Tag Archives: alternative

Mean-Variance-Optimization Applied To Portfolios Using QQQ During Bear Markets

Summary Portfolios using QQQ and bond mutual funds achieved high returns with low risk from 1999 to 2015. The parameters of the mean-variance optimization (MVO) algorithm can be easily adapted to the risk tolerance of the investors. MVO strategy is very robust, and it may continue to perform well in the future. The idea of writing this article came from a comment by Varan, a frequent contributor on Seeking Alpha. Varan suggested that I investigate the performance of a portfolio using the PowerShares QQQ Trust ETF (NASDAQ: QQQ ) during the 2000 to 2003 period. Since two funds in the portfolio, the iShares 1-3 Year Treasury Bond ETF (NYSEARCA: SHY ) and the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ), were created in July 2002, Varan suggested that I use two mutual funds with similar holdings, the Vanguard Long Term Treasury Fund (MUTF: VUSTX ) and the Fidelity Limited Term Government Fund (MUTF: FFXSX ). In the articles on the simple ETF portfolio the simulations did not cover the 2000-03 bear market when QQQ had a maximum drawdown of -82.96%. We frequently hear investors saying that tactical asset allocation using bond funds will not work anymore because everybody expects a secular bond bear market. So, it is relevant to ask how tactical asset allocation worked using an asset that suffered a severe bear market. In that respect, QQQ is a prime example, having suffered such deep and prolonged losses during the 2000-03 bear market. It has taken twelve years for QQQ to recover and reach the level it had at its top in March 2000. The new portfolio is made up of the following four assets: SPDR S&P MidCap 400 ETF (NYSEARCA: MDY ) PowerShares QQQ Trust ETF Vanguard Long Term Treasury Fund Fidelity Limited Term Government Fund Basic information about the funds was extracted from Yahoo Finance and marketwatch.com and it is shown in table 1. Table 1. Symbol Inception Date Net Assets Yield% Category MDY 5/04/1995 14.23B 1.41% Mid-Cap Blend QQQ 3/03/1999 36.93B 0.96% Large Growth VUSTX 5/19/1986 3.27B 2.75% Long Term Treasury Bond FFXSX 11/10/1986 385M 0.68% Short Term Treasury Bond The data for the study were downloaded from Yahoo Finance on the Historical Prices menu for MDY, QQQ, VUSTX, and FFXSX. We use the daily price data adjusted for dividend payments. For the adaptive allocation strategy, the portfolio is managed as dictated by the Mean-Variance Optimization (MVO) algorithm developed on the Modern Portfolio Theory (Markowitz). The allocation is rebalanced monthly at market closing of the first trading day of the month. The optimization algorithm seeks to maximize the return under a constraint on the portfolio risk determined as the standard deviation of daily returns. The portfolios are optimized for three levels of risk: LOW, MID and HIGH. The corresponding annual volatility targets are 5%, 10% and 15% respectively. In Table 2 we show the performance of the strategy applied monthly from June 1999 to September 2015. Table 2. Performance of MVO algorithm applied monthly versus 100% in QQQ.   TotRet% CAGR% VOL% maxDD% Sharpe Sortino 2015 return LOW risk 268.91 8.32 5.51 -5.51 1.51 2.19 3.60% MID risk 553.49 12.18 10.3 -10.55 1.18 1.68 3.10% HIGH risk 824.31 14.59 15.11 -16.12 0.97 1.36 -0.24% QQQ 124.69 5.08 29.43 -82.96 0.17 0.23 -1.22% In table 2 we see that all MVO portfolios had stellar performance over the 16 years of this study, even though QQQ had a very rocky ride. Also, notice that the realized volatilities of the MVO strategies are well correlated with the maximum drawdown and the realized annual returns. The 2015 returns column reports the results during 2015 to the end of September. It shows that all MVO strategies performed better than QQQ. The LOW and MID risk portfolios achieved a positive return of over 3% while QQQ lost 1.33%. The HIGH risk portfolio lost a minute 0.24%. The equity curves for all portfolios are shown in Figure 1. (click to enlarge) Figure 1. Equity curves of the portfolios with MVO monthly optimization versus QQQ over the whole time interval from June 1999 to September 2015. Source: All charts in this article are based on calculations using the adjusted daily closing share prices of securities. In figure 2 we show the equity curves during a shorter period that includes the 2000-03 bear market, specifically, we show the June 1999 to December 2003 interval. During the first nine months there was a steep increase in QQQ price followed by a three year bear market. We also included a nine month period of recovery. (click to enlarge) Figure 2. Equity curves of the portfolios with MVO monthly optimization versus QQQ over the time interval from June 1999 to December 2003. We see that all MVO portfolios increased at a slow pace during the bear market. The HIGH risk portfolio was basically flat from March 2000 to March 2003, while the LOW and MID risk portfolios achieved small but steady gains. The details of their performance are given in table 3. Table 3. Returns of QQQ and MVO portfolios during the 2000-03 bear market. Time Interval QQQ LOW_Risk MID_Risk HIGH_Risk 6/10/1999-3/28/2000 123.95% 13.32% 23.93% 53.15% 3/29/2000-3/11/2003 -79.79% 26.21% 22.72% 6.65% 3/12/2003-12/31/2003 53.25% 10.59% 17.86% 34.09% In figure 3 we show the equity curves of the MVO portfolio during the 2008-09 bear market. We included nine months of recovery from April to December 2009. (click to enlarge) Figure 3. Equity curves of the portfolios with MVO monthly optimization versus QQQ over the time interval from October 2007 to December 2009. In figure 3 we see that QQQ suffered a large loss from October 2007 to March 2009. During the same interval, the HIGH risk portfolio lost 8.40%, the MID portfolio was flat, and the LOW risk portfolio gained 7.29%. The exact numbers are given in table 4. Table 4. Returns of QQQ and MVO portfolios during the 2008-09 bear market. Time Interval QQQ LOW_Risk MID_Risk HIGH_Risk 10/1/2007-3/09/2009 -50.27 7.29 0.37 -8.40 3/10/2009-12/31/2009 78.72 8.71 19.35 42.54 Finally, in figure 4 we show the equity curves from September 2014 to September 2015. (click to enlarge) Figure 4. Equity curves of the portfolios with MVO monthly optimization versus QQQ over the time interval from September 2014 to September 2015. In figure 4 we see that QQQ as well as all the MVO portfolios were very volatile, but their equity was bound in a narrow range. Still, the LOW and MID risk portfolios outperformed by realizing modest gains. The exact gains and losses are given in table 5. Table 5. Returns of QQQ and MVO portfolios during the latest one year and the first nine months of 2015. Time Interval QQQ LOW_Risk MID_Risk HIGH_Risk 9/30/2014-9/30/2015 3.63 8.18 9.17 3.58 12/31/2014-9/30/2015 -1.22 3.60 3.10 -0.24 To give the reader more insight into how the MVO strategy succeeds in making gains even when an asset of the portfolio suffers extremely large losses, we present in the following three figures the monthly allocations during the period from June 1999 to December 2003. We decided to display the allocations over a short time interval in order to get graphs that are easy to read. (click to enlarge) Figure 5. Monthly allocations of the portfolios LOW risk strategy over the 2000-03 bear market. In figure 5 we see that the LOW risk strategy allocated, on average, over 60% of the money to the short term bond fund. QQQ was not allocated any funds between March 2000 and November 2002. The long term bond fund was allocated substantial funds during the bear market. (click to enlarge) Figure 6. Monthly allocations of the portfolios MID risk strategy over the 2000-03 bear market. The MID risk strategy allocated more funds to the long term bond fund than to the short term during the bear market. Again, QQQ was allocated the smallest amount of funds during the bear market. (click to enlarge) Figure 7. Monthly allocations of the portfolios HIGH risk strategy over the 2000-03 bear market. The HIGH risk portfolio allocated very little money to the short term bonds. During the bear market most money went alternately to the long term bonds and the mid cap MDY. QQQ was still not allocated any significant funds from April 2000 to November 2002. In table 6 we show the October 2015 allocations for all the strategies. Table 6. Current allocations for October 2015.   MDY QQQ FFXSX VUSTX LOW risk 0% 0% 70% 30% MID risk 0% 0% 31% 69% HIGH risk 0% 0% 0% 100% Conclusion The Mean-Variance Optimization strategy applied to a well-constructed portfolio of stocks and bonds performs quite satisfactorily during deep bear markets. It also offers a very simple mechanism of adaptation to the risk tolerance of the investors by trading off risk and returns. The illustrations of this article give us confidence that MVO strategy is very robust, and it may continue to perform well in the future. Additional disclosure: The article was written for educational purposes and should not be considered as specific investment advice.

401(k) Fund Spotlight: Franklin High Income

Summary Franklin High Income has been the worst performing high yield bond fund over the last twelve months. The fund has suffered due to its heavy exposure to commodities via the debt of energy and materials companies. The fund sports a 7.14% yield, but investors should subtract 1% for the fallout that is to come to the coal debt the fund still holds. High yield debt will likely rebound in the short term, but I’d rather own small cap U.S. stocks instead. Introduction I select funds on behalf of my investment advisory clients in many different defined contribution plans, namely 401(k)s and 403(b)s. I have looked at a lot of different funds over the years. 401(k) Fund Spotlight is an article series that focuses on one particular fund at a time that is widely offered to Americans in their 401(k) plans. 401(k)s are now the foundational retirement savings vehicle for many Americans. They should be maximized to the fullest extent. A detailed understanding of fund options is a worthwhile endeavor. To get the most out of this article, it is helpful to understand my approach to investing in 401(k)s . I strive to write these articles for the benefit of the novice and professional. Please comment if you have a question. I always try to give substantive responses. Franklin High Income Fund The Franklin High Income Fund has the following share classes: If the fund is an option in your 401(k), it will likely come in the form of the R or R6 shares. The expense ratio for the R shares is 1.11% and for the R6 shares it is .47%. For the purposes of this article, I will assume the A shares are being discussed since that share class holds most of the fund’s assets. Some readers may also own the fund outside of a company retirement plan. The expense ratio of the A shares is .76%. The Franklin High Income Fund is a typical high yield bond fund investing in lower-rated, higher yielding corporate bonds. As of September 30, 2015, the fund’s holdings were most heavily weighted to the following six industries: Energy – 16% Health Care – 10% Finance – 8% Cable Satellite – 8% Metals & Mining – 7% Wireless – 7% Beaten Up By Energy Investors who have pay attention to the markets would be right to be concerned about the large exposure to Energy and Metals & Mining, which make up almost a quarter of the portfolio. Actually, 25% of the portfolio was in energy last November and this has clearly been a source of pain for the fund since. Here is a few places where some serious damage was done: Bond Principal Amount on November 30, 2014 Market Value as of November 30, 2014 Principal Amount on September 30, 2015 Market Value as of September 30, 2015 Alpha Natural Resources $25,000,000 $19,812,500 $25,000,000 $1,812,500 Chaparral Energy ( 3 different issues ) $31,700,000 $31,339,000 $31,700,000 $9,866,500 Peabody Energy ( 3 to 4 issues ) $64,400,000 $61,575,000 $58,445,000 $17,831,000 Quicksilver Resources $35,000,000 $27,925,000 $15,175,000 $5,690,625 Terrible Performance Recently, But Better Long-Term I suspect that this is the primary reason why the fund has been the worst performing high yield bond fund over the last year (at least it is using the Barron’s fund screener ). The following chart shows the vast underperformance of the fund over the last 12 months versus the iShares High Yield Corporate Bond ETF (NYSEARCA: HYG ), a good proxy for a high yield index. FHAIX Total Return Price data by YCharts However, to be fair, the fund’s longer term performance has been much better, as shown on the following chart: FHAIX Total Return Price data by YCharts Outlook It is likely that in the near term the worst is over for high yield bonds and the Franklin High Income fund. However, the fund’s 7.14% 30-day SEC yield is still not enough to tempt me. The fund continues to have a fair amount of exposure to the U.S. shale oil and gas industry. I am bullish on oil, but this may very well come at the expense of more bankruptcies in the U.S. shale industry. The fund continues to hold debt of coal companies Alpha Natural Resources ( OTCPK:ANRZQ ), CONSOL Energy (NYSE: CNX ), and Peabody Energy (NYSE: BTU ). I’ve done the research on coal and I remain bearish. As far as I’m concerned, you might as well subtract 1% off this fund’s yield to cover the fallout that is coming. I will give the fund an honorable mention though for holding a little over 1% of the portfolio in the 2022 debt of Fortescue Metals, a company whose debt I have touted several times on Seeking Alpha. The one advantage that this fund and the high yield universe, in general, currently has is that interest rates have yet to rise. There is less rollover risk for companies having to refinance their debt. Because of this, I would not be surprised to see high yield bonds stage a comeback in the short term. Strategic Positioning My view is that we are entering the latter stages of the economic cycle and high yield bonds have already felt the tremors of more trouble to come. At present, I prefer to hold U.S. equities-namely small caps where valuations have recently come down quite a bit-over high yield debt and also a lot of cash. Nevertheless, if the fund’s high yield is too much for you to pass up, given that short term rates are near zero, I would limit exposure to no more than 5% of your entire 401(k). Investing Disclosure 401(k) Spotlight articles focus on the specific attributes of mutual funds that are widely available to Americans within employer provided defined contribution plans. Fund recommendations are general in nature and not geared towards any specific reader. Fund positioning should be considered as part of a comprehensive asset allocation strategy, based upon the financial situation, investment objectives, and particular needs of the investor. Readers are encouraged to obtain experienced, professional advice. Important Regulatory Disclosures I am a Registered Investment Advisor in the State of Pennsylvania. I screen electronic communications from prospective clients in other states to ensure that I do not communicate directly with any prospect in another state where I have not met the registration requirements or do not have an applicable exemption. Positive comments made regarding this article should not be construed by readers to be an endorsement of my abilities to act as an investment adviser.

Multi-Alternative Funds: The Best And Worst Of September

By DailyAlts Staff Multi-alternative mutual funds offer varying exposures to different alternative strategies, often managed by separate underlying managers. Thus, it’s not surprising that the category has fairly wide dispersion between its best- and worst-performing funds on a monthly basis: In September, the funds in Morningstar’s Multi-alternative category returned an average of -1.15%, slightly outperforming a 60%/40% blend of the S&P 500 Index and the Barclays U.S. Aggregate Bond Index, which returned -1.31% for the month. The top fund in the category returned +5.57%, while the worst performer posted a monthly return of -5.08% – a difference of more than 1,000 basis points. Top Performing Funds in September AQR boasted the top two multialternative funds in September: the AQR Style Premia Alternative Fund (MUTF: QSPIX ) and the AQR Multi-Strategy Alternative Fund (MUTF: ASAIX ). The funds posted respective one-month gains of 5.57% and 4.19%, easily surpassing the 1.84% gains of #3-ranked Cornerstone Advisors Public Alternative Fund (MUTF: CAALX ). The AQR funds also significantly outclass the Cornerstone fund in terms of assets under management (“AUM”), and returns over the past three, nine, and twelve months. AQR’s QSPIX and ASAIX had respective AUM of $1.3 billion and $2.2 billion as of October 19, compared to the Cornerstone fund’s healthy $474.4 million in assets. QSPIX’s returns over the past three, nine, and twelve months through September 30 were +7.30%, +5.78%, and +13.56%; while ASAIX posted returns of +6.64%, +6.97%, and +12.38% for the given periods. The Cornerstone fund, by contrast, returned +1.74% over the three months ending September 30, and +2.83 and +5.87%, respectively, for the nine- and twelve-month periods ending on that date. Worst Performing Funds in September One month doesn’t make a year as we will see with the bottom performers in September, but does highlight potential risks in particular funds and the need to have a longer-term view. The following multi-alternative mutual funds were the worst performers for the month: Catalyst’s Macro Strategy fund may have had a bad September, losing 5.08% and ranking at the rock bottom of the category, but over the first nine months of 2015, the fund returned an astounding +28.86%! That total is far better than any of the nine-month returns for September’s top-performing multi-alternative mutual funds. The fund’s returns over the three- and twelve-months ending September 30 were +3.18% and +26.22%, respectively. The Quaker Event-Arbitrage and AIP Dynamic Alpha Capture funds lost 4.94% and 4.70%, respectively, in September. Unlike the Catalyst Macro Strategy Fund, the Quaker and AIP Dynamic funds had negative returns for the three- and nine-month periods ending September 30. Conclusion Multi-alternative funds cover a lot of ground – you can tell by a quick glimpse at their names. Terms like “style premia,” “macro strategy,” and “event-arbitrage” would seem to describe different styles, and these funds do have different emphases – which is why their returns can vary by such wide amounts. Not only was there a 1,065-basis point disparity between the best and worst multi-alternative funds in September, but those same funds had a more than 23% differential in the other direction for the first nine months of the year. Clearly, investors interested in adding multi-alternative exposure to their portfolios can’t make their decision based on one month’s worth of returns – this is especially driven home by the immense gulf between the Catalyst fund’s one-month and one-year performance. But beyond merely looking at returns, prospective multi-alternative investors need to conduct deeper due diligence to ensure they understand the exposures they’re adding to their portfolios. With effective fund selection, multi-alternative investing should improve portfolio diversification, and this could contribute to improved risk-adjusted portfolio returns. Past performance does not necessarily predict future results.