The typical dose of daily financial news is something like “Stock XYZ did this today”; if we are lucky, is something more general like “Stocks went up/down” or, more likely these days, “Bonds did this and that”. For the average investor, there is little value in that information. Their holdings are most likely very different from the stock/index mentioned. Considering home-country bias, the daily reference to the S&P500 (or god forbid, the Dow) is not that accurate for someone living outside the US.
And yet we all form our opinions based on that information. If the news is upbeat, we are happy. And we are happy because we think our portfolio, our financial assets did well. But it is so?
Do you remember the pissing comments on gold and commodities as investments? Yeah, hard to find them now but they were everywhere as recently as six months ago. The risk of reading (and writing) these lines in such ‘absolute’ terms, gold sucks it is an asset only for boomers, is that most of the time an investment should be valued in the context of a portfolio, what it does for a specific investor in their specific context.
Some months ago I had a discussion on Twitter with the guy behind the InCassaforte podcast on this same topic about bonds. The point of diversification is that at any point in time you always have an investment that makes you feel like an idiot. And that’s should be the rule; if there is a moment where you are happy about all your investments, then it means you are not diversified enough.
In a typical recession, a business-cycle driven one, bonds go up (Central Banks cut rates to support the economy) while stocks go down. In an inflation driven recession, stocks and bonds go down but…commodities go up. Ok, I think Verdad explains this topic better than I could do, read it from them:
Based on the quadrant the economy is in, different asset classes perform in different ways. This was the OG principle behind the invention of risk-parity and it is why you want to be diversified…unless you can predict the economy and inflation, in that case you are better off rotating your portfolio to the best performing asset for the incoming future, easy peasy.
We spent almost ten years in Quadrant 1 and obviously we were under a relentless flow of comments on gold shitty performance. If you did not have a post-it stick to your monitor saying “hey, you own gold because Quadrant 3 is always a possibility”, you would have probably sold it (if you were old enough to own it in the first place). And now that Q3 is coming, good luck.
A Model Portfolio is basically that post-it. A periodic cleanser of the daily news cycle that brings back everything into the right context. Monevator is running one, called the Slow and Steady passive portfolio, and I think I should run one too. I talk about asset allocation and financial portfolios anyway, this would be the best way to translate into a practical example of what I am preaching.
Despite all my efforts, I suffer from daily news hallucinations as well.
Having lived in a number of countries, I have bank accounts spread all over Europe, a relic of my financial past. I still have the first brokerage account I opened 20 (???) years ago in Italy. The reason why I still have it is probably a story for another post; when I opened the account with Interactive Brokers here in the UK, I tried to transfer the assets from the Italian account, only to discover that the process was a pain (silver lining: I am transferring a pretty standard bond mandate from a manager to another at my job and…it is a pain even there. Crypto is not going to solve this because…information is already in digital form, is people that are assholes). Anyway, the Italian broker was acquired by another bank, so I had to migrate from one online platform to another. Thank god I am not a day-trader otherwise I would be out of business based on how seamlessly they run that migration. So mid-Q1/22 I finally get all the credentials for the new platform and I see that the portfolio value is c1% less than where it was at the end of 2021. Makes sense no? Stocks and bonds were both off their highs from last year so obviously my portfolio went down.
Actually
At the end of the quarter, I did my usual line-by-line review and I found out that the value of my portfolio went up compared to last year, the total figure reported on the platform front page, the one I checked post-migration, was wrong (how can I trust a bank that is not even able to report correctly your holdings balance? yeeeeeeeeeeah…..and we are dealing with the biggest bank by market-cap in Italy, not a fu**ing random regional bank. I really miss Italy). The value of my portfolio went up because the vast majority of my holdings are in USD and the USD had a very good performance against EUR in the quarter. This is the type of relationship that even if you are glued to Bloomberg every day of the week is difficult to intuitively put together. This is why you need to monitor your portfolio and why I will introduce a Model Portfolio here.
[This is something you will rarely read in the financial blogosphere because 80% of it is US-based, therefore all their investments are in USD. The USD is generally considered a safe-haven asset, so in periods of crisis, it tends to go up. This is really good for my portfolio, and maybe yours as well because the USD acts as a natural volatility-dampener. In risk-on years I have lower returns compared to the ‘standard’ (i.e. US-based) 60/40 but in risk-off years my lows are shallower, a trade I’m more than glad to accept. In the longer run, I basically save the interest rate differential between USD and EUR compared to someone who’s 100% FX hedged; lately, it meant around 100bps/year, not peanuts]
My Portfolio
The bulk of my savings, pension & ISA, is in a simple World Index ETF. But I also run a more interesting portfolio, with the following asset allocation:
- 57.5% stocks
- 30% bonds
- 7.5% REITs
- 5% commodities
All levered up 1.25x, or in other words:
- 71.88% stocks
- 37.5% bonds
- 9.37% REITs
- 6.25% commodities
- -25% cash
Why 1.25x leverage? Because that is the maximum I can get on IB. Why leverage? See this, now 1-year-old (!), post on the topic; the same post is also a great introduction for the Model Portfolio I will present below.
My initial idea was to report this portfolio via IB reporting tool (like here and here). Unfortunately, the UK taxman was not on the same page; to be tax-efficient, I have to hold the bond assets in the ISA wrapper and therefore outside IB. It makes automatic reporting impossible and also the leverage management a bit of a nightmare (but still manageable).
Why those %? I started from the standard 60/40 and adjusted it to my personal preferences. I know from a theoretical point of view the commodity bucket should be higher to achieve a better Sharpe ratio but…I cannot stomach it (there is any other way to put it). Within stocks and bonds, I have a core-satellite sub-portfolios. Stocks core is the World Index, satellites are tilted toward three factors: value, momentum and LowVol. Putting together three factors should bring that total allocation back to a neutral tilt, so…pointless?, but I am trying to time those factors, i.e. add more to the one underperforming. There is plenty of research showing that what I am doing is useless at best, a drag on performance at worst; the reason I am doing it, is because I want to learn how those factors move and having skin in the game is the only way for me to pay attention. You should not do it. All considered, my stock allocation should be ‘less risky’ than the S&P500 because I invest, generally speaking, in lower valuations.
The core part of the bond allocation is the Barclays Aggregate; I combine it with some spice, in the form of High Yield and Emerging Markets. So my bond allocation is (way) riskier than the standard bond allocation, which should be just US Treasuries. Again, it is me trying to do some market timing, given the very low yields on Govies in the last decade. Now that the world is normalising, I will shift an increasing part of the allocation towards more traditional bonds. If you look at the quadrants above, the choice was the right one, since we spent the best part of the decade in Quadrant 1.
My Model Portfolio
There are two assets that are missing in my portfolio that I would like to have exposure to: Tail Risk and Trend (CTAs). Despite all my research, I did not find any suitable investment vehicle for a European investor. This is the main reason why I hesitated so far to publish here a model portfolio: I did not want to use something I consider a sub-optimal choice.
Now that we have Composer, I can play with my Model Portfolio in a few clicks 🙂 It looks like this:
- 60% stocks (via NTSX)
- 40% bonds (via NTSX)
- 20% trend (via DBMF)
- 10% commodities trend (via COM)
- 4% Tail risk (via TAIL)
- -34% cash
The idea behind the portfolio is stolen from here. The link offers the best explanation to what I think is the most common question related to it, i.e. why the portfolio use leverage (and why in this context leverage decrease risk).
Quick FAQ to the Model Portfolio
Why the back-test period is so short?
Some of the ETFs I use are fairly new and my goal is to build a track record from here. If you are curious about how the portfolio would have performed in the past (great, I am too!), either you hire me as a PM or you have to rely on the research on the internet around the same idea 😉
Why did you choose those ETFs specifically?
Based on my research, they are good at achieving the objective of the portfolio. If you have any suggestions, post them in the comments.
What is NTSX (or DBMF, COM, TAIL)?
If you are reading here you probably have access to Google. Learn how to use it and thank me later, it is a great skill to have 🙂 NTSX is the ETF that provides the embedded leverage, allocating 66% of the portfolio to this ETF will provide the full 60/40 exposure and free capital to invest in the other, uncorrelated assets.
Why did you create a portfolio that cannot be replicated by European investors?
Because I hope that one day an ETF provider will realise there is this type of appetite in Europe as well. There are a lot of ‘standard’ model portfolios out there (see Monevator), and I want you to follow something more thought-provoking.
How can leverage decrease risk?
The portfolio uses leverage to free capital to invest in additional uncorrelated assets. Even if leverage increases the volatility of the stock and bond parts, the overall portfolio volatility is smaller due to the low correlation between its components. More important, drawdowns are shallower: this means the portfolio ‘compounds better’ because it takes a lower % rebound to go back above a previous high. Listen to this great podcast episode to better understand this point.
Is the portfolio missing anything?
Probably a complementary exposure to real assets next to commodities, in the form of Real Estate and/or inflation-linked bonds.
Conclusion
The Model Portfolio is now saved in Composer, so I can easily provide a quarterly update on its performance. It would be interesting to see its returns, or lack of, against the most common financial narrative at each point in time. For example in Q1, the portfolio was down 2.6%, not bad for a period in which stocks and bonds were quite correlated to the downside.
As for any portfolio, the largest drawdown is the one that did not happen yet: I am curious to see what the future will look like.
To be continued…
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