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Mutual Fund MaxDD Calculations: How to Ying your Portfolio's Yang (@David_Snowball)

beebee
edited May 2017 in Fund Discussions
@David_Snowball offered readers this month a peak inside his portfolio and an exercise in understanding portfolio risk using a MaxDD calculation. One thing that occurred to me was the timing or correlation of MaxDD for different assets held in a portfolio. Highly correlated assets would be additive as in David's example, but not all assets experience MaxDD at the same time. Cash has a MaxDD of inflation...always. Bonds and hard assets often expressed what I will call MaxFTS (Maximum Flight to Safety) at the very moment that equity assets are experiencing MaxDD. So holding a percentage of cash, Bonds or hard assets may very well serve at the best way to counter balance an equity asset's MaxDD.

I'll use David Snowball's table included here as a way to gauge a need for uncorrelated assets in a portfolio.
image

If these were my equity holdings I could approach the MaxDD risk I might hold an equivalent amount of cash equal to the impact MaxDD would have on these holdings. In David's example this would be 16.56% of what these holdings are worth at any given point in time. If this part of his portfolio (he states 55%) has a value of $100K, then $16,560 (plus inflation) might be held in cash. This would be where an investor could turn for distributions during MaxDD periods. This cash might also be used to buy discounted shares of these very same equity holdings that are experiencing MAXDD.

Bonds and hard assets in an portfolio could also serve both of these functions (distribution demand and reallocation). Bonds, especially those that experience a highly correlated MaxFTS, have proven themselves as a great counterbalance when equities falter. Here is a chart showing the benefit of holding uncorrelated assets (VFINX & EDV), the S&P 500 and Long Duration Treasuries.
image
I believe a well constructed portfolio needs to Ying while it Yangs. I'll assume that the rest of David's (the other 45%) portfolio includes some of these uncorrelated assets.

Comments

  • Sweet!
  • edited May 2017
    In a perfect DD storm, everything will sink together, i.e. worse case scenario. Needless to say I gave up on overly volatile investments, i.e. individual sectors or highly focused funds and/or keep them to very short percentage of my portfolios. Instead of fretting about ying and yang, I simply have a mental stop loss I use. It's just easier for me that way.

    ANALysis is simpler than analysis. I'm not smart enough for analysis. What's in uppercase I can see more clearly. Besides VFINX + EDV probably equals Vanguard Balanced Index right?

    PS - Is there a tool that can take ying-yang chart above, combine and draw a zen line showing how the portfolio value moved? I think that would be really useful, no?
  • beebee
    edited May 2017
    @VintageFreak said,
    Besides VFINX + EDV probably equals Vanguard Balanced Index right?

    PS - Is there a tool that can take ying-yang chart above, combine and draw a zen line showing how the portfolio value moved? I think that would be really useful, no?
    I like to use Portfolio Visualizer and it's link to Back Test Asset Allocation:
    https://portfoliovisualizer.com/backtest-portfolio

    Historical performance comparisons can be made of mutual funds, etf, stocks individually or as a percentage of an asset allocation. This site also provides a wealth of data including MaxDD (check out the "i" symbol next to the MaxDD data for length of MaxDD...very cool)

    In the chart below I charted VBINX (60/40) allocation as "Portfolio 1", 60% VFINX and 40% EDV as "Portfolio 2", and I added VWELX (a managed 60/40 fund) as "Portfolio 3". Here's the result:

    image

    VBINX and VWELX performed comparatively similar with VWELX getting the edge. The (VFINX/EDV) portfolio had the greatest drawdown (during the 2009 period), but was also the least correlated to the market at 0.48.

    Taking VBINX and VWELX back to 1993 shows the success of Wellington's management team verses VBINX. Here's this chart:

    image
  • @bee, Well done.
  • It all depends on your gastric acidity and if you need the money. Excluding the Great depression, if you believe James Clooney of AAII regardless of the downturn if you can hang on for four years and not sell you will be OK.

    While I cannot really counter this argument intellectually, I know myself emotionally and having experienced October 2008, I know that I will not be able to hang on if I lost 30% of my retirement savings, even if I do not need the money tomorrow.

    So I am willing to accept lower returns as the price of not buying all the Prilosec at CVS.

    It is critical to look at what you could loose to know how far out on a limb you are.

    BUT the bond market is a lot different now than 2008. I hope we get fair warning of recurrent "stagflation" where bonds crash as do equities.
  • @bee @doh! I just had to plot 50-50 in portfolio. My name is Idiotus Maximus.
    So anyways, the point is why ying-yang when you can just zen?

    Vanguard Tax Managed Balanced is what I would go with. I just think right now bond funds should have active.
  • Have not been finding zaggers to counter ziggs for a great many years now.
    Have placed a modest portion of total nut into RE funds including FRIFX and VNQI, and have left it alone. Not much diversification there, really.
    Otherwise am watching DSENX balanced w/ PONDX/PDI for the much larger remainder.
  • edited May 2017
    Been thinking about this post lately. One of challenges I think for investors today is that we've had a 30+ year bond bull. Just not sure that many fixed income funds have been around during periods of rising interest rates, so difficult to gage historical downside through different business cycles.

    In the '60s and '70s, bonds had a much tougher ride (deeper and longer drawdowns) than they have since 1980. Remember when cash was king? From 1966-1984, it actually returned 7.8% annualized. (Ref. Bond Performance During Periods of Raising Interest Rates.) Hard to imagine now.

    Certainly like to believe that core bond and core stock funds, say AGG and SPY, are negatively correlated, but as was recently mentioned in another post, they may be simply uncorrelated. Which I guess is the scary part. AGG did relatively great in 2008 when stocks dropped a ton, but not so sure if it would have done as well in 1970 and 1974.

    In any case, will noddle on this topic more.
  • EDV and TLT are more negatively correlated than AGG with SPY. Maybe that's enough, which I think is bee's main point (I'm just slow). But I'm gonna try re-visiting pre-1980 data to get better feel for bonds during periods of rising rates.
  • beebee
    edited May 2017
    @Charles,

    Equities and bond often go through periods of bifurcation.

    As imperfect as EDV or TLT may be as investments in rising rate environments, they more importantly serve as a sort of "portfolio insurance" policy during "MAXDD FTS" (Maximum Drawn Down Flight To Safety) time frames. "Portfolio insurance" that reacts in the direct opposite direction of equities during market sell offs would be the optimum coverage. Not always the case.

    The cost of holding this type of "portfolio insurance" in a rising rate environment might be another discussion. Maybe there are better suited "insurance policies" during rising rate cycles. But for shear, in the moment, market meltdown, flight to safety protection these types of investment have worked pretty consistently in the past.

    Look forward to what your research uncovers.

    Thanks for commenting and for all the work you do here at MFO
  • I like your thoughts on "portfolio insurance"! The key to finding adequate investment vehicles, IMHO, to truly satisfy this requirement is COST! Some are fortunate to have access to the G Fund inside the TSP. G Fund price only moves in one direction...UP! This satisfies my requirement for portfolio protection for pennies on the dollar! @15% of my investment portfolio.
  • edited May 2017
    I bought HSGFX as portfolio insurance. Well, I did pay high premiums for protection against accident that did not happen, right?

    IMO, it is best to not drive insured car when you see a blizzard coming. Better to just get out of the way until you see sun peaking through the clouds again. Life more predictable that way.

    Just saying...
  • beebee
    edited May 2017
    @VintageFreak, I like your weather analogy. Your suggestion welcome (please review mine below).

    MaxDD Portfolio Options:

    -Trust the investment weatherman to predict when to stay off the road and get back on. Good luck with that.

    -Store enough cash to weather the storm (MaxDD time duration). Better. I believe this what @David_Snowball was suggesting in his commentary piece. Snowball...weather analogy...hmm...I see a pattern here.

    -Always maintain and drive a kick ass 4 wheel drive portfolio in any kind of weather. Now you're talking.

    -Move your portfolio into a cave - all cash, all gold...find a cave woman...have a lot of cave babies...she will soon get tried of your cave ways and kick you out...keep a little extra Woolly Monmouth meat in an second cave. Repeat process until ice age ends.

    Your thoughts?
  • @bee No habla espanol.
  • @bee, I like you're thinking about some insurance policies being better under certain conditions than others. It's not always easy, however, to "predict" how the markets will react regardless of whether we can say now it would be reasonable to expect a rising rate environment.

    I've never done this but if I was considering insurance I'd think about a simple moving average system. Here's a nice article: https://advisorperspectives.com/dshort/updates/2017/04/28/moving-averages-april-month-end-update

    The good news is that it'll protect you from the big declines as long as they don't happen very rapidly like Black Monday. I think, just looking at the graphs in the article, and by back testing both VFINX and VTSMX, there's a good chance you'd come out pretty close to the buy and hold return with less downside volatility.

    The bad news is that you can get whipsawed and that's happened a few times since 2009 so the time period considered makes an important difference in the cost of the insurance. It's also not very good or easy with a portfolio full of active funds. Finally, it's not terribly tax efficient if you're someone who is able to buy & hold forever but it'd be fine in a tax advantaged account and it might not be terrible if you're someone who trades occasionally anyway.

    In the end, the history suggests you'd get a better result than using long treasuries and better risk adjusted results as well so it might be an option to consider depending on each person's specific circumstances.

  • >> a little extra Woolly Monmouth meat

    mmm, Jerseyburgers
  • @LLJB,

    Thanks, nice article. The ETFreplay site (mentioned in the article) allows users to backtest 5 etf for free.
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