The Case for Post-MPT as a Liquid Alternative
Posted on: 09/18/2015
It is a little known fact that the iSectors Post-MPT Growth Allocation actually started out as a hedge fund way back in 2005. Very shortly thereafter, it was decided that ETFs would be a much more efficient and simple way to access the type of exposure the model was looking to find.
Since then, the Post-MPT Allocation origin as an alternative investment was mostly thrown to the wayside—having been known as a replacement for the majority of the equity portion of portfolios (the model is bench-marked vs. the S&P 500).
However, now that the “liquid alternative” wave is sweeping over the investment arena and more specifically, the ETF landscape (given the rise of alternative ETFs that have been issued over the past year or so), we thought it was a perfect time to bring our flagship strategy full circle and embrace it for what it was originally created to be, a (liquid) alternative investment.
It may seem like a stretch to call a model comprised of all large-cap sector ETFs an alternative investment, but the iSectors Post-MPT Allocation is actually the very definition of a (supremely) liquid alternative investment.
Vanguard has published a very well written article entitled “Liquid Alternatives: A Better Mouse Trap?”— which includes the definition of a liquid alternative:
Often touted as a natural extension of private hedge funds, liquid alternatives have several distinguishing features. Covering a diverse array of investment strategies, they seek to generate returns using complex, nontraditional methods and are frequently marketed as a way to diversify against equity risk or fixed income risk. The common thread is that these strategies can bet against traditional capital markets, use investments outside those markets, and/or tactically move within and across markets. Although their investment focus may be similar to that of hedge funds, liquid alternatives are subject to registered investment vehicle regulations covering liquidity, diversification, and leverage.
It should also be noted that this is just one definition of a liquid alternative. There are, and will continue to be a variety of liquid alternative definitions. That said we believe that Vanguard has put together a very fair one.
There are six criteria, imbedded in the Vanguard definition above, that define the iSectors Post-MPT Growth Allocation as a liquid alternative investment:
- “Natural Extension of Private Hedge Funds”
As was mentioned in the opening paragraph, iSectors Post-MPT Growth originally started as a hedge fund but transitioned to using ETFs due to their liquid nature.
- “Generate returns using complex, nontraditional methods”
iSectors Post-MPT Growth uses a proprietary quantitative modeling program that utilizes over a dozen economic and capital market factors to allocate between 9 low correlated asset classes on a monthly basis, with the possibility to use up to 33% leverage. Sounds complex and nontraditional, doesn’t it?
- “Diversify against equity risk or fixed income risk”
The low correlation offered by the 9 different asset classes mentioned in the last point greatly diversifies Post-MPT Growth from traditional equity and fixed income indices. (Correlation to S&P 500 Index: 58.5% over the last 10 years. Correlation to Barclays Aggregate Bond Index: 30.5% over the last 10 years.)
- “Bet against traditional capital markets, use investments outside those markets”
The nine asset classes (or sectors) used by Post-MPT are: basic materials, bonds, energy, financials, gold stocks, healthcare, real estate, technology, and utilities. With the inclusion of bonds, gold stocks, and real estate there is an opportunity to invest in sectors (up to 30% each) that are not usually classified as traditional capital markets. In fact, the model explicitly does not invest in the traditional Morningstar “9 box style” due to the high correlations between large cap growth, large cap value, small cap growth, small cap value, etc.
- “Tactically move within and across markets”
On a monthly basis our quantitative model is run to determine the allocation between the nine asset classes that were listed in the last paragraph. Bonds can be allocated up to 50%, and the remaining 8 up to 30%. As an example of moving within and across markets, during the financial crisis of 2008, gold and bonds occupied the highest amount of the portfolio, while currently the model has emphasized the finance and healthcare sectors.
- “Liquidity, diversification, and leverage”
iSectors uses some of the largest and most liquid sector ETFs in its Post-MPT allocations, which covers the liquidity. Diversification was discussed in paragraphs 3 and 4. As for leverage, it was mentioned briefly before, but Post-MPT Growth has the capability to leverage up to 33% of the portfolio. This is obtained through the use of leveraged ETFs as opposed to actually borrowing any money.
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