The following portfolio on WhoTrades Live is a lightly leveraged and moderately balanced asset allocation, with some stocks, some bonds, and some commodities. It mostly avoids environmental bias that characterizes portfolios concentrated in specific asset classes, which helps limit drawdowns. (Source: Portfolio page) __ Over the past 12 months, the return has been 6.6% with a maximum drawdown of 11.2%. The overall idea is to have something close to a neutral position to the market. Indexing is a reasonable strategy for those who want broad-level exposure to a certain part of the market. But just because a certain ETF has hundreds of different securities in it doesn’t mean it provides diversification. For example, the S&P 500 may contain some 500-ish stocks, but buying an S&P 500 index fund doesn’t balance your risk because individual stocks are highly correlated to each other. When you own a bunch of stocks you end up with a portfolio that is very concentrated accordingly. It’ll do well when the economy does well and not so good when the economy does poorly. Stocks might provide the highest returns over the long-run over any of the main asset classes, but they’ll also go through cycles where they lose a lot of value because of their volatility (attributed to being in the most subordinate position in companies’ capital structures). It’s a natural tendency for investors to focus too much on return and not enough thinking about their risk. If the economy does well and borrowing costs don’t outweigh this re-rating in growth expectations, you know stocks and riskier bonds will do well. If the economy does poorly and inflation falls, then you know investment-grade sovereign bonds or the very highest-quality corporate bonds will do well. If inflation rises, you know this environment is favorable to commodities, inflation-indexed bonds, and gold. __ Here is the allocation breakdown: $VT – 35% $VCIT – 45% $EMLC – 5% $IAU – 5% $BCI – 5% $SGGB – 5% __ VT is a global stock index. VCIT is intermediate-duration, investment-grade bonds. EMLC is emerging market local currency bonds. IAU is gold. BCI is a broad-level commodities ETF. SGGB is sugar. __ This portfolio isn’t completely balanced. It’s still skewed toward risk assets since the leverage is only 2x. You don’t have to be overly perfect about maximizing reward-to-risk in cash-only or lightly leveraged portfolios otherwise you’ll perhaps be too conservative and sacrifice yield. Obviously it depends on what your goals are. Stocks Having stocks at only 35% of the allocation seems low, but stocks are about twice as volatile as intermediate-duration, investment-grade bonds, so stocks actually comprise about half the risk in this portfolio. Stocks will obviously help the portfolio when the economy is doing well and rates aren’t materially rising. US Bonds The investment-grade bonds will help give the portfolio yield and shouldn’t materially decline when growth turns down. In fact, you should actually get a little bit of capital appreciation out of it. Intermediate-duration bonds are chosen to balance the trade-offs between yield and duration risk. As bond prices become fairer as yields rise and the future trajectory of inflation stabilizes, then adding duration exposure can once again begin to make sense. (Investment-grade debt is largely driven by inflation expectations and to a lesser extent their credit risk.) Emerging Market Local-Currency Bonds The EM bonds provide yield and also some currency diversification. They are also trading around 52-week lows due to the strength of the US dollar, but this should be a passing phenomenon. Most emerging market economies have a reasonable amount of exposure to the US economy (some 24% of the world’s economic output), but many EM economies still have output gaps so it’s natural to expect a growth runway to continue. Risks with this trade include divergences in monetary and fiscal policies among developed market countries. In the US, fiscal policy is relatively loose while EU fiscal policy is comparatively tight considering European unemployment and tepid demand. Yet their monetary policies are the opposite. The US is in a trend of rising rates and balance sheet tapering. Yet the EU is still pressed down to zero on its bank rate and buying up financial assets to bring down rates elsewhere on the curve. You see these differences manifesting in trade imbalances and yield disparities in their bond markets. This is the current driver of a stronger US dollar, as funds migrate from EU to USD assets (and of course from other markets as well). Since many emerging market economies borrow in dollars (since interest rates are lower relative to borrowing in their own currencies), dollar strength increases the cost of this debt. Namely, their own currencies don’t go as far. This causes a consequent drop in the value of EM local-currency bonds and pressures emerging markets more generally. Gold Gold is a diversification asset. It generally moves opposite the US dollar. Whenever you’re dealing with some sort of adverse development in the economy, whether it’s supply-related, debt-related, politically/geopolitically related, and so forth, then gold is nice to have as a hedge in some smaller amount. It plays a role that stocks and bonds can’t play on their own. Having stocks and bonds equally weighted in terms of risk (which is going to be quite different from monetary weighting) will hedge you against oscillations in growth expectations, but both will go down when inflation surprises to the upside. This has been rare since the early 1980s, so stocks/bonds portfolios have done well accordingly, but there will come a time when this isn’t true. February 2018 was an example when both stocks and bond portfolios got hit a material amount simultaneously. Commodities Commodities can be thought of as alternative currencies that do best in an inflationary environment. If that inflation is accompanied by a stagnation or drop in growth then commodities are likely to be the best performers in your portfolio. This can help offset the fall that stocks and non-inflation-linked bonds are likely to take in low growth/high inflation environments. The particular ETF that this portfolio uses (BCI) makes use of the roll yield or roll return concept, which is caused from rolling short-term futures contracts into longer-dated ones. Roll yield is positive when the markets are in backwardation (negatively sloped futures curve) and negative when the markets are in contango (positively sloped futures curve). What’s in backwardation and what’s in contango obviously depend on what the individual commodity markets are. When in backwardation, normally you’d want to roll the contract into the steepest part of the curve to maximize the yield (usually just one month forward). When in contango, you’d generally want to roll the contract into the flattest part of the curve to minimize the roll cost, which is generally further out. I’ve designed some example diagrams below to better illustrate the concept: Contango (click to enlarge) In contango markets, it is generally standard procedure for commodity indexes – and the index funds they’re based on – to roll forward to the next available contract, which is the next month. However, this is usually the steepest part of the curve. Since you went from $100 per contract to $102 per contract, your annualized cost in this case would be about $24, holding all else equal ($24 is obtained by taking the difference of $2 per contract multiplied by the number of months in the year). However, if we roll forward to the next contract 12 months out, the annualized roll cost would be only a bit over $6, as illustrated in the diagram above. Backwardation (click to enlarge) In backwardation, to maximize your annual roll yield, you want to roll forward into the steepest part of the curve (the opposite of contango). So here it does make sense to roll into the next available contract based on this curve. For those who trade futures contracts, maximizing roll yield is a common strategy to maximize your yield and generate carry off your commodities trades rather than simply betting on price movements alone. The BCI ETF aims to fulfill this same basic strategy. As an equity product this translates into a dividend of some sort, issued annually. Sugar Sugar is added in a 5% quantity, as the commodity is currently trading below its cost of production. It’s still a heavily shorted market and supply hasn’t washed out, so exercising patience is necessary. __ Other Tidbits There are no inflation-linked bonds in this portfolio. This account is equity products only and inflation-indexed bond ETFs don’t do a very good job of compensating you fairly based on the bid/ask spreads (most bond ETFs are like this to varying degrees). For example, a 7-year TIPS bond should be paying you 2.9%-3.0% using 7-year breakeven inflation rate combined with the yield offered by the corresponding constant maturity. However, a TIPS ETF of comparable duration, such as TIP is only giving you 2.2%-2.3% yield when including the fees. A 70-bp discrepancy is too much. This portfolio will provide around a 4.5% unleveraged annual yield at 7%-8% annualized volatility if thought of from a long-term perspective (10+ years). By comparison, 100% stocks will get you a little less than 7% unleveraged at 15% annualized volatility. The 4.5% yield may sound unappealing, but the reward-to-risk is superior over the long-run. Using moderate amounts of cheap leverage, this can generate a decent yield. The Sharpe ratio of this portfolio over the long-term – i.e., if it were to be run passively – will be around 0.35-0.40, depending on whether you use a risk-free rate at the very front end of the curve or toward the middle of the curve. (Using current mid-curve rates will lower the Sharpe since the rate – your “risk-free alternative” – is higher.) The long-run Sharpe ratio of stocks will be around 0.25-0.33, again depending on the specified risk-free return. If you want to lower the volatility of the portfolio, you can cut down on stocks (VT), EM bonds (EMLC), and commodities (BCI, SGGB) and raise bonds (VCIT). This will, however, cut into expected unleveraged return. __ Like this trader, there are thousands of traders on WhoTrades Live where you can check out strategies of interest, track their progress over time, and generate trade ideas for your own portfolio.