FINANCIALLY ENGINEERING AN "ALL-WEATHER" EQUITY PORTFOLIO

In principle, any asset class or security can be levered up/down to create the desired risk return payoff. Based on this concept, two negatively correlated securities can be combined to achieve a given level of expected return with lower risk (defined in terms of standard deviation). Using this paradigm, I seek to configure a portfolio with the expected return of equities, but lower standard deviation: the "all weather equity portfolio".

Treasury yields/prices and equities are positively/negatively correlated (see exhibit 1). This property is particularly helpful in creating the "all the weather portfolio". During the 20th century, U.S. stocks and bonds generated yearly real returns of 6.7% and 1.6%, respectively. Assuming 2% inflation going forward, I construct the portfolio as follows:

1. Long U.S. Treasuries: 1.25
2. S&P 500: 0.5
3. Borrowing: -0.75

Effectively, I buy U.S. Treasuries on leverage to achieve equity like returns. I used ETFs to conduct this exercise for the period July 30, 2002 to June 11, 2009: TLT: + 20yr Treasuries and SPY. I assume leverage at 8.5% (the margin rate for a personal investor). Institutional investors can finance the bond portfolio cheaply in the GC-repo market. Finally, the portfolio is rebalanced every day.

The performance of the portfolio can be observed in exhibit 2. Importantly, while the S&P 500 rose about 5% during the period under consideration, the all weather portfolio was up 11%. At the peak of the price appreciation cycle, stocks were up about 74%, while our financially engineered portfolio climbed only 42%. This under performance in the bull market is a function of the high interest rate I used for assuming leverage. Interestingly, the all-weather portfolio reached its peak with 62% total return in December 2008 – a time when the equity only portfolio had failed to generate any return since inception.

Redoing the calculation with the GC-repo rate (average for the period: 2.54%), I get more favorable (and more realistic for institutional investors) results (see exhibit 2). In this case, the all weather portfolio keeps pace with equities in the up move, and protects downside during the market crash of 2008.


Exhibit 1. Positive Correlation: U.S. Equities vs. U.S. Treasury Yields



Exhibit 2. "All-Weather" Portfolio Performance: Institutional



Exhibit 3. "All-Weather" Portfolio Performance: Personal



Exhibit 4. Daily Return Statistics




Geek Notes

For calculating the total returns of the all-weather portfolio, I used the average yield on the 30-year U.S. Treasury as a proxy for coupon. And, I credited this coupon return on a daily basis. This implies that the returns on the all-weather portfolio are somewhat over-stated due to daily compounding.

Source: Bloomberg
Dimson, Staunton and Marsh; Triumph of the Optimists
Bridgewater Associates