Contents of this month’s post include:
- How your risk parity portfolio can benefit from Dynamic Risk Allocation
- Portfolio changes: Scaled down Bitcoin, switched part of Long-Term Government Bonds currency exposure from USD to EUR
- Monthly Update for December 2020
- Book tip: Risk Parity Fundamentals by Edward Qian (link at the bottom of the article)
- In case you missed it: My latest Insight article about How VIX ETFs can improve portfolio performance and stability in volatile environments
It is official, we have survived 2020!
Hopefully, 2021 will be a much better year, but only because the calendar now shows “2021” instead of “2020”, it does not automatically mean that the situation has changed. We still face many of the same challenge as we did only a week ago.
On that positive note, I am glad to have you back for a new year with this blog about the All Seasons Portfolio and how retail investors can get access to the benefits from risk parity strategies. I have now been writing this blog for 2 years, and it has been an incredible experience. I have learnt a lot along the way, and I hope you have too! But mostly, I enjoy all the discussions with you readers, both in the comment section and bilaterally through different channels. I think discussions are an even better tool for learning and improving, as triangulation of strategies and analyses are important.
I look forward for a new year with this blog, and if you have any ideas of how to make it even better, I am always open for your input! My plan is to continue with the monthly updates, and mix in Insights post about various relevant topics. I will also try to find the time to create a better library over the key components of risk parity investing as different pages to the blog, to provide a better learning experience. I’ll try to find the time to do that as soon as possible.
In other news, I have barely left the apartment in December and am getting a bit restless. It is good though that we have recently moved in so we have a fresh view to take in. Also, there are still furnishing jobs to do, meaning that I have been able to spend some days painting walls, putting up wallpaper, and assembling furniture. Let’s hang in there for a little while longer though – hopefully the vaccine rollout will be successful, and at least soon it is spring again with more light and warmth.
As for my portfolio, it looks more or less the same since the last update. The performance in December was positive, and I have only done a few small rebalancing trades. More on that later in this article.
First though, we will dig into a summary on Dynamic Risk Allocation, meaning how you can make allocation shifts in a fairly static portfolio to increase risk-adjusted return during environments that will be disadvantageous for certain assets.
Thanks again for your continuing to take the time to follow this blog. It is fantastic to see that there are more investors out there who knows that it is incredibly risky to only be invested on the stock market. Diversification is important, and it is vital to prepare for all the twists and turns of a complex modern financial market. But let us now get started with the last monthly update of 2020.
How can you benefit from Dynamic Risk Allocation?
To understand dynamic risk allocation, let us first remind ourselves what risk parity investing is all about, for example when using the All Seasons Portfolio strategy.
The All Seasons Portfolio strategy is a simplified risk parity portfolio that is suitable for retail investors to apply when investing. Commonly, risk parity funds use around 15 different asset classes with low correlation to achieve a portfolio with balanced risk. Such portfolios are cumbersome to replicate without significant wealth, why the All Seasons Portfolio achieves similar benefits of risk parity, but only with 4-5 asset classes.
These uncorrelated assets will perform differently in different market environments (changes in expectations of growth and inflation) and all have different degrees volatility. For example, stocks are more volatile than bonds, and commodities are more volatile than stocks.
With the different degrees of volatility in mind, you would fashion a balanced portfolio of the 4-5 assets. Each asset class’ weight in the portfolio would be determined by its volatility and bias for economic environments. With a found balance, the portfolio could then be left untouched for long periods of time, with only the occasional rebalancing (for example annual or quarterly) to keep the asset class splits around their aimed percentages.
For example, my All Seasons Portfolio is built as shown in the chart below. It is based on 5 core assets (equities, bonds, inflation-linked bonds, gold, and commodities), with the addition of VIX and cryptocurrencies.
The core concept of the risk parity portfolio is that you are prepared to face any economic environment that can develop at any time. If growth would stagnate, risk assets such as stocks and commodities would perform badly, but that would be offset by the positive performance of safe assets such as bonds and gold.
To some extent, this passive way of investing may feel limiting. While an All Seasons Portfolio is a safe foundation to stand on as an investor, there may come times when the balanced approach will be perceived as a constraint. This feeling of limitation could occur either when certain assets would be disadvantages in certain environments or when you want to take a bet on a trade to further improve your performance. You would then stand at a cross-roads with a choice of sticking with your balanced portfolio and your strategy on the one hand, and trying to take a bet and improve your return on the other hand.
This is were Dynamic Risk Allocation (DRA) comes to play. DRA is a temporary tactical shift in risk allocation where the investor can dynamically allocate more risk to certain assets at the expense of other assets. This is usually done in connection to expected shifts in environments. Therefore, when used right, DRA can improve the overall risk-adjusted return of the total portfolio.
For best use of DRA, it is best to beforehand have researched and implemented certain rules for what shifts to execute when. Otherwise, you are at risk at taking foolish bets, defeating the purpose of why you implemented a risk parity portfolio to begin with. To be clear, you do not need to set up all rules already before you begin investing, but identify them and implement them thoughtfully as you go along and as the situations emerge.
For even further reading, the book Risk Parity Fundamentals by Edward Qian elaborates more on dynamic risk allocation and other important aspects of risk parity investing, which you may feel useful.
To make Dynamic Risk Allocation a bit more concrete, let us look at a recent shift I have made in my portfolio, being a shift from inflation-linked bonds to long-term government bonds and gold. I described it briefly in the November 2020 post, but will go through the case more thoroughly here.
Currently, the yields of US Treasury Bonds are at historically low levels – the 10Y yields has just jumped above 1.00% for the first time since March 2020 (as per 6 January 2021). Low interest rates imply low inflation in the short-term (as the yield of the bonds is theoretically “supposed” to award the investor with compensation for both risk premium and expected inflation). Low rates thus imply that in the near term, inflation is expected to be low, and even negative.
Negative inflation – or deflation – is especially harmful for inflation-linked bonds. This is the case as the yield of TIPS is much lower than of regular bonds as there is no compensation for inflation included, but also because the nominal value of the bond is adjusted by the inflation rate, meaning that it is decreasing in deflationary environments.
Thus, to avoid the risk of losing money on inflation-linked bonds in times of imminent deflation, the sharp investor can dynamically shift part of the TIPS allocation to other asset classes with better prospects. To maintain a neutral hedge against both inflation and deflation, the investor can decrease the inflation-linked bonds share of the portfolio and increase gold and long-term bonds. Hence, the portfolio’s bias to economic growth remains unchanged (as all of the described assets are biased to perform better in low-growth environments), but the hedge against inflation remains by increasing the gold portion, and a hedge against deflation is improved by increasing the long-term bond portion.
This kind reallocation can easily be made rule-based to avoid human mistakes and spontaneous bets to take over. The RPAR ETF, for example, employs the described inflation-linked bonds play when the 10Y U.S. Treasury Bond yield drops below 1.00%, being the trigger. The play is then reversed when the yield has increased above 1.00% for two consecutive quarters.
On 6 January 2021, the UST 10Y yield jumped above the 1.00% mark for the first time since March 2020, following the apparent likelihood of a Democratic win in the Georgia senate election. Whether this level of yields will hold firm or if it would drop again in the beginning of 2021 remains to be seen. Times are still very much uncertain.
The modern financial markets are a complex being, and the intervention of central banks makes the playfield trickier to navigate. It will risk putting some strategies out of play when skewing markets with excess liquidity and stimulus. But on the other hand, new opportunities may emerge elsewhere and you could take bets to capitalize on them by reallocating the risk in your portfolio.
For example, the current magnitude of global central bank stimulus, may fuel inflation inflation if growth and confidence of consumers return on a positive vaccine rollout. However, growth expectations may remain subdued, and at the very least, may not meet the expectations priced in to stock values. Hence, another play being relevant right now is to tilt the portfolio toward higher inflation, while keeping it neutral in growth. This can be done by decreasing stock allocation, and adding to commodities and gold – a play that is neutral in growth, but tilted toward higher inflation.
Structural market changes require flexibility for the investor, allowing the portfolio to become adaptive to changing market conditions. It is therefore desirable that you allow yourself the flexibility to make adjustments to your balanced portfolio, but be careful not to stray away too far from your straight path of risk parity.
Ideally, you would backtest your shift in risk allocation rule to see how it holds up historically in similar environments and changes in market conditions. For example, considering a current case for inflation and making a play on it, it is wise to go back and review the great inflation of the 1970s and see what would have happened with your strategy in that environment. Sure, the circumstances may not be 100% replicated, but could anyway give some sort of guidance on what to expect. In the 1970s, easy money policy from the Fed, introduced to boost growth and tackle double digit unemployment rates, and with high government spending on the Vietnam war and social welfare resulting in high inflation. In combination with external factors driving energy prices (the 1970s energy crisis), additional force put further upward pressure on inflation. If you see similar patterns today (high government spending, vast central bank stimulus, and a pressure on commodity prices), a bet on higher expected inflation may not completely controversial.
Just make sure that when you make shifts in your risk allocation, you do so thoughtfully and responsibly. The end-goal for any investors is to achieve as good risk-adjusted return as possible, but be mindful not to explode your downside protection.
Are you using dynamic risk allocation in your portfolio, and what such shifts are you currently taking a position in? Keep the exchange going in the comments!
December 2020 Portfolio Update
In last month’s post, I asked you about how much of a portfolio that you think should be allocated to cryptocurrencies. The poll received many responses, and before we dive into the December update, let us take a moment to review the outcome.
A clear majority of you believe that cryptocurrencies have a natural place in a diversified portfolio. 85% of respondees state that a portfolio should include cryptocurrencies while 15% disagrees. How much allocation would then be appropriate? According to 60% of the answers, the best allocation is more than 0% but less than 5%. This is sensible in my opinion, i.e. that only a small portion of a portfolio should be allocated to so risky and volatile assets as cryptocurrencies. This is similar view as I have, as I have dedicated only 3% of my portfolio to Bitcoin exposure.
While the consensus seems to be that cryptocurrencies should constitute only a small portion of the portfolio, there was 1 outlying response asserting that cryptocurrencies should constitute more than or equal to 15% but less than 20%. That sort of allocation is a bit too extreme for my taste, but then again, there are many investors with much better understanding of the field than I.
If you are looking to invest in Bitcoin or other cryptocurrencies directly instead of exchange-traded certificates, consider using Coinbase – the most trusted cryptocurrency exchange with more than 43 million registered users, where you can securely trade and store more than 30 different cryptocurrencies directly in your own wallet.
Changes in my portfolio
In December, I have made a few small changes to my portfolio. These are rather minor and mainly related to rebalancing and currency exposure:
Firstly, on December 10th, I scaled down my Bitcoin exposure in the rally, as this position had grown to become a substantial part of my portfolio. I still have too much exposure, but will leave it for now, but I will remain ready to scale down a bit. Unfortunately, the ratio between the unit size of the BTC certificate and the portfolio allocation is not so good, so my 2 units make up almost 6% of the portfolio. There is thus not much flexibility to work with, and even less when I sell one of the two units I have.
Secondly (and finally), on December 30th, I decreased my USD exposure for my long-term US Treasury Bonds. What I did was that I sold half my bond holdings, and bought the EUR Hedged version of the same ETF. Hence, I have shifted a larger part of my currency exposure closer to home, being a European (but not eurozone) citizen. This ties back to the discussion on currency hedging that I wrote in connection to the July 2020 monthly update.
It is extremely hard to say which currency will perform best in the months and years to come. Central banks globally are letting the money printers keep humming at a steady pace, increasing the money supply. The generous stimulus by the Fed has weakened the dollar through the second half of 2020 against a basket of foreign currencies. However, in the fight against low inflation, other central banks, such as the ECB, cannot see its own currency strengthening too much, or stagflation would become a very real threat.
Instead, central banks are in an apparent race to the bottom devaluing the currencies, as a consequence for Covid stimulus and supporting growth through aiding exporting companies. This debasement cannot end well, but it is incredibly hard to predict which currency will perform the worst. So I will for now keep a balanced exposure to both USD and EUR.
I am not an expert on currencies and FX trading, so any input from qualified sources is welcomed in the comment section. Instead, I will, for the time being, keep a balanced allocation to both USD and EUR, hoping we will get wiser soon enough.
Looking more closely at my portfolio, I remain underweight in the bonds portions of the portfolio based on yield uncertainty (long-term government bonds) and a short-term inflation scare (TIPS), but I am balancing that by having an increased exposure to gold and commodities.
I the graph below, it may seem so that my cryptocurrencies have shrunk, even though Bitcoin saw a great rally in the end of 2020. This has been a good investment for me so far, and the decrease is explained by me shaving of 1/3 of my holdings. In other news, stocks still perform rather well into the new year, and in December LT bonds, inflation-linked bonds, and VIX were performing (marginally) negatively.
That the spike in Bitcoin price is evident in the below graph is a great understatement. Sure, cryptos have helped my portfolio perform rather well since included in November, but I am still vary over this asset class’ volatility. Adoption of this asset is growing, but many risks remain. My finger is therefore still hovering over the sell button for further scaling down of that position.
Lastly, here’s a view of the ETFs in my portfolio, and the performance of each asset during the last month, in table form.
|iShares Global Inflation Linked Govt Bond UCITS ETF||TIPS||IE00B3B8PX14||€456.00||€450.96||-1.11%|
|iShares USD Treasury Bond 20+yr UCITS ETF||Govt Bond Long||IE00BSKRJZ44||€0.00||€625.32||New|
|iShares USD Treasury Bond 20+yr EUR Hedged UCITS ETF||Govt Bond Long||IE00BD8PGZ49||€1,232.46||€622.25||-49.51% (sold half)|
|Market Access Rogers International Commodity UCITS ETF||Commodities||LU0249326488||€343.39||€351.21||2.28%|
|Vanguard FTSE All-World UCITS ETF||Equity||IE00B3RBWM25||€1,359.52||€1,384.80||1.86%|
|Lyxor S&P 500 VIX Futures Enhanced Roll UCITS ETF - Acc||VIX||LU0832435464||€138.32||€136.36||-1.42%|
|Bitcoin Tracker One||Crypto||SE0007126024||€232.47||€221.28||-4.81% (sold half)|
As always, thank you so much for your attention and for taking the time to reading my updates.
I am currently working on an annual summary for 2020, which will be an article that includes not only a review of my portfolio, but also some great takeaways from the crisis months in the spring of 2020. There are many lessons to be learned from the havoc on financial markets, which can make us even better prepared for the next crises. It is experience that shape us as good investors.
If you have any ideas for what you want to read more (and less) about in these monthly updates and Insights posts, let me know in the comment section or by email to firstname.lastname@example.org. I appreciate all discussions with readers and I believe it adds a lot of value to talk about ideas on investing and strategies.
I have also set up a Patreon site, to cover hosting costs, which reach a couple hundred euros annually. If you find any content here at all useful and feel that you can treat me for the equivalent of an espresso, read more about what this means on the Support page here on the website. My annual hosting bill for running the website is around EUR 140, so any support is extremely helpful, as the monetization of this blog is very limited.
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Looking forward to hearing from you,
Book tip: Risk Parity Fundamentals
Despite recent progress in the theoretical analysis and practical applications of risk parity, many important fundamental questions still need to be answered. Risk Parity Fundamentals uses fundamental, quantitative, and historical analysis to address these issues, such as:
- What are the macroeconomic dimensions of risk in risk parity portfolios?
- What are the appropriate risk premiums in a risk parity portfolio?
- What are market environments in which risk parity might thrive or struggle?
- What is the role of leverage in a risk parity portfolio?
Edward Qian is an experienced researcher and portfolio manager who coined the term “risk parity”. The author provides investors with a practical understanding of the risk parity investment approach. Investors will gain insight into the merit of risk parity as well as the practical and underlying aspects of risk parity investing.
In this book, the concept of dynamic risk allocation is described in great details, together with many other relevant topics to consider for the retail investor who looks for more balance in his or her portfolio, and for understanding how diversification between asset classes can further benefit risk-adjusted returns.
Or check out other great books on the topic on the Book recommendation page.
Check it out today on Amazon (affiliate link):