure out that index funds extract 99% of the return from any asset class, without the stress and fees (and risk of underperformance) of betting on individual stocks. The next evolution in investing is for the public to learn the use of the “momentum factor” — a form of gradual asset rotation that is distinct from market timing.

The former CEO of the giant PIMCO wealth-management firm, Mohamed El-Erian, placed his finger squarely on the problem at the tail end of the financial crisis: “Diversification alone is no longer sufficient to temper risk. In the past year, we saw virtually every asset class hammered. You need something more to manage risk well.” (Kiplinger’s Personal Finance, March 2009.) Asset rotation takes advantage of diversification while keeping people’s life savings safe from the panics the market is heir to.

The vast majority of 401(k) account holders are not permitted to buy individual stocks, only mutual funds and similar collective securities. Most plans also don’t allow participants to change their portfolio positions more often than once or twice a month.

A lot of these hard-working people — many of whom barely remember the 2008 crash — will lose one-third to one-half their life savings if they let their money drift in a buy-and-hold strategy through the next crash. Too many of those individuals, once burned, will swear off stocks “for good.” Having liquidated, these unfortunates will miss the strong upmove that usually begins the bull market that always follows a bear.

The word is starting to get out, but we have a long road ahead of us.

Technical note: Asset correlations in the first image above were computed by the PortfolioVisualizer.com calculator. Figures represent the actual named funds net of fees from Nov. 18, 2004, through Sept. 8, 2017. Exception: The commodities correlation begins on Feb. 6, 2006, the inception date of DBC. Different time periods will produce different figures. Illustration by Pieter Tandjung.


With great knowledge comes great responsibility.

—Brian Livingston

CEO, Muscular Portfolios

Send story ideas to MaxGaines “at” BrianLivingston.com

 

Brian Livingston
About the author: is a successful dot-com entrepreneur, an award-winning business and financial journalist, and the author of Muscular Portfolios: The Investing Revolution for Superior Returns with Lower Risk. He has more than two decades of experience and is now turning his attention directly on the investment industry. Based in Seattle, Livingston is now the CEO of MuscularPortfolios.com, the first website to reveal Wall Street's secret buy-and-sell signals, absolutely free. He first learned computer programming on an IBM 360 in 1968 at age 15. Learn More