One of the key benefits of ETF investing is allowing investors to have exposure to multiple asset classes such as stocks, bonds, real estate and commodities. By placing uncorrelated bets across different asset classes, investors are able to reduce risk and increase the risk adjusted returns.
Another advantage of ETF investing is that it is extremely simple to implement. We only need to manage between 2 to 5 ETFs as compared to pure equity investors that typically hold around 20 to 30 stocks. Because of the convenience of ETF investing, it can be implemented easily on your own using a discount broker such as Interactive Brokers which can save you almost 1% per year on advisory fees.
In this article, I’m going to discuss 3 powerful ETF investing strategies for conservative investors that can outperform the S&P 500.
Strategy 1: 60/40 Portfolio
The 60/40 portfolio is a well known investing recommendation where the investor allocates 60% of their portfolio to large cap stocks and 40% to treasuries or investment grade bonds.
This investment strategy is often misunderstood by most people. The common impression is that since the portfolio has such a high percentage of bonds, which are considered low risk assets, the overall portfolio returns are going to be significantly worse than a buy and hold strategy on a 100% equity portfolio. Is that actually what happens?
To find out, I ran a strategic allocation backtest where I allocated 60% of the portfolio weight to SPY (S&P 500 ETF) and 40% of the portfolio weight to TLT (Treasuries ETF). I specified a 10% rebalance band where if the actual weights of the portfolio deviated from the 60/40 target allocation by more than 10% due to price movements, the algorithm would rebalance the portfolio back to its original target weights.
The results are surprising. Despite having such a large percentage of bonds in the portfolio, the 60/40 portfolio’s total return is almost the same as a buy and hold strategy on the S&P 500!
Taking a look at the statistics, while the annualized returns between the 60/40 portfolio and the S&P 500 are very close at 9.3% vs 9.5%, the 60/40 portfolio has a much lower risk with a volatility of 10.4% and a max drawdown of 31.2%.
The key reason why the 60/40 portfolio performs well is due to rebalancing. Rebalancing is the process of realigning the weights of stocks and bonds in the portfolio back to their target weights of 60% stocks and 40% bonds. Rebalance needs to be done because over time, the prices of stocks and bonds change, causing their weights to drift away from the 60/40 target allocation.
For example, during the 2008 global financial crisis, the value of stocks fell while the value of bonds increased. This was because investors rotated from risky assets such as stocks into safe assets such as bonds to protect their portfolios. If you were holding a 60/40 portfolio previously, the portfolio’s stock weightage would fall below 60% while its bond weightage would increase above 40% due to the price movements. To rebalance your portfolio back to the 60/40 target allocation, you would need to sell some of your bonds which have gone up in value and buy more stocks which have fallen in value. This process of taking profit on your bonds to buy stocks when they are cheap tends to improve your portfolio’s performance in the long run.
For conservative investors, the 60/40 portfolio done with ETF investing is an attractive option because we can achieve similar expected returns as a buy and hold strategy on the S&P 500 with almost half the level of risk.
Also known as a lazy portfolio, the three-fund portfolio is designed to perform well in most market conditions. This portfolio can be implemented with 3 low-cost ETFs and can be rebalanced easily without the hassle of trading numerous instruments.
To implement the three-fund portfolio, I use the following ETFs:
SPDR S&P 500 Index (SPY) as the domestic index fund
iShares MSCI ACWI ETF (ACWI) as the international index fund
iShares 20+ Year Treasury Bond ETF (TLT) as the bond fund
I assigned equal weights to each of these ETFs at 33% each and ran a backtest to compare the strategy’s performance against the S&P 500.
At an initial glance, the three-fund portfolio seems to perform worse than a buy and hold strategy on the S&P 500.
Looking at the statistics, the three-fund portfolio has a lower annualized return of 8.7% vs the S&P 500 which does 10%. However, the three-fund portfolio’s risk is significantly lower with a volatility of 12.3% vs 20.6% and a max drawdown of -35.7% vs -51.5% for the S&P 500.
To compare the performance between these 2 strategies, we can look at the Sharpe ratio, which is a measure of risk adjusted returns. The three-fund portfolio has a Sharpe of 0.47 while the S&P 500 has a Sharpe of 0.41. This implies that adjusting both funds for the same level of risk, the three-fund portfolio has a stronger performance than the S&P 500.
As an example, we can use leverage which investors can access using a margin account to amplify both the risk and returns of the three-fund portfolio such that both the three-fund portfolio and the S&P 500 have the same volatility.
The backtest results show that when we leverage the three-fund portfolio 1.66X, the volatility of the three-fund portfolio matches the volatility of the S&P 500 at 20.6%. With a leverage of 1.66X, the annualized returns of the three-fund portfolio is 13.8%, outperforming the S&P 500 which has an annualized return of 10%.
Strategy 3: Ray Dalio All Weather Portfolio
The Ray Dalio All Weather Portfolio also uses asset class diversification to reduce portfolio volatility and drawdown which makes an excellent choice for conservative investors. Unlike the 60/40 portfolio and three-fund portfolio, this strategy provides exposure to 5 different asset classes including stocks, bonds and commodities through ETF investing. These are the 5 ETFs and their portfolio weights:
30% in Vanguard Total Stock Market (VTI)
40% in iShares 20+ Year Treasury Bond (TLT)
15% in iShares 3-7 Year Treasury Bond (IEI)
7.5% in SPDR Gold Trust (GLD)
7.5% in iShares S&P GSCI Commodity Indexed Trust (GSG)
Using the power of rebalancing, during a recession when gold and bonds significantly outperform stocks, the strategy will sell gold and bonds and reinvest the profits into stocks which are cheap. Conversely during a bull market when stocks outperform gold and bonds, the strategy will sell stocks and reinvest profits into gold and bonds at lower prices. This allows the all weather portfolio to achieve high risk adjusted returns regardless of market conditions.
The backtest results show that even though the all weather portfolio has a lower total return compared to the S&P 500, the strategy’s returns look a lot smoother than the S&P 500 with a significantly lower volatility and drawdown.
Examining the statistics, over the period from 2007 to 2020, while the all weather strategy has a lower annualized return (7.4% vs 9.1%), its volatility and drawdown is almost one third of the S&P 500. In exchange for having an annualized return that is 1.7% less than the S&P 500, we are able to reduce our risk to one third the risk of the S&P 500. Sounds like a pretty good deal!
Consequently, the risk adjusted returns of the all weather portfolio is higher with a Sharpe of 0.56 vs 0.37 for the S&P 500.
One drawback of this strategy though is that since the annualized returns are relatively low at 7.4%, investors with a large risk appetite might not be able to achieve their expected returns even with leverage. Due to Reg T constraints on margin accounts, a retail investor is capped at 2X leverage due to initial margin requirements.
When I re-ran the all weather portfolio with 2X leverage, it achieves an annualized return of 14.4% and a volatility of 14.8%. While this performance is already significantly better than the S&P 500, for investors with a target volatility above 20%, they would need to consider the use of futures and options to gain additional leverage that ETFs do not provide.
For conservative investors to sleep well at night, using ETF investing to gain exposure across multiple asset classes is a great way to reduce risk and increase risk adjusted returns. The 3 ETF investing strategies discussed in this article are able to outperform the S&P 500 benchmark with higher risk adjusted returns.
As a follow up exercise, I invite you to clone the Ray Dalio all weather portfolio and backtest your investment strategy using PyInvesting’s backtesting software. I've also attached a tutorial video below to guide you on how to create a strategic allocation backtest.
Happy investing and may the odds be in your favour.