Ivy Portfolio Strategy: Keep It Simple, Stupid

Introduction

The Ivy Portfolio strategy was popularized by the book “The Ivy Portfolio” and its authors Mebane Faber and Eric Richardson. We have been following and working with the strategy since late 2011 and believe it is a worthwhile strategy for investors.

The strategy has its own twists from a traditional buy-and-hold portfolio, which might make it unappealing to some investors. For investors who want to hold cash, realize losses at times and work on a total return basis, then this can be an attractive proposition. It’s a simple and elegant strategy that doesn’t get bogged down in financial nuances to achieve its goals. And from our point of view, it achieves these goals by using the “Keep it simple, stupid” principle (or KISS for short).

Strategy

The Ivy Portfolio strategy is a total return strategy based on the combination of a diversified portfolio and a risk management system. The diversified portfolio is based on several asset classes, including equities, bonds and inflation-linked assets. The risk management system is a rules-based system that uses a trending system to determine whether to hold or sell an investment. The combination of diversification and trend following reduces portfolio volatility and minimizes large portfolio declines.

The strategy can be tailored to the specific needs of investors, making it a very flexible portfolio strategy. The level of diversification, the definition of the trend duration, and the rebalancing schedule are all flexible and determined by investor preferences. Note that the emphasis on total return is largely due to the fact that, as any asset can be bought or sold in this system, planning for a constant flow of income (dividends or interest income) is problematic. .

Goals

The objective of the portfolio strategy is to provide a a respectable total return over an entire market cycle compared to alternative investment strategies. We use two simple portfolio metrics to measure the success of the portfolio strategy. The Sharpe ratio measures the attractiveness of the strategy on a risk-adjusted return basis, which takes into account the excess return over a risk-free return and the volatility achieved to generate that excess return. Second, we measure downside protection by calculating the portfolio’s historical maximum declines or maximum decline (MaxDD).

Risk management rules

The unique feature of the strategy is the risk management system. The rules can be modified but must follow the general framework:

  • At a set periodic interval (usually monthly), compare the price of each investment (either held directly or allocated but not currently held) to its moving average.
  • For each investment held, if the price is above the average, continue to hold. If the price is below average, buy back and keep the money.
  • For each investment held in cash (allocated but previously below trend), if the price is above average, buy. If the price remains below the trend, continue to hold liquidity.

These rules are about as simple as it gets and clearly adhere to the KISS principle.

Sample Portfolio Review

The Ivy Portfolio strategy is ultimately a framework that can be tailored to each investor’s preferences. While each individual portfolio may have its own twists, we will follow the KISS theme and review a simple and diverse portfolio comprised of 6 asset classes.

In honor of the Ivy portfolio’s namesake, our portfolio construction will come from David Swensen, Chief Investment Officer at Yale University, as described in his book “Unconventional Success: A Fundamental Approach to Personal Investment” (and found on page 84).

Figure 1: Swensen Asset Allocation Model Portfolio 6

Our preference is to use exchange-traded funds (ETFs) whenever possible. When an ETF is not available due to limited trading history, we use mutual funds.

The rules-based system is based on month-end prices and the 10-month moving average (10-MMA). [Investors can choose any length trend from 7 months to 12 months. Because the 10-MMA is similar to the 200-Day MA, which is widely followed, utilizing a different length trend such as the 9-MMA might avoid some of the overlap and/or whipsaws that can happen in choppy or non-trending markets.]

Figure 2 highlights the monthly closing price (adjusted for dividends) of the National Equity Fund (VTI) and its 10-month moving average. When the monthly closing price (blue line) falls below the 10-MMA (red line), it is sold and converted into cash.

Figure 2: National Stock Market Fund

Figure 3 highlights a theoretical performance of the based strategy and compared to a traditional balanced fund. We use Vanguard’s reputable balanced fund (VBINX) for our proxy. The model portfolio includes approximately 1% annual friction, which is arbitrary but should take into account certain costs associated with commissions and/or other fees. (Taxes are not taken into account in this exercise.) Finally, the portfolio is rebalanced quarterly.

Figure 3: Swensen 6 Asset Class Portfolio Return Model

The following figure illustrates how the risk management system works over time. This portfolio strategy is currently 34% in cash. The average percentage of cash held over the past 8-year period has been approximately 22%. In general, when the markets go up, the portfolio becomes fully invested. As volatility rises and markets fall, the portfolio turns to cash. Due to the lagging nature of the risk management system, unstable or trendless environments will cause underperformance against buy and hold strategies.

Figure 4: Composition of investment and cash portfolio

In terms of monthly returns, the worst month in the past 8 years was October 2008 at -6.5%, with May 2010 taking second place at -5.3%. Monthly return data shows a positive bias with the bulk of returns in the 0% to 3% range.

Figure 5: Monthly returns

The performance of the Swensen 6 asset class portfolio has been comparable to that of a balanced fund over the past 8 years. Based on portfolio objectives – the strategy was a success. First, the Sharpe ratio of 0.50 is higher than the balanced fund’s Sharpe ratio of 0.36. (The Sharpe ratio is the compounded return net of the risk-free rate divided by the annualized volatility.) Since the returns are similar, the higher Sharpe ratio is largely due to the fund’s 30% lower realized volatility. We used the compound annual return of iShares Barclay’s 1-3 Year Treasury Bond (SHY) as a proxy for the risk-free rate.

Second, the maximum drawdown (MaxDD) of the portfolio was significantly lower than that of the balanced fund at 9.8%, which occurred from October 2007 to October 2008. The balanced fund, which was meant to be held throughout the market decline of 2007-2009, had a maximum decline of 32.6%. Although not indicated in the data, minimizing the downside has significant behavioral financial implications and removes much of the fear during the market constraint and ensuing panic selling.

Figure 6: Risk and return indicators of the Swensen 6 asset class portfolio

Conclusion

As stock markets recover and money continues to flow into mutual funds and ETFs, the appeal of risk-managed portfolio strategies is diminishing. This is a natural occurrence, especially in an investment climate with low volatility for equities, as recent performance is king. Unfortunately, the attractiveness of any risk management strategy is usually seen in hindsight.

However, the Ivy Portfolio remains an attractive strategy for long-term investors looking for a full market cycle investment strategy that mitigates monthly volatility and downside risk. Its KISS design principle is simple and requires no heavy lifting to implement. If the modeled portfolio performance of the Swensen 6 asset class is any indication, the strategy should achieve its objectives of attractive risk-adjusted returns and mitigating steep portfolio declines.

Disclosure: I have been following VNQ for a long time. I wrote this article myself, and it expresses my own opinions. I don’t get any compensation for this (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Smith Patrick Financial Advisors clients own VNQ at the time of writing. This article is written for informational purposes and we believe that investors should perform their own due diligence before making investment decisions.


Source link

Don F. Davis