Category: Portfolio review

A tough month for the model portfolio (April 2018 review)

  • MTD portfolio performance: -0.76% (-0.62% since inception)
  • MTD benchmark performance: +0.10% (-0.70% since inception)
  • Net performance: -0.85% (+0.08% since inception)

Markets recap

Developed market equities trended up this month while emerging markets and frontier markets lost ground. Meanwhile, volatility levels receded, US treasury yields climbed higher and oil continued on its upwards trajectory.

  • The S&P500 returned +0.38% but on year-to-date basis is still down -0.38%. Emerging Market stocks (EEM) lost -2.8% and frontier markets (FM) as much as -3.9%
  • The VIX volatility index declined from 20.0 at start of the month to 15.9 at the end of the month. Besides some volatility early in the month it mostly was a gradual decline.
  • US 10 year treasury yields saw a strong spike upwards from 2.74% to 2.95% (+21bps), intra-month touching above the 3% for the first time since 2014.
  • Brent Crude Oil continued its march upwards, increasing from 70 to 75 (+7%)

Theme returns

NameMarAprMayJunJulAugSepOctNovDec2018
Broad Market (VT)-1.29%+0.42%-0.88%
Hard Brexit-1.79%+2.88%+1.04%
Rising interest rates-0.48%-0.05%-0.53%
The next market crash+0.32%-0.96%-0.64%
Trade wars+1.32%-0.10%+1.22%
Stagflation+0.25%+1.13%+1.38%
Low volatility high yield-0.20%+1.40%+1.20%
Robotics / Automation-2.45%-2.51%-4.90%
Water scarcity+1.56%-0.20%+1.36%
Global tourism-2.41%-1.22%-3.60%
Frontier Markets+2.49%-3.94%-1.55%
Healthcare Innovation+0.48%-1.96%-1.49%
Core Bond+1.02%-1.29%-0.28%
Core Equity-0.19%-1.11%-1.30%
Batteries-3.62%+0.21%-3.42%
Blockchain-3.39%+0.49%-2.92%
Fintech+1.21%+0.94%+2.16%
Space Race-2.41%-5.01%-7.30%
Clean Energy+1.71%+3.47%+5.24%
Millennials-3.62%-0.11%-3.73%
Urbanisation-0.90%+1.64%+0.73%
Modern Agriculture-2.23%+0.13%-2.10%
Self-driving vehicles-4.06%+0.91%-3.19%
Emerging Markets-0.21%-2.77%-2.97%
Post Trump Administration+1.05%-0.54%+0.50%
Late Cycle+0.65%+1.09%+1.75%
Dawn of Eurasia-1.21%-2.42%-3.60%
Cybersecurity+0.54%+4.23%+4.79%

Winning themes: Cybersecurity, Clean Energy, Brexit

  • Cybersecurity. One of the biggest winners of this month was Cybersecurity, returning +4.2%. Both ETFs which make up half-half of the portfolio did well and returned 3% to 5%. Looking at the CIBR ETF (+3.2%), we see that companies like Palo Alto Networks, Symantec and VMware (together nearly 20% of the constituents), all returned in the range of +6% to +10%. Cybersecurity is a hot topic right now.
  • Clean Energy. The Clean Energy theme had a very good month, returning +3.5%. Many of its largest constituents had very strong returns, such as Siemens Gamesa Renewable Energy (+8%) and Verbund AG (+7%). But perhaps most significant was China Longyuan Power Group which returned 29% and is 5% of the ETF.
  • Brexit. Pound sterling weakened, commodities rallied (good for BHP Billiton) and British stocks rallied (good for the likes of Sky and Vodafone). As worries about a hard Brexit grew, almost everything came together for our Brexit portfolio, which returned +2.9%. I would expect this theme to keep doing its job as crucial dates creep closer.

Losing themes: Space Race, Frontier and Emerging Markets

  • Space Race. The iShares US Aerospace & Defense ETF saw terrible returns (-6%), causing the Space Race theme to sell off and lose -5.0%. Notable were returns of -5% on United Technologies Corp and Lockheed (together 14% of the ETF).
  • Frontier Markets. Frontier Markets saw mostly negative returns, largely off the back of US dollar strength. The theme lost -3.9%. The larger Frontier Markets ETF lost -5%, and especially Vietnam at -9% in one month had a fall from grace, having previously been one of the best performers YTD. Egypt saved the day returning +2%, but it didn’t help much.
  • Emerging Markets. Emerging Markets similarly had a bad time due to US dollar strength and lost -2.8%. Brazil, Indonesia and Russia all lost -4% to -8%. In local currency terms all but Indonesia actually gained value, but especially Russia could do nothing as the US imposed more sanctions and its currency went in free fall.

Model allocation and returns

2018-04 allocation2018-04 theme returns2018-04 model contributors

When coupled with the Emerging and Frontier markets constituents of the Core equity theme, the portfolio contains a total of 8.3% emerging market and 7.8% frontier market exposure. In a month where both asset classes sold off on a resurgent US dollar, that hurt returns. On their own, these two added some -0.5% to total return. Exposure to Healthcare Innovation and Robotics and Automation further sunk the portfolio.

The stock benchmark (VT) returned +0.42% and was outperformed by themes like Clean Energy (+3.5%) and Urbanisation (+1.6%). It was on the other hand underperformed by themes like Frontier Markets (-3.9%), Robotics and Automation (-2.5%), Healthcare Innovation (-2.0%) and Global Tourism (-1.2%). The Core Equity portfolio returned -1.11% due to its larger emerging and frontier market exposure.

The bond benchmark (BND) returned -0.87% as US interest rates climbed 21bps. It was still underperformed by the Core Bond portfolio (-1.3%) as there were slightly better returns on non-US developed market bonds (-0.2%) but far worse returns on emerging market bonds (-3.4%) that form part of it. Other themes that can be seen as going up against the bond benchmark fared better, for instance rising interest rates (-0.05%), low volatility high yield (+1.4%) and trade wars (-0.1%).

What changes am I making to my asset allocation?

This month I am making quite a few changes which should hopefully position the portfolio better for currently changing markets:

  • Reducing Emerging and Frontier Market exposure. Both the Core Equity theme (30% EM and 10% FM) as well as the frontier market portfolios are cut down to size. I expect more dollar strength and eventually a serious market downturn and at this point want to lower my sensitivity to that.
  • Reducing Clean Energy, Tourism and Healthcare Innovation. These are themes I have had my eye on throughout the month. Clean Energy has rallied tremendously in April but like the other two seem ripe for repricing.
  • Close the Trade Wars theme, add Cybersecurity and Blockchain. It seemed to work for a while during April, and then it did not. No harm done, but with today’s announcement that steel and aluminum sanctions will be postponed, it does not seem to me like a real trade war is forthcoming. I am adding Cybersecurity and Blockchain at minimal exposures. Let’s see what they can do.
  • Increase Low Volatility High Yield and add Late Cycle, Stagflation. I like what I’ve seen so far in the low vol high yield theme, and am getting convinced this one will help to soften the blow and build up a buffer for the next market downturn, all the while generating decent returns. Best of both worlds. I am adding a significant bit of exposure to the Late Cycle and Stagflation themes, which should play into the current market environment quite well.

Stock markets will crash: how to prepare your portfolio for the inevitable

The yield curve has been rising, but (with exception of the last several days), short term rates have been moving up faster than long term rates. A flatter and perhaps at some point inverted yield curve has typically preceded a recession, as it implies that long-term views of the economy are becoming less rosy.

At the same time P/E ratios of stocks are getting close to all-time highs and commodity prices are rising sharply, which in the past has generally been followed by a recession. In the mean time the Federal Reserve is reducing their balance sheet and draining liquidity from the market.

As of writing, the S&P 500 has again turned officially negative for the year while volatility is higher than it has been for years. European and Japanese stocks are moving right along while emerging and frontier markets are still bucking the trend but also heading in the same direction. Not to sound gloomy but we may be working up to a period of sharply lower returns. How can an investor adjust their portfolio to cope?

IMG_E43A2994BD3B-1

Year-to-date stock returns on S&P, Nikkei, Hang Seng, Eurostoxx 50, Emerging and Frontier markets

IMG_71AE4BC98818-1

The US Treasury actives curve, between now, December 2017 and December 2016

IMG_E4AF4B622334-1

Spread between 2 year and 10 year US Treasuries

Crude oil during the previous two crises vs today

S&P500: The run up to the previous two market crashes vs today

What are the risks on the horizon?

I believe we will be going through two distinct periods. First there will be a time of sharply higher interest rates and commodity prices. Meanwhile equity markets start moving sideways as positive earnings surprises fail to excite, and the positive sentiment around their generally good results has to contend with worries about what is to come. Secondly, there will be a time of sharply negative stock returns as a recession brings things back to earth.

In the first period you will want little fixed income exposure except very short maturity and higher yielding bonds. You can complement that with some commodities and selective equity exposure. The latter can for instance be to high yielding stocks, or themes, countries or sectors that still have some life in them or are in an earlier part of the cycle.

In the second period you will want practically no equity exposure at all, keep a significant part of your portfolio in cash and complement that with long maturity fixed income and safe haven assets like gold. You will also be looking to buy the dip.

I believe we have now entered the first period. How long it will last is uncertain, but if the previous two market crashes (2000 and 2008) offer any guidance for the future, we are probably looking at anywhere between 9 months to 18 months (note that the 1989 crash actually happened in a much shorter time span but we are going to work off the assumption that we will face something more similar to 2000 or 2008).

That means that potentially until year-end or even summer 2019 there could be positive returns to be had, but you need to be selective.

How to modify your portfolio

At this point we want to be cautious. But we also don’t want to stand on the sideline until the middle of 2019 if select sectors of the market deliver healthy returns before then. To avoid getting caught out by rising interest rates we will want to reduce our fixed income exposure today and shift into more defensive, less volatile or higher yielding stocks. In addition, some commodity exposure is probably warranted.

Next, over the next 6-9 months or so we want to gradually adjust the portfolio to be recession-ready. That means at least reducing the most risky equity exposure, reducing commodity exposure and adding cash. Once interest rates are sufficiently high it may be a smart move to increase fixed income exposure.

How my model portfolio looks and what changes will be needed

CategoryNameMax% alloc*Alloc% todayAlloc% in 6 monthsDifference
Total portfolio100.0%100.0%
Lower RiskRising interest rates12.5%10.0%10.0%0.0%
Lower RiskThe next market crash20.0%5.0%8.3%+3.3%
Lower RiskLow volatility high yield11.7%5.0%11.7%+6.7%
Higher RiskRobotics / Automation9.4%5.0%2.5%-2.5%
Higher RiskWater scarcity9.9%10.0%6.3%-3.7%
Higher RiskGlobal tourism8.1%2.5%1.4%-1.1%
Higher RiskFrontier Markets11.9%5.0%0.0%-5.0%
Higher RiskHealthcare Innovation14.0%12.5%5.0%-7.5%
Lower RiskCore Bond9.0%5.0%1.0%-4.0%
Higher RiskCore Equity46.7%27.5%24.0%-3.5%
Higher RiskClean Energy16.4%5.0%2.5%-2.5%
Higher RiskUrbanisation12.6%2.5%1.4%-1.1%
Higher RiskModern Agriculture12.8%2.5%0.9%-1.6%
Higher RiskTrade wars14.0%2.5%0.0%-2.5%
Higher RiskLate Cycle16.1%0.0%7.5%+7.5%
Higher RiskStagflation17.3%0.0%2.5%+2.5%
CashCash100.0%0.0%15.0%+15.0%

* Refers to our position sizing methodology

 

  • Longer term themes. 45% of the portfolio is currently invested in longer term themes such as healthcare innovation, water scarcity, robotics, clean energy, tourism, urbanisation, modern agriculture and frontier markets. Some of these themes are less diversified and their constituents overvalued. For instance the ICLN ETF in Clean Energy has a P/E of 106 while the HEAL ETF in Healthcare is as high as 102. This clearly needs to be lowered. 6 months target: 20.0%. Since this is a thematic portfolio, we keep exposure to our conviction themes at all times, and once themes become significantly undervalued we want to move back in and pile up the allocation.
  • Core equity and bond. 32.5% of the portfolio is in the core equity and bond themes. Both carry higher risk from emerging markets, while the core bond theme has relatively high interest rate sensitivity. I will reduce their combined allocation to 25.0%
  • Short-term themes. 17.5% of the portfolio is currently in themes that play in on rising interest rates, a market crash and trade wars. These will be gradually raised to 28.3% as risks intensify. The Late Cycle and Stagflation themes are added into the mix
  • Low vol high yield. 5.0% of the portfolio is invested in the low volatility high yield theme. This theme has been holding up well and would likely add diversification in any crash, and I will increase it to 11.7% (its maximum allocation per our sizing methodology)
  • Cash. The remainder of the portfolio will be held in cash

Model Portfolio review (first half April 2018): the core portfolios underperform

  • MTD portfolio performance: +0.15% (+0.28% since inception)
  • MTD benchmark performance: +0.47% (-0.33% since inception)
  • Net performance: -0.33% (+0.61% since inception)

Theme returns and model allocation

2018-04M theme returns

2018-04M allocation

2018-04M model contributors

Markets recap

On month to date basis, the S&P500 is up +0.66% while crude oil is up +3.77% and US 10 year yields are up +9bps to 2.83%. Meanwhile emerging market bonds are down -0.66%. The dollar was flat against the euro and a bit stronger against JPY (+1.0%). Finally, the VIX index has come down to about 17% as of yesterday’s close.

There have been worries about a potential trade war between China and the US, but after soothing words from both sides the bulls returned to the market. Having said that, Donald Trump just ordered attacks (supposedly a one-off) on Syria in retaliation for Assad’s use of chemical weapons, and Russia has vowed to retaliate. The general risk-on mood may sour in the last two weeks of the month depending on how this all plays out.

Notable portfolio underperformers

Core equity (27.5% allocation). Returned -0.07% vs +0.68% on Vanguard Total World. Non-US developed market stocks did better than the Total World index (which itself is 35% part of this theme), but emerging market stocks and frontier markets are getting hammered this month on worries around trade wars.

Core bond (5.0% allocation). Returned -0.33% vs -0.15% on Vanguard Total Bond Mkt. Given the rally in US rates, international diversification to developed markets worked out well, but the inclusion of 25% EM bonds in the portfolio hurt. Notably bonds of Russia (~5% of the index our EM bond ETF tracks) took a hit as the US imposed new sanctions.

Global tourism (2.5% allocation). Returned -2.20%. In the portfolio of 9 equal-weighted tourism related stocks, CTrip, Carnival and Wyndham each sold off -4% to -6%. It is easy to see that the airline stocks in the portfolio (RyanAir and Singapore Airlines) would sell off on the higher oil prices, and perhaps that sentiment resonates throughout the sector.

Notable portfolio outperformers

Clean energy (5.0% allocation). Returned +2.31%. A lot of that was driven by the second biggest holding in the ETF, Huaneng Renewables, to return nearly +11% MTD based on several rating upgrades from analysts.

Modern agriculture (2.5% allocation). Returned +1.22%. Mostly due to +2.3% on FTAG (First Trust Index Global Agriculture ETF). Within that index, Monsanto and Bayer AG are the two largest constituents forming 20% of the total and each returned +8% on the news that Bayer will be allowed to buy Monsanto by the US Department of Justice.

Urbanisation (2.5% allocation). Returned +1.20%. Mostly on the SPDR Metals and Mining ETF (XME) which returned +4.4% in the month. Alcoa, the largest holding in the ETF at over 5%, returned +22% as the price of aluminum shocked upwards after the US imposition of sanctions on Russia, targeting Rusal.

Thoughts on the portfolio going forward

I want to say I am 100% happy with my portfolio but to be honest at the moment I am not. Core equity and core bond have significant portions invested in emerging markets which over the longer run (I am talking about years) should really aid outperformance, however I am getting the feeling that we are working up towards major market turmoil and I am not sure if I want to stick with these allocations while going through that. It is a pity that I don’t rebalance intra-month because otherwise I would probably want to make some changes today.

I am still pondering over it, but for the moment I am also considering to reduce allocation to core equity (-5% or more). Also I am intending to reduce healthcare and robotics by as much as 5% to 10% as while I believe in the themes, a lot of the companies in the underlying ETFs seem quite overvalued from a P/E point of view. They will work, but not in the months where it all comes crashing down. To replace that allocation, I will likely add money in themes like Low Vol High Yield and Late Cycle.

Model Portfolio review (March 2018): winners and losers in a volatile month

  • MTD portfolio performance: +0.13% (+0.13% since inception)
  • MTD benchmark performance: -0.80% (-0.80% since inception)
  • Net performance: +0.93% (+0.93% since inception)

Theme returns and model allocation

2018-03 theme returns

2018-03 allocation

2018-03 model contributors

Markets recap

It has been quite an edge-of-your-seat type of month for everybody watching financial markets. The volatility spike that happened in early February 2018 has not receded and has made asset prices wildly gyrate throughout the month:

  • The VIX volatility index started the month around 22.5, in between moving in a 14.6-26.0 range and finishing slightly lower at 20.0. That is still a lot higher than the low teens we have been seeing for the last year
  • US 10 year treasury yields started the month at 2.83% but headed lower to 2.74% at month-end. the short-end and ultra long-end of the curve did the same
  • The S&P500 ended the month down -2.5%, meaning that on YTD basis it is now down -0.8%

Looking at the various themes that we track on this website, four clear winners were frontier markets (+2.49%), clean energy (+1.71%), water scarcity (+1.56%) and trade war (+1.32%). Meanwhile, the big losers were mostly technology related as self-driving vehicles (-4.06%), batteries (-3.62%), millennials (-3.62%) and blockchain (-3.39%) sold off. For reference, the broad market ETF (VT) returned -1.29%.

NameMarAprMayJunJulAugSepOctNovDec2018
Broad Market (VT)-1.29%+0.42%-0.88%
Hard Brexit-1.79%+2.88%+1.04%
Rising interest rates-0.48%-0.05%-0.53%
The next market crash+0.32%-0.96%-0.64%
Trade wars+1.32%-0.10%+1.22%
Stagflation+0.25%+1.13%+1.38%
Low volatility high yield-0.20%+1.40%+1.20%
Robotics / Automation-2.45%-2.51%-4.90%
Water scarcity+1.56%-0.20%+1.36%
Global tourism-2.41%-1.22%-3.60%
Frontier Markets+2.49%-3.94%-1.55%
Healthcare Innovation+0.48%-1.96%-1.49%
Core Bond+1.02%-1.29%-0.28%
Core Equity-0.19%-1.11%-1.30%
Batteries-3.62%+0.21%-3.42%
Blockchain-3.39%+0.49%-2.92%
Fintech+1.21%+0.94%+2.16%
Space Race-2.41%-5.01%-7.30%
Clean Energy+1.71%+3.47%+5.24%
Millennials-3.62%-0.11%-3.73%
Urbanisation-0.90%+1.64%+0.73%
Modern Agriculture-2.23%+0.13%-2.10%
Self-driving vehicles-4.06%+0.91%-3.19%
Emerging Markets-0.21%-2.77%-2.97%
Post Trump Administration+1.05%-0.54%+0.50%
Late Cycle+0.65%+1.09%+1.75%
Dawn of Eurasia-1.21%-2.42%-3.60%
Cybersecurity+0.54%+4.23%+4.79%

Winning themes: frontier markets and trade war

  • Frontier Markets. It is fascinating to see that a potentially high risk theme like frontier markets did so well this month. Returning +2.49% in a month when broad equity markets sell off quite strongly is impressive. Argentina and Nigeria were slightly down while Vietnam was up nearly 5%. But the real impressive figures came from Egypt which delivered a stunning +14% return.
  • Trade War. In a month of escalating rhetoric between the US, China and the EU on tariffs, it is no surprise (fortunately) that the constructed trade war portfolio performed well. Each component in it rallied: China and US small caps, US Treasury, long JPY and commodities.

Losing themes: Self-driving vehicles and batteries

  • Self-driving Cars. This theme had a bad month and lost -4.06%. Uber had a fatal accident involving an autonomous vehicle, and tech (which forms a big part of the theme through for instance Intel, Google and Baidu) sold off on the back of worries about a data breach at Facebook. The Cars ETF itself returned -4.3%
  • Batteries. The one constituent of this portfolio lost -3.6%, similarly on the worries about the technology industry mentioned above

Portfolio recap

The model portfolio outperformed its benchmark by 93bps, as it returned +0.13% while the benchmark returned -0.80%. In a month where the S&P500 ended down -2.5% that is not a bad result. The low risk (mostly fixed income) portion (25%) underperformed given declining interest rates during the month, while the model is positioned to do better than the benchmark when rates are rising.

The fixed income portion had close to a flat return. The high risk (mostly equity) portion (75%) strongly outperformed, returning +0.17% vs the benchmark return of -1.29%. The main reasons were higher frontier market and emerging market exposure, while themes like clean energy, water and healthcare managed to deliver positive returns even when the market as a whole was down

The model portfolio overall did pretty well and outperformed its benchmark by +0.93%, avoiding allocation to all the four worst performing themes mentioned above.

  • Model portfolio return: +0.13%
  • Benchmark return: -0.80% (75% VT Vanguard Total World Stock and 25% BND Vanguard Total Bond Market)
  • Net outperformance: +0.93%

The lower risk (fixed income) portion of the benchmark (BND) returned +0.69% versus +0.04% in the model. Meanwhile the higher risk (equity) portion returned -1.29% versus +0.17% in the model. The benchmark therefore netted -0.80%, while the model returned +0.13%. On the risky side of the allocation (equity) the portfolio was able to generate strong outperformance, while on the low risk side it slightly underperformed:

  • Lower Risk Portion. The 25% low-risk component of my allocation, which I have structured to go head to head with the BND ETF, returned as follows. Core Bond (+1.02%), rising rates (-0.48%), low vol high yield (-0.2%), next market crash (+0.32%). That makes for a +0.04% total return on this bucket, which therefore underperformed the benchmark component.
  • Higher Risk Portion. The 75% equity component returned some +0.17% vs -1.29% on its benchmark. Notably my Core Equity portfolio did much better (-0.19%) given its frontier and EM market components. But themes like Clean Energy, Water, Healthcare etc. also delivered positive returns

The main reason the low risk bucket underperformed is that my portfolio is structured for rising rates, and in fact interest rates declined by 9bps due to the general risk-off environment. Note though that my Core Bond portfolio did outperform the fixed income benchmark, so the 4 ETFs would still have been better than the single bond ETF portfolio.

What changes am I making to my asset allocation?

  • I am selling 2.5% healthcare (+0.48%) this month, and buying 2.5% trade wars (+1.32%)