In his MarketWatch article today, Mark Hulbert writes,

Would you be interested in an all-weather portfolio that, despite hardly ever changing its composition, performs creditably in almost all market environments?

Hulbert characterizes the Permanent Portfolio this way:

Browne’s idea was to invest in a basket of asset classes, each one of which has a low correlation with the others. As a result, when any one of the asset classes is performing poorly, there is a good chance that the others will at least be holding their own — if not actually appreciating in value.

He describes Harry Browne’s Permanent Portfolio as an antidote to volatility. He then gives some past performance of the PRPFX fund which somewhat implements Harry Browne’s concept:

This fund over the last 15 years (through Apr. 30) has produced an 8.2% annualized return, which is remarkable given that stocks, gold and bonds did not, individually, do as well: The Wilshire 5000 index gained 7.9% over the same period, the Shearson Lehman Treasury Index produced a 6.3% annualized return, and gold bullion rose at a 7.7% annualized pace.

I might suggest that while the result of the four asset classes is low correlation, that is not the way Harry Browne explained the reasoning. Instead, the portfolio is designed to have one component that does well in each of four different economic circumstances: prosperity (stocks), inflation (gold), deflation (LT Bonds), and recession (cash). Harry said that while you can expect one of the assets to go down, the one that goes up more than makes up for the loser. For example, while one asset may go down 30% or 40%, the winning asset can go up 200% or 300%, more than making up for the loss.

I think the best thing about the portfolio is this: No one can predict the future so we might as well invest in all possibilities.

So, how has the Harry Browne Permanent Portfolio done so far in 2010?

Thru yesterday’s market turmoil, the components have done the following:

VTI +2.8% (Stocks)

TLT +9.2% (Bonds)

SHY +1.3% (Cash)

GLD +10.4% (Gold)

And the total portfolio, assuming 25% in each at the start of 2010 is…

+5.9%

How’s that compare with YOUR portfolio?

If you have any questions about Harry Browne’s Permanent Portfolio, head over to the Permanent Portfolio Discussion Forum that CraigR just started over at CrawlingRoad.com. Experts there have studied it from all angles and can help you get it implemented yourself.

And here’s the book you need to read:

Harry Browne’s Permanent Portfolio is so simple. Split your investments into equal parts stocks, bonds, cash, and gold. Is it too simple? Can it be improved yet remain simple? I used Simba’s spreadsheet (from Bogleheads.org) to back-test some alternatives from 1972 through 2009.

First, the original portfolio:

Stocks: VTSMX (Total US Stock Market)
Bonds: VUSTX (Long-term Bond)
Cash: VMPXX (Money Market)
Gold (Kitco 1972-2004, GLD 2004-2009)

yielded the following return vs. risk:

P1 (HBPP):

Compound Annual Growth Rate (CAGR): 9.1%
Standard Deviation (Risk): 8.02%
Sharpe Ratio: 0.46

Next, substitute 2-Year Short Term Treasuries (VFISX) instead of Money Market:

P2 (P1 with 2-yr T-Bills):

CAGR: 9.5%
Standard Deviation (Risk): 8.17%
Sharpe Ratio: 0.50

Alternatively, how about for the “Prosperity” component, i.e., Stocks, we substitute  half US Small-Cap Value and half Emerging Markets for the US Total Stock Market:

P3 (P1 with 12.5% VISVX and 12.5% VEIEX):

CAGR: 10.8%
Standard Deviation (Risk): 8.57%
Sharpe Ratio: 0.64

And finally, combine P2 and P3 to have 2-yr T-Bills, US Small Cap Value, and Emerging Market:

P4 (P2 with 12.5% VISVX and 12.5% VEIEX):

CAGR: 11.3%
Standard Deviation (Risk): 8.65%
Sharpe Ratio: 0.68

And just for comparison I ran “Solver” on Simba’s spreadsheet to find the least risky portfolio that yielded 11.3% of that time span. It came up with the following mix:

VISVX (US Small Cap Value): 13.43%
VEIEX (Emerging Market): 14.30%
PCRIX (Commodities): 5.19%
VFITX (5-Yr T-Bills): 49.31%
VFISX (2-Yr T-Bills): 7.88%
Gold: 9.88%

Which resulted in:

P5 (Solver optimized portfolio):

CAGR: 11.3%
Standard Deviation (Risk): 7.25%
Sharpe Ratio: 0.80

And here is a chart with them all plotted, CAGR vs. Standard Deviaion (Risk):

I’ve played with lots of combinations of back-tested portfolios through many different time periods and one thing is common: substituting VISVX and VEIEX for VTSMX resulted in higher returns and a higher Sharpe Ratio. And short term T-Bills for cash also added nicely.

Note that I only show the Solver optimized portfolio (P5) for reference. I believe it strays too far from the Permanent Portfolio strategy to be safe going forward.

I talked about P4 on MMM-175: The Perfect Portfolio. While I am not yet invested in it, it is the one I am targeting. I do not expect a CAGR of 11.3% for the next 37 years, but if I can get 6% I will be very happy.

The previous post looked at the effect of gold in a portfolio for the 10-year period 1990-2009. Some may say that 10 years is not statistically long enough to be meaningful. So in this post I take a look at the 38 years from 1972 through 2009.

To start, I selected a widely-followed portfolio of stocks and bonds. The Fund Advice Vanguard Moderate portfolio has the following composition:

(Fund Advice recently split their recommended 12% of VDMIX into 6% VDMIX and 6% VFSVX, the All-World ex-US Small Cap index.)

The Fund Advice portfolio placed 32% in fixed-income and 68% in equities. For the period 1972 through 2009, the portfolio achieved a compound annual growth rate (CAGR) of 10.95% with a standard deviation (risk) of 11.6%. This works out to a Sharpe ratio of 0.51.

Let’s now see what would have happened if instead of 100%, we placed 75% of our investment in the Fund Advice portfolio and the remaining 25% in gold. We would have achieved a CAGR of 11.09%, a risk of 10.08%, and a Sharpe ratio of 0.58. So gold did add to the returns for the period while reducing the risk. How could that be since gold itself was very risky over the period? Gold by itself returned only 8.62% while being a whopping 26.88% risky.

How about instead of investing the 25% in risky gold, we had placed the 25% in safe but similarly rewarding Treasury Money Market fund? The Vanguard VMPXX by itself for 1972 through 2009 had a CAGR of 5.66% with a risk of only 3.03%. The resulting combination with the Fund Advice portfolio shows a CAGR of 9.75%, a risk of 8.77%, and a Sharpe ratio of 0.5.

The return vs. risk of the three portfolio mixes and the individual components gold and money market (MM) are shown in the following graph.

So against our intuition, investing in risky gold actually reduced risk in the overall portfolio while adding to the returns. It even beat a comparable portfolio that invested in money markets. This is the power of Modern Portfolio Theory in action showing that while some assets zig, others zag to combine in wonderful ways.

Sources: Vanguard.com, Simba’s spreadsheet (with 2009 data added), Bogelheads.org, FundAdvice.com.

Should a portfolio own gold? I am on the quest to obtain the definitive answer to that question. Here are the results of one exercise in which I take a model Vanguard portfolio and compare it with the same portfolio with a 25% allocation to gold for the time period 1999 through 2009.

Here is the model portfolio composition which is based on the IFA Index Portfolio 25 (source). We will call this the Vanguard 25 portfolio:

I am going to use the time period from 1999 through 2009 for the analysis. Crunching the numbers in Simba’s spreadsheet (Revised with 2009 data added. More info about the spreadsheet at the Bogleheads forum.) I come up with a compound annual growth rate (CAGR) of 5.6% with a average annualized standard deviation (risk) of 7.1%. This works out to a Sharpe ratio of 0.41 for the time span.

So, what if instead of having 100% of our total investment in the Vanguard 25 portfolio we placed just 75% of our investment in it and placed the remaining 25% in gold? Running the numbers in Simba’s spreadsheet (Simba uses this source for gold’s annual return.)  I come up with a CAGR of 7.5% with a risk of 6.9% resulting in a Sharpe ratio of 0.70. Call this one Vanguard 25 w/ Gold. The following chart plots these two results. As a reference I also show on the following charts the Harry Browne Permanent Portfolio which is comprised of 25% each of Total Stock Market (VTSMX), Long Term Gov’t Bond (VUSTX), Money Market (VMPXX), and Gold.

Also shown in the chart is the same exercise but instead of placing 25% in gold we substitute a Treasury bill money market fund (VMPXX) for the 25%. The portfolio with money market fund added resulted in a CAGR of 5.0%, risk of 5.3%, and a Sharpe ratio of 0.41. Call it the Vanguard 25 w/ T-Bills. Note that the Sharpe ratio is the same as the original portfolio because in a Sharpe ratio calculation we subtract out the risk-free rate of return of money markets. So adding money markets to a portfolio does not change the ratio of return vs. risk.

The next chart adds the individual return vs. risk of gold and money market for the same time period showing the higher risk with accompanying higher return of gold for the period.

This next chart adds the individual return vs. risk of all of the other components of the Vanguard 25 portfolio for the same time period.

And for the fun of it, I computed the optimal portfolio for the time span based upon the highest Sharpe ratio and as computed by Excel Solver. This tool allows you to specify an attribute you wish to maximize while varying the percentage amounts of the various funds. In this case, we chose to maximize the Sharpe ratio and allow Excel Solver to pick which combination of which funds achieved it. The following table shows the result.

The OPTIMAL portfolio resulted in a CAGR of 5.8%, a risk of 2.6%, and the resulting Sharpe ratio of 1.12. Its addition to the first chart is shown below.

How about continuing to optimize with a high Sharpe ratio yet obtaining greater return? To do that I subtracted some short-term bonds and added some gold leaving the other two components the same. That is, gold at 35% and bonds at 57%. This resulted in a CAGR of 7.6%, risk of 7.7% and Sharpe ratio of 0.99 and can be seen in the following chart.

Therefore, to answer the original question, “Should a portfolio own gold?” it appears that for the period 1999 through 2009 the answer would have been a resounding “yes.” We find that adding gold to the portfolio resulted in higher returns with less risk.

I caution that this process is called data mining and should only serve as input into future portfolio analysis and not serve as the only decision regarding future investments. In subsequent analysis I will not limit the possibilities to just the Vanguard 25 fund set but will open it up to Vanguard funds available since 1972 and/or 1985.

Sources: Vanguard.com, Bogleheads.org, IFA.com, and http://www.finfacts.ie/Private/curency/goldmarketprice.htm

Let’s go back and gather up the gains for 2005 and 2006 to add to our analysis with this chart.

As you can see, the Harry Browne Permanent Portfolio still has the best “top-leftedness” of these select Lazy Portfolios. It had an annualized return of 8% with an annualized standard deviation of 8.8%. That results in a nicely high Sharpe ratio of 0.75, assuming a risk-free rate of return of 1.37% for all 5 years (not likely).

The HBPP’s out-performance is due to the stellar performance of gold through all of these years. I am still not convinced this is the one for all seasons. So I will be performing some analysis of this portfolio for the years that were most favorable to equities and not gold and see how the HBPP would have held up.

Here is a chart that sort of goes with the previous posting’s table. I have taken just a few of the portfolios of interest and computed their standard deviation for the time period of three years. Then plotted their ANNUALIZED return on the Y axis vs. their annualized standard deviation along the X axis.

Remember that you’d want your portfolio to be at the top left of the chart because their you get the higher return with the lower risk.

So for the three year period from 2007 through 2009 the Harry Browne Permanent Portfolio showed the best return and the least risk of any of the featured lazy portfolios. More analysis to come…

Leveraged Exchange Traded Funds (ETFs) such as FAZ, FAS, and SKF are designed to multiply the DAILY PERCENTAGE change of the underlying index by factors of 2 or 3. They are thus toxic to your wealth and must not be held. Here’s a simple explaination of why. Take the FAS which is the 3X of XLF, the Financials fund. When XLF rises 1% in a day, the FAS is supposed to rise 3%. When things are going your way, everything is fine. But when the XLF drops, very bad things happen to FAS.

Have a look at this table:

On day 1, XLF rose 10% so FAS rose 30%. Great, you’re in the money.

But on day 2, XLF dropped back down to its starting price of $10.00, a decline of 9.09%. The bad news is that FAS declined 3X this amount or -27.27%. This takes its share price down to $9.45 instead of the $10 that you might expect.

So whereas XLF is unchanged after 2 days, FAS is down 5.45% after those same two days.

Why? The power of daily compounding instead of cumulative compounding. The leveraged ETFs are structured in a way that they compound on daily percent changes, not cumulative price changes. The day 2 decline of FAS should only be 23.08% to take it back to its original $10.00 per share price. But because it is 3X of XLF’s daily change, instead it declines 27.27%.

Said another way, the leveraged ETFs operate on the daily percent change not on the price of the underlying index.

Definitely not a buy and hold type of ETF! Not even for one day. Traders: set tight stops!

On Jim Cramer’s Mad Money show on Monday February 23rd, Jim said about SKF , the 2X UltraShort Financials ETF:

"…they don’t even perform as expected. The index the SKF tracks is down 14% over the past three months, so you’d figure an ETF that double or triple shorts that index would offer great returns, right? Wrong. The SKF is down 28% over the same time period.

I took a quick calculation of XLF vs SKF to see if he is right. I brought weekly historical quotes from Yahoo finance into a spreadsheet, inverted the SKF’s weekly returns and divided by two and charted it. Here’s the chart, you decide if he’s right.

The Austrian economists anticipated the present crisis. Should we listen to them when it comes to their predictions about what comes next? In one voice they are saying we will experience inflation unlike we’ve seen in the USA in over 100 years. Inflation is defined as the increase in the supply of money and credit. We are certainly experiencing an increase in the supply of money at present. But the draw-down of credit is counter-acting the monetary inflation and we are hovering in inflationary stasis at present.

Fed Chairman Ben Bernanke said the same thing on February 18th:

Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve will ultimately stoke inflation. The Fed’s lending activities have indeed resulted in a large increase in the reserves held by banks and thus in the narrowest definition of the money supply, the monetary base. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of unacceptably high inflation in the near term; indeed, we expect inflation to be quite low for some time.

He acknowledged that they are inflating. But he threw a red herring into the mix by talking about weak economic activity and low commodity prices (Heh, except gold, right Ben?) trying to infer that they are somehow the cause of inflation. No, they are the result of inflation. Next, he went into how they will correct their inflation:

However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to moderate growth in the money supply and begin to raise the federal funds rate. To reduce policy accommodation, the Fed will have to unwind some of its credit-easing programs and allow its balance sheet to shrink. … However, the principal factor determining the timing and pace of that process will be the Federal Reserve’s assessment of the condition of credit markets and the prospects for the economy.

Bernanke recognized that the plane is in a nosedive and at the last minute he plans to push on the stick and go airborne again. I hope it is not a cloudy day when he has to judge how far the plane is from the ground. He wrapped up his thoughts on inflation and how to avoid it:

As we consider new programs or the expansion of old ones, the Federal Reserve will carefully weigh the implications for the exit strategy. And we will take all necessary actions to ensure that the unwinding of our programs is accomplished smoothly and in a timely way, consistent with meeting our obligation to foster maximum employment and price stability.

What do *you* think the chances are that the Fed will get all of the necessary actions right? Have they gotten the necessary actions right up to this point? Let us examine a scenario where they are not able to get it right and we do indeed experience undesirable inflation, which I will define to be anything above 5% annually.

How might the various asset classes be affected in times of inflation? To answer this question, I utilized Simba ‘s spreadsheet for back-testing portfolios (which I imported into Google Spreadsheets) to do a correlation between CPI (Consumer Price Index, the government’s official inflation number) and various stock fund, bond fund, and gold returns. The data in the spreadsheet uses annual returns of Vanguard index funds along with the yearly closing price of gold from the years 1971 – 2008.  The spreadsheet already calculated the cross-correlation between each of the mutual funds and it lists the annual CPI index. So it was very easy to drop the CPI into one of the mutual fund slots and instantly see the correlation between every asset class and inflation. Here are the results, sorted by correlation:

The table shows those asset classes that were most closely correlated with the CPI at the top. Note in the third column that a value of 1 would mean the asset is perfectly correlated, -1 would mean perfectly correlated inversely (it went down exactly as CPI went up), and 0 means there was no correlation: it was random.

So we see that those assets that were most highly correlated with CPI were T-bills, gold, long-term government bonds (inversely), short-term Treasuries, and commodities.  Everything else was below 0.25 correlation. Interestingly, micro cap stocks were totally uncorrelated with inflation.

So how did a portfolio of those assets perform during the years 1973-1981 in which CPI was 8.7, 12.3, 6.9, 4.9, 6.7, 9, 13.3, 12.5, and 8.9%?

I constructed a portfolio along the lines of the Harry Browne Permanent Portfolio (HBPP invests 25% each into total US stock market, long-term bonds, money market, and gold) but I added some small cap value, micro cap, and eliminated the long-term bond fund. I then back-tested that portfolio during those inflation years. Here is the portfolio what I came up with:

The Inflation Portfolio:

VISVX (Small Cap Value) 15%
BRSIX (Micro Cap) 15%
PCRIX (Commodities) 10%
VMPXX (Money Market) 45%
Gold 15%

The "Inflation Portfolio" had a CAGR (Compound Annual Growth Rate) of 15.5% and a risk (as measured by standard deviation) of 10.5%. Plotting that on a chart, here’s what it looks like compared with some other portfolios and the assets themselves:

The chart shows plots for various portfolios during those inflation years. The plot point directly above HBPP simply substituted BRSIX for VTSMX in the HBPP. The major components of the Inflation Portfolio are also plotted separately showing how volatile gold and BRSIX were themselves. When tempered together with VMPXX, the risk came down considerably while retaining significant returns. You can see all of the rest of the details in the Google spreadsheet that I created for this scenario and you can test out other hypotheses yourself.

The Inflation Portfolio worked from 1973 through 1981. If we see inflation return, would it work again? Some folks are discussing these findings at the Bogleheads forum if you want to chime in.

Please note this is not a recommendation to invest your net worth in the Inflation Portfolio!