1 The The 7 7 Twelve Twelve Portfolio Portfolio The Benefits of Low Correlation The Benefits of Low Correlation Craig Craig L L . . Israelsen Israelsen , , Ph Ph . . D D . . Brigham Young University Brigham Young University www www . . 7 7 TwelvePortfolio TwelvePortfolio . . com com 41 41 slides slides
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The The 77TwelveTwelve PortfolioPortfolio The Benefits of Low CorrelationThe Benefits of Low Correlation
Craig Craig LL. . IsraelsenIsraelsen, , PhPh..DD.. Brigham Young UniversityBrigham Young University
wwwwww..77TwelvePortfolioTwelvePortfolio..comcom
41 41 slidesslides
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This document is a research report presenting portfolio research and analysis.
This document is neither investment advice nor an investment solicitation.
Implementation of the 77TwelveTwelve portfolio is no guarantee of performance.
►►Part One provides a historical context of the Part One provides a historical context of the
benefits of a multibenefits of a multi--assetasset, , low correlation low correlation
portfolioportfolio..
►►Part Two introduces the Part Two introduces the 77TwelveTwelve PortfolioPortfolio, ,
a multia multi--assetasset, , low correlation global low correlation global
portfolioportfolio.. 3
Part OnePart One
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Historical Asset ReturnsHistorical Asset Returns
38-Year Period from 1970-2007
Annualized Return (%)
Std Dev of Annual Returns
Growth of $10,000
REIT 12.38 18.45 843,476
Commodities 12.02 23.93 747,183
US Small Stock 11.74 21.68 678,684
US Large Stock 11.08 16.62 542,040
International Stock 10.86 21.54 503,316
Bonds (Intermediate) 8.10 5.39 193,131
Cash 6.29 3.07 101,701
Inflation 4.62 3.08 55,618
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DataData
►► LargeLarge--cap US equitycap US equity represented by the Srepresented by the S&&P P 500500 IndexIndex..
►► SmallSmall--cap US equitycap US equity represented by the Ibbotson Small Companies Index represented by the Ibbotson Small Companies Index from from 19701970--19781978, , and the Russell and the Russell 20002000 Index from Index from 19791979--20072007. .
►► NonNon--US equityUS equity represented by the MSCI EAFE Indexrepresented by the MSCI EAFE Index. .
►► Real estateReal estate represented by the NAREIT Index from represented by the NAREIT Index from 19701970--19771977 and the Dow and the Dow Jones Wilshire REIT Index from Jones Wilshire REIT Index from 19781978--20072007..
►► CommoditiesCommodities represented by the Goldman Sachs Commodities Index represented by the Goldman Sachs Commodities Index ((GSCIGSCI). ). As of February As of February 66, , 20072007, , the GSCI became the Sthe GSCI became the S&&P GSCI Commodity IndexP GSCI Commodity Index..
►► UU..SS. . intermediate term bondsintermediate term bonds represented by the Ibbotson Intermediate represented by the Ibbotson Intermediate Term Bond Index from Term Bond Index from 19701970--7373 and the Lehman Brothers Intermediate Term and the Lehman Brothers Intermediate Term Government Bond index from Government Bond index from 19741974--20072007. .
►► CashCash represented by represented by 33--month Treasury Billsmonth Treasury Bills. .
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Historical Upside and DownsideHistorical Upside and Downside
among the internal assetsamong the internal assets..
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Correlation of Correlation of Major Asset ClassesMajor Asset Classes ((19701970--20072007))
Large US Equity
Small US Equity
Non-US Equity
US Bonds
Cash REIT
Small US Equity .74
Non-US Equity .59 .47
US Bonds .21 .05 -.11
Cash .05 .01 -.12 .42
REIT .39 .71 .25 .00 -.05
Commodities -.28 -.32 -.14 -.20 .00 -.24
Aggregate (Average) Correlation in Equal-Weighted 7-Asset Portfolio = 0.12
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Correlation Correlation MattersMatters Commodities and small US stock had a similar Commodities and small US stock had a similar 3838--year returnyear return——but blending commodities with large US stock was far more benefibut blending commodities with large US stock was far more beneficial cial
because commodities has a lower correlation to large US stock because commodities has a lower correlation to large US stock ((--00..2828) ) than does small US stock than does small US stock ((00..7474).). Growth of $10,000 1970-2007
$0
$100,000
$200,000
$300,000
$400,000
$500,000
$600,000
$700,000
$800,000
$900,000
$1,000,000
S&P 500 50% S&P 500/50% Small US 50% S&P 500/50% GSCI
WhatWhat’’s Different in s Different in 20082008? ? Commodities and real estate are not helping as much as in prior Commodities and real estate are not helping as much as in prior downturnsdownturns..
Frequency of Loss (as measured by % Change in Year-to-Year Account Value)
Inte
rnal R
ate
of R
etu
rn (
1970-2
007)
1 = One-asset portfolio (100% Cash) 2 = Two-asset portfolio (50% each Bonds, Cash) 3 = Three-asset portfolio (33% each Cash, Bonds, Large US Stock) 4 = Four-asset portfolio (25% each Cash, Bonds, Large US Stock, Small US Stock) 5 = Five-asset portfolio (20% each Cash, Bonds, Large US Stock, Small US Stock, Non-US Stock) 6 = Six-asset portfolio (16.7% each Cash, Bonds, Large US Stock, Small US Stock, Non-US Stock, REIT) EW = Seven-asset equal-weighted portfolio (14.3% each Cash, Bonds, Large US Stock, Small US Stock, Non-US Stock, REIT, Commodities) CW = Seven-asset custom-weighted portfolio (12% Large US, 8% Small US, 10% Non-US, 5% REIT, 5% Commodities, 40% Bond, 20% Cash) 60/40 = 30% Large US, 15% Small US, 15% Non-US, 30% Bond, 10% Cash 40/60 = 20% Large US, 10% Small US, 10% Non-US, 50% Bond, 10% Cash
$500,000 Initial Portfolio Value 5% withdraw rate 3% inflation rate of annual withdrawal
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►►Minimizing Minimizing frequency of lossfrequency of loss and and size of size of
portfolio lossportfolio loss while generating robust while generating robust
performance are distinct benefits of low performance are distinct benefits of low
correlation portfolioscorrelation portfolios——provided that each provided that each
asset is assigned a asset is assigned a meaningful allocationmeaningful allocation..
►►Recovering from large losses is more Recovering from large losses is more
difficult in distribution portfoliosdifficult in distribution portfolios----when when
money is being systematically withdrawnmoney is being systematically withdrawn..
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Portfolio Loss
Needed Average Annual % Return to Restore Original Portfolio Balance
WITHDRAWAL Portfolio First Year Withdrawal of 5% of initial balance, 3% increase of annual withdrawal
Within Within 1 1 YearYear
Within Within 2 2 YearsYears
Within Within 3 3 YearsYears
Within Within 4 4 YearsYears
Within Within 5 5 YearsYears
-5% 16.8% 11.1% 9.3% 8.4% 8.0%
-10% 23.7% 14.4% 11.5% 10.1% 9.4%
-15% 31.4% 18.0% 13.9% 12.0% 10.9%
-20% 40.2% 22.0% 16.5% 14.0% 12.5%
-25% 50.2% 26.4% 19.4% 16.1% 14.3%
Portfolio Loss
BUY-and-HOLD Portfolio
Within 1 Year
Within 2 Years
Within 3 Years
Within 4 Years
Within 5 Years
-5% 5.3% 2.6% 1.7% 1.3% 1.0%
-10% 11.1% 5.4% 3.6% 2.7% 2.1%
-15% 17.6% 8.5% 5.6% 4.1% 3.3%
-20% 25.0% 11.8% 7.7% 5.7% 4.6%
-25% 33.3% 15.5% 10.1% 7.5% 5.9%
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Portfolio (Equity/
Fixed Income)
Large US Stock
Small US Stock
Non-US Stock
Bonds Cash
60/4060/40 30%30% 15%15% 15%15% 30%30% 10%10%
40/6040/60 20%20% 10%10% 10%10% 50%50% 10%10%
20/8020/80 10%10% 5%5% 5%5% 60%60% 20%20%
0/1000/100 0%0% 0%0% 0%0% 70%70% 30%30%
Example Distribution Example Distribution PortfoliosPortfolios
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Final Outcomes Final Outcomes Are Very Are Very Dependent on Timing of ReturnsDependent on Timing of Returns
60% Equity/40% Fixed Income 40% Equity/60% Fixed Income 20% Equity/80% Fixed Income 100% Fixed Income
60/40
40/60
20/80
0/100
DISTRIBUTION PORTFOLIO $500,000 Initial Portfolio Value 5% withdraw rate 3% inflation rate of annual withdrawal
1975-1994
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Distribution Portfolio GoalsDistribution Portfolio Goals Stabilize Returns to Minimize Timing DependenceStabilize Returns to Minimize Timing Dependence
Maintain Robust Performance to Increase Portfolio LongevityMaintain Robust Performance to Increase Portfolio Longevity
(5)
0
5
10
15
20
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1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
40/60 Equal-Weighted 7 Asset Portfolio
3-Year Annualized Rolling Returns
1970-2007
Ave. 3-Yr Return Ave. 3-Yr Std Dev
40 Equity/60 Fixed Income 9.8% 4.3% 7-Asset EW Portfolio 11.7% 4.4%
Part TwoPart Two
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Building Building a a MultipleMultiple--Asset Asset