Part III: Applications
Chapter 16: Combined Portfolios
Defining goals and constraints
There are many ways to use the previous strategies in real portfolios. A simple one is to combine two or more strategies. The best solution depends on each investor’s goals and constraints, expressed in terms of:
- frequency and time available for portfolio management,
- capital invested,
- appetite for risk,
- aversion to market-timing or hedging,
- aversion or attraction to specific sectors,
- potential to trade in a margin account,
- economic data and personal opinions on sectors,
- other assets and incomes correlated with specific sectors.
This chapter shows two examples adapted to different situations.
1. 10 stock defensive portfolio
This is a portfolio adapted to manage capital under $100K.
Table 16.1: Strategy description: Defensive-SP500
Fig 16.1: Simulation data and equity curve: Defensive-SP500
Comment
This looks a good solution for investors who want to invest only in very liquid stocks and are not attracted to market-timing and/or hedging. As it uses two defensive sectors, the drawdown is smoother than for the benchmark, but it is still deep. Of course, it is also possible to hedge this portfolio.
2. Diversified portfolio quarterly rebalanced
This solution is adapted for an investor wanting to manage his/her portfolio only once per quarter, with capital above $100K.
Table 16.2: Strategy description: Diversified-Quarterly
Fig 16.2: Simulation data and equity curve: Diversified-Quarterly
Comment
This portfolio is diversified by market capitalisation (half large caps, half small caps) and by sector (half defensive, half cyclical). Each position represents only 2.5% of the capital, which limits the idiosyncratic risk. No more than 25% of the capital is invested in a single sector.
It is interesting to note that thanks to a wider diversification a quarterly rebalancing gives a better performance than a four-week rebalancing when trading costs are taken into account. It is possible to hedge, but in this case the hedging position must be managed monthly or weekly to offer real protection. Even without that, this combined portfolio offers good Sharpe and Sortino ratios, especially for a quarterly strategy.
Chapter 17: Other Applications
The lazy strategies can also be an entry point for investors who are not so lazy and have the time and skills to do additional work. If followed with discipline, using a set of quantitative models over the long term is probably the best way to get a steady and profitable performance, which can be improved by adding some discretionary analysis.
Quick check-up
An investor faithfully following four or five strategies like those presented in my two books has a serious edge to beat the market in the long term. But for those who have a couple of extra hours every month I recommend doing a quick check-up of the selected stocks.
The quick check-up is a permissive elimination process. When one of the selected stocks has an ugly chart or very bad news, it may be profitable to eliminate it. I recommend eliminating a stock if it has a very bad period, but if there is some doubt then keep it in the selection. That is usually what I do for more sophisticated strategies in my portfolio and newsletter: when a stock looks really bad at first glance, I exclude it from my selection for the current week, and I take the next one in my ranking.
For example, I ran the Staples-R2000 model on 3/31/2014. Here is the list of tickers I obtained:
BGS, BREW, CALM, COKE, FARM, IMKTA, LFVN, LNCE, NATR, OME, REV, RNDY, SAM, SNAK, SPTN, SYUT, TIS, USNA, VGR, VLGEA.
I took a few minutes to look at the charts of the 20 stocks. I noted that two of them were in a downtrend on their daily charts and had broken supports on their weekly closing price: SYUT (Synutra International) and VLGEA (Village Super Market).
Some of the 18 other charts were not very nice, but these two really stood out as bad. For the four weeks starting 3/31/2014, the whole portfolio with 20 stocks returned -1.4%, with SYUT down -13.9% and VLGEA down -4.9%. Eliminating these two stocks and keeping the 18 others, the return was -0.5%, almost 1% better in four weeks. Of course, eliminating one or two stocks on discretionary criteria may not bring an advantage every time, but it may make a difference in the long term.
In a quick check-up I look at the following:
- the daily candlestick chart,
- the weekly candlestick chart, and
- headings of the latest articles published on financial websites. If one looks especially negative, I read it quickly to figure out if it is fact or opinion.
Nothing more. Various financial websites give all the information publicly available about a stock. My preference is for finviz.com, which aggregates everything on a single page.
If you don’t know anything about chart patterns and candlesticks, it may be better to just follow the chosen models. This is just a potential enhancement for some investors.
Deeper analysis
More and more professional analysts use screeners to select candidates for a full analysis. In this case the lazy analysis may be a prelude to the real work, including due diligence research. Pre-selection models may simplify and accelerate the investment decision process.
All strategies listed here can serve this purpose. They specialise the pre-selection by sector. This may be an advantage for fund managers and professional investors who have sector-based diversification rules for their portfolios.
Top-down strategies
Tactical allocation is a concept aimed at performance optimisation by selecting or overweighting asset types (e.g. sectors) that are expected to outperform in the near future.
It may be profitable to mix tactical allocation and sector-based models in a top-down approach. The “top” part is the choice of one or several sectors; the “down” part is the selection of individual stocks inside these sectors.
Each sector is influenced by economic cycles of different and variable lengths. Theories of economic cycles are numerous and complicated. Their superposition sometimes shows a clear trend, sometimes it is chaotic. Selecting the right sectors is not an easy task. The choice may be discretionary, based on an evaluation of the current market cycles and qualitative analysis. It may also be based on quantitative elements like valuation ratios, price momentum, or other relative strength measures.
Once a set of sectors is selected in the higher part of the decision process, an investing choice can be made in the lower part: for example sector ETFs, or lazy strategies (see following illustration).
My previous book Quantitative Investing details an example of a tactical allocation strategy for sectors using simple technical analysis. Most tactical allocation strategies use ETFs or Futures contracts on specialised indexes.
We saw in Chapter 15 that the lazy strategies outperformed the corresponding ETFs. The idea of this top-down approach is to replace ETFs with our lazy portfolios in a tactical allocation framework. It should be able to produce a better performance. I write “should” because finance is in the realm of complexity. A property of, and indeed the very definition of a complex system, is that you may not be able to predict its behaviour from the behaviours of its parts.
Fig 17.1: Top-Down Approach
Part III summary
A defensive portfolio on 10 positions mixing two strategies is proposed. It is suitable for a capital under $100K.
A more diversified portfolio on 40 positions mixing four strategies and rebalanced only once every three months is proposed to manage a capital over $100K.
The last sections discuss mixing the sector-based strategies presented here with discretionary analysis or tactical allocation.