Post-MPT Growth: Taking Equity Risk at Attractive Times

On March 10, 2015

Stock Market investing is a fascinating activity!  Historical studies show that over long periods of time, equities outperform all other major asset classes.  Thus, the financially logical course of action is to be 100% invested in stocks at all times.

Behavior economics tells us that, unfortunately, few humans are comfortable with the volatility in account value such an asset allocation entails.  We also know from history that there could be long periods of time when equities lose money.  This is especially relevant for retirement accounts.  If you had retired in August 1929, been 100% invested in large capitalization stocks, and took withdrawals from the account on which to live, you would not have much left by June 1932 when these stocks declined 83% on a total return basis.  Although equities recovered from that point, your capital base would be so small that your retirement account would be in jeopardy.

Even if you did not need to take withdrawals from your account, it was over 15 years (January 1945) before stocks matched the 1929 low level.  Even in recent times, it took the NASDAQ Composite Index 15 years to match its January 2000 highs.

Taking Equity Risk at Attractive Times FRED 1
To address these facts, iSectors® developed the Post-MPT Growth Allocation. Over the strategy’s ten year history, its standard deviation (volatility) has matched that of the Standard & Poor’s 500 benchmark. Although past performance may not reflect future returns, the Allocation’s performance pattern over the past ten years has been superior to that of the S&P 500:

  • The maximum drawdown was only two-thirds of the benchmark’s
  • The upside capture was 63% while the downside capture was only 40%
  • On a gross of fees basis, Post-MPT Growth outperformed the benchmark by over 2.5% on an annualized basis.

If Post-MPT Growth had market volatility but protected downside volatility, how did it do so?  The quantitative work behind the Allocation predicts the range of likely future returns for each investible sector and then chooses an asset allocation that minimizes downside risk.  In essence, the model decides when to take aggressive market risk and when to be more conservative.

To make this point clearer, let’s look at stock and bond markets movements over the last ten years.

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In the stock market, there have been three distinct trends during this period of time:

  • Bull market from the beginning of the period to the 2007 fourth quarter
  • Bear market from the 2007 fourth quarter to the 2009 first quarter
  • Bull market from 2009 first quarter to the present time

Below you will find the historical asset allocations for the Post-MPT Growth strategy over the past ten years.  There are a couple of distinct features of the Allocation displayed in this chart:

  • In addition to six of the S&P economic sectors, long-term Treasury bonds, gold stocks and real estate investment trusts can receive allocations from the model
  • Exchange-traded funds (ETFs) are utilized to invest in these sectors
  • Since the strategy can use two-times leveraged ETFs up to 33% of asset value, it can be, and has been, more than 100% invested

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Let’s look at the three trends separately.  It was easy to win in the bull market ending in 2007 as long as you were fully invested.  Post-MPT Growth was not only fully invested, but leveraged in 2005.  Although bond holdings detracted from performance, they reduced volatility and earned an annual return of 5% during this period.

The strategy truly proved its mettle during the bear market.  By the end of 2007, it had a 50% bond position as interest rates were declining (when interest rates decline, bond prices rise.)  Although the Allocation was leveraged during 2008, stocks sectors comprised of less than 40% of market value during most of the year.  By the end of 2008, the health care sector was the only equity investment in the portfolio.  Thus, stock market risk was taken off of the table during this time.

In the current bull market, the changing risk position has helped Post-MPT Growth returns.  Although the model had embraced rising stocks by mid-year 2009, it became too conservative and missed the 2010 increase.  But it was poised to defend against the last equity correction we have experienced, which took place in 2011.  It was leveraged to a bond allocation during this time, which performed well as interest rates dropped during the stock slide.  Since the middle of 2013, the strategy has been consistently leveraged with equity sector allocations and benefitting from a stock market that has reached many new all-time highs.

In summary, Post-MPT Growth took has taken on above-average equity risk in the bull markets and significantly below-average risk in the bear markets and corrections.  Overall, the strategy has provided exposure to stocks consistent with the benchmark.  But it has shifted the assumption of this volatility to periods of greatest return potential.

Financial advisors can receive more information by contacting Scott Jones at 800.869.5184 or [email protected].

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Hermonta M Godwin says

Has the Post MPT model been updated since inception? I ask because of the comment that the model was too conservative in 2010 and missed some upside. Has the model been updated to act differently in similar situations as to those found in 2010?


isectors-webmaster says

The model automatically updates itself as it receives more experience. It is important to remember that the objective of the model is to reduce the probability of downside losses. Although past performance is not indicative of future results, the model has reduced or eliminated negative returns in the past while capturing over 65% of upside return.

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