Diversification through Equity Blending

In a sound asset allocation framework, it is never a good idea to over weight the risky portion of the portfolio. One example would be the traditional 60/40 portfolio whereby an investor allocates 60% to equities and 40% to bonds. Such allocation may intuitively makes sense as you “feel” diversified but when extraordinary events happen, you will be less protected. Below is the performance of the 60/40 allocation rebalanced monthly since 2003. Note I used SPY and IEF for the mix.

In this post, I would like to show some ideas that will reduce risk and increase return by bringing in a different type of return stream. Traditional asset allocation focuses mainly on optimal diversification of assets, here I will focus on allocation to strategies. From my own research, there are only so many asset classes the individual can choose to mix to form portfolios, not to mention the less than reliable cross correlation between assets classes in market turmoil (2008). To bring stability for the core portfolio, I will incorporate Harry Browne’s Permanent Portfolio. This return stream is composed of equal weight allocation to equities, gold, bonds. and liquid cash. For the more aggressive part, I will use daily equity mean reversion (RSI2). Note that a basic strategy overlay on an asset can produce a return stream that can have diversification benefits. Below are three different equity curves. Black, green and red represents, mean reversion, 60/40 equal weight allocation of both strategies, and permanent portfolio respectively.  

To summarize, I have taken two return streams derived from strategies traded over assets and combined them to form a portfolio. The allocation percentage is 40% to the risk asset (mean reversion/MR) and 60% to the conservative asset (Permanent Portfolio/PP). And here are the performance metrics.

Traditional represents the traditional 60/40 allocation to equity and bonds while B-H represents buy and hold for the SP500. This superficial analysis is only meant to prove the powerful idea of equity blending of assets and trading strategies. When traditional search for diversification becomes fruitless, this idea of incorporating different strategies can have a huge impact on your underlying performance.

I will come back later for the R code as its pretty late and I have class tomorrow!

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2 comments

  1. Nice post. Strategy diversification is a powerful concept.

    My views differ slightly from yours regarding 60/40 portfolio risk assessment though. One way to reduce risk is to put less weight in risky portion of the portfolio as your post suggests. Also that is the default assumption taken by many quant approaches. The premise behind this assumption is volatility = risk. But what if one defines risk differently or hedges assets differently. For example, say if one were to use dynamic hedging mechanism in Maeben Faber’s TAA paper for 60/40 portfolio and use that to define risk, then will the risky portion of 60/40 still be same? Also then reducing weight to stocks in 60/40 still a yield better outcome?

    Regards

    1. Thanks for your comment,

      In the 60/40 portfolio demonstration, I didn’t define any risk measure as its just equal weight for both assets. On the other hand, if I were doing mean variance optimization for weights, than risk, in the traditional sense is defined as the volatility.

      But to the more general topic of defining risk, I think there are numerous ways of approaching it. Its hotly debated. Faber’s hedging style is pretty good in terms of curtailing tail risk for asset allocation but it uses MAs for entry and exit in asset classes while traditional asset allocation enter and exit based on monthly rebalancing. In the latter case, risk can also be defined in numerous ways like downside deviation.

      I will do a post on parameter sensitivity in the upcoming weeks for checking the performance if you vary the weights of 60/40. Stay tuned.

      M

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