Summary In this volatility targeting approach, the allocation between equity and bond assets is varied on a monthly basis based on a specified target volatility level. Low volatility is the goal. Two strategies are presented: 1) a moderate growth version and 2) a capital preservation version. 30 years of backtesting results are presented using mutual funds as proxies for ETFs. For the moderate growth version, backtests show a CAGR of 12.6%, a MaxDD of -7.4% (based on monthly returns), and a return-to-risk (CAGR/MaxDD) of 1.7. For the capital preservation version, CAGR = 10.2%, MaxDD = -4.9%, and return-to-risk (CAGR/MaxDD) = 2.1. In live trading, ETFs can be substituted for the mutual funds. Short-term backtesting results using ETFs are presented. I must admit I am somewhat of a novice at using volatility targeting in a tactical strategy. But recently, the commercially free Portfolio Visualizer [PV] added a new backtest tool to their arsenal, so I started studying volatility targeting and how it works. Volatility targeting as used by PV is a method to adjust monthly allocations of assets within a portfolio based on the volatility of the assets over the previous month(s). In this case, we are only looking at high volatility equities and very low volatility bonds. To maintain a constant level of volatility for the portfolio, when the volatility of the equity asset(s) increases, allocation to the bond asset(s) increases because the bond asset has low volatility. And when the volatility of the equity asset(s) decrease, allocation to the bond asset(s) decreases. In PV, you can specify a target volatility level for the portfolio. Since I wanted an overall low volatility strategy with moderate growth (greater than 12% compounded annualized growth rate), I mainly focused on very low volatility target levels. I ended up using a monthly lookback period on volatility to determine the asset allocations because monthly lookbacks produced the best overall results. I quickly came to realize that high-growth equity assets are desired for the equity holdings, and a low-risk (low volatility) bond asset is preferred for the bond fund. In order to assess the strategy, I used mutual funds that have backtest histories to 1985. This enabled backtesting to Jan 1986. In live trading, ETFs that mimic the funds can be used. I will show results using the mutual funds as well as the ETFs. The equity assets I selected were Vanguard Health Care Fund (MUTF: VGHCX ) and Berkshire Hathaway (NYSE: BRK.A ) stock. Either Vanguard Health Care ETF (NYSEARCA: VHT ) or Guggenheim – Rydex S&P Equal Weight Health Care ETF (NYSEARCA: RYH ) can be substituted for VGHCX in live trading. BRK.A is, of course, a long-standing diversified stock. These two equity assets were selected because of their high performance over the years. Of course, these equities had substantial drawdowns in bear markets, something we want to avoid in our strategy. But in volatility targeting, as I have found out, it is advantageous to use the best-performing equities, not just index-based equities. Of course, it is assumed that these equities will continue to perform well in the future as they have in the past 30 years, and that may or may not be the case. For the low-risk bond asset class, I used the GNMA bond class. The selection of the GNMA bond class was made after studying performance and risk using other bond classes such as money market, short-term Treasuries, long-term Treasuries, etc. The GNMA class turned out to be the best. I selected Vanguard GNMA Fund (MUTF: VFIIX ) for backtesting, so that the backtests could extend to Jan 1986. There are a number of options for ETFs that can be used in live trading, e.g. iShares Barclays MBS Fixed-Rate Bond ETF (NYSEARCA: MBB ). Moderate Growth Version (CAGR = 12.6%) A moderate growth version is considered first. VGHCX and BRK.A are the equities always held in a 66%/34% split; VFIIX is the bond asset; and the target volatility is 6%. The backtested results from 1986-2015 are shown below compared to a buy and hold strategy of the equities (rebalanced annually). (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) It can be seen that the compounded annualized growth rate [CAGR] is 12.6%, the maximum drawdown [MaxDD] is -7.4% (based on monthly returns), and the return-to-risk [MAR = CAGR/MaxDD] is 1.7. There are three years with essentially zero or very slightly negative returns: 1999, 2002 and 2008. The worst year (2008) had a -1.6% return. The monthly win rate is 74%. The percentage of VFIIX varies between 1% and 93% for any given month. The Vanguard Wellesley 60/40 Equity/Bond Fund (MUTF: VWINX ) is a good benchmark for this strategy. The overall performance and risk of VWINX are shown below. It can be seen that the CAGR is 9.1%, while the MaxDD is -18.9%. These performance and risk numbers are quite good for a buy and hold mutual fund, but the volatility targeting strategy produces higher CAGR and much lower MaxDD. VWINX Benchmark Results: 1986-2015 (click to enlarge) Capital Preservation Version (MAR = 2.1) For this version, the target volatility was set to a very low level of 3.5%. This volatility level produced the lowest MAR. The results using PV are shown below. (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) It can be seen that the CAGR is 10.2%, the MaxDD is -4.9%, and the MAR is 2.1. Every year has a positive return; the worst year has a return of +0.4%. The monthly win rate is 75%. Limited Backtesting Using ETFs To show how this strategy would play out in live trading, I have substituted RYH for VGHCX and MBB for VFIIX. The second equity asset is BRK.A as before. Backtesting is limited to 2008 with these ETFs and the BRK.A stock. The backtest results are shown below. (click to enlarge) (click to enlarge) The ETF results can be compared with the mutual fund results from 2008 to 2015. The mutual fund results are shown below. (click to enlarge) (click to enlarge) It can be seen that the overall performance over these years is lower than seen over the past 30 years. The CAGR is 9.7% from 2008 to 2015 for the mutual funds and 9.3% for the ETFs. Although this performance in recent years is less than earlier performance, it is still deemed acceptable for most retired investors interested in preserving their nest egg while accumulating modest growth. The good quantitative agreement between mutual funds and ETFs between 2008 and 2015 provides some confidence that using ETFs is a viable option for this strategy. Overall Conclusions The tactical volatility targeting strategy I have presented has good potential to mitigate risk and still provides moderate growth in a retirement portfolio. The moderate growth version has a CAGR of 12.6% and a MaxDD of -7.4% in 30 years of backtesting. The capital preservation version has a CAGR of 10.2% and a MaxDD of -4.9% over this same timespan. The return-to-risk MAR using target volatility is much better than passive buy and hold approaches, especially in bear markets when large drawdowns may occur even in diversified portfolios.