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Four Funds for a Lifetime

edited March 2014 in Fund Discussions

After last discussion, A Look at Risk Adjusted Returns, I wanted to explore further the issues of under performance and substantial down years for even top ranked risk adjusted funds.

Building on a tip from MikeM:

I used to do my own risk analysis by just calculating the probability of what a fund could make or loose in any given year. Probability is just a calculation using the funds average returns and its standard deviation. Using 1x stdev would give you a probability confidence value of 68%. 2x stdev would be 95%.

Instead of standard deviation STDEV, however, I focused on the down side and draw down deviations that represent the denominators in Sortino and Martin ratios, respectively. The Sortino denominator is the annualized downside deviation DSDEV, which uses only monthly returns falling below TBill average. The Martin denominator is the Ulcer Index (UI), which is the square root of the mean of the squared percentage draw downs in value.

I imposed a threshold on these two measures to protect against substantial down year performance. The threshold assumed a simple, four fund portfolio - one fund in each broad type (equity, asset allocation or "balanced," fixed income, and money market), each holding equal share.

For pain threshold, I used 15% loss for the portfolio in a down year. Nominally, this translates to a maximum tolerable loss of 30% in the equity fund, 20% in asset allocation fund, 10% in the fixed, and zero for money market.

Accounting for a 3x deviation down side occurrence (more conservative than MikeM's example), the attendant thresholds become 10% for equity funds, 7% for asset allocation, and 4% for fixed income, in round numbers.

First off, it is extraordinary just how many equity funds fail to meet this 10% down side threshold on either DSDEV or UI! Here is a summary of funds evaluated, all oldest share class:

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Once the funds were screened for down side volatility, I simply sought top returning funds for each type, relative to SP500 for equity and asset allocation, and TBill for fixed income and money market. This step protects against selecting an under performing fund that may have a very high risk-adjusted rate of return.

Below is the result, by fund inception date:

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Some observations:

- Worst performing year (highlighted in red) was 2008, of course, with the 15+ age group portfolio down the most at -13.7%, but still within the -15% pain threshold.

- Overall portfolio lifetime returns (green) appear very respectable for all age groups, most even beating SP500 (blue), despite the healthy cash holding.

- Great returns are achievable without high volatility, evidenced by some seriously good funds included on this list, like Sequoia SEQUX, Vanguard Wellesley Inc Investor VWINX, Mutual Quest Z MQIFX, Oakmark Equity & Income I OAKBX, Osterweis Strategic Income OSTIX, and Yacktman Svc YACKX.

- The 25+ age portfolio produced 9.7% APR versus 8.9% for SP500. It includes stand outs Vanguard Health Care Investor VGHCX, T. Rowe Price Cap Appreciation PRWCX, and PIMCO Total Return Institutional PTTRX.

- The 5+ age portfolio produced 7% APR versus 1.7% for the SP500. It includes MainStay Marketfield I MFLDX and PIMCO Income A PONAX.

- In the 40+ age group, only one money market fund existed, so that was included by default, even though it has a negative lifetime Sharpe.

- Of the fifteen fixed income funds in the 50+ age group, none met the less the 4% down side volatility criteria.

I'm pretty impressed with the result actually. The simple approach imposed a 10-7-4 down side volatility screen, then sought top returning APR, un-adjusted. Now, if I could only figure out how to ensure it works going forward...

Comments

  • Charles your threads are more like college dessertations...amazing. Thanks for all the time you put into these data points.
  • Reply to @bee: Thanks bee. Mostly, I hope you enjoy reading the results as much as I enjoy posting them. Very much appreciate your feedback...and learning from your threads as well.
  • Very impressive research and post. This will take several days to fully digest but will be well worth the time, especially since several of these funds are current holdings of mine.

    Thanks, Charles.
  • Hi Charles,

    Once again, thank you for your current posting. It is an daunting piece of work that documents your commitment to manage your portfolio in a risk control manner. I’m sure your end portfolio wealth will reward you for your diligence and work ethic.

    Also, thank you for introducing me to Martin’s Ulcer Index. Until your posting, I was not familiar with that alternate risk measurement. Risk is a complex concept that likely means different things to different folks. I’ll definitely add the Ulcer formulation to my array of risk assessment measures.

    Your findings reinforce the adage that portfolio diversification works wonders in the risk control arena. Reducing portfolio volatility increases geometric returns which is paramount to portfolio end wealth. It also decreases the sheer number of negative annual returns and any maximum annual loss. Both of these factors reduce anxiety and encourage a “stay the course” discipline. All this is in the goodness direction.

    As in any serious study (and your study is indeed serious), the conclusions are tightly coupled to the assumptions, constraints, and selection criteria imposed on the overall study.

    You greatly expanded the solution map by examining thousands of mutual fund candidates over numerous timeframes extending backward to over 40 years. Great. You greatly restricted the solution map by postulating a maximum annual portfolio loss (ultimately your 10 %, 7 %, 4 % component criteria) and by specifying a conservative 4-component portfolio that featured a rather large cash component and a 30 % to 40 % equity position.

    These criteria are needed to identify candidate funds, but are not universal. Modify any of these elements and the solution map is immediately changed. These assumptions and constraints govern the remaining portfolio choices (not surprisingly since they were designed with that goal). But because of these reservations, your findings can not be quickly extrapolated to other portfolio constructions or downside risk tolerance without hazard. I’m sure you recognize these limitations; others may not.

    In your final observation you questioned if your specific current findings can be used as a forecasting tool. Your results to date provide a partial answer – No. That provisional negative answer is informed by the various timeframes that you explored.

    Each timeframe that you examined yielded a different array of “winning” mutual funds. Performance persistence was never established. A performance regression-to-the-mean seemed to be the operative paradigm. Several academic and industry studies have demonstrated that even superior performing mutual funds have a few very bad years imbedded in their overall outstanding record. Projecting future performance is a tough nut.

    In no way do these comments diminish the advantages of portfolio diversification. It’s useful stuff. In a sense your findings support the John Bogle admonishment to fully diversify, but to do so with passive Index options to not only control risk, but control costs too.

    Charles, you are doing yeomen work. In no way are my comments meant to denigrate or demean your fine efforts. Your work can only enhance your market understanding, your insights, and your portfolio construction.

    In the end, you will enjoy a more stress free retirement. Good for you. Your postings will inform all MFO participants. Good for us.

    Best Wishes.
  • edited January 2013
    Hi again MJG. Thanks for good words of encouragement...a lot of this stuff is your doing!

    Hey, my bad for not reiterating on this post, but the results presented here are based on life-time only performance from fund inception date, similar to the way results were presented in the Funds That Beat The Market thread.
    Each timeframe that you examined yielded a different array of “winning” mutual funds. Performance persistence was never established.
    Funds from the older age groups were not included in the rankings of the funds from the younger age groups. So, they were not competed, as you say.

    That's actually my next project...persistence!

    I suspect though that funds like Sequoia SEQUX and T Rowe Price Capital Appreciation PRWCX may do pretty well. Both are seasoned funds, but with recent accolades.

    Until then...

    PS. I like the Ulcer Index too...my kind of no-nonsense risk measure.
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