Volatlity Harvesting

[rocketdog]

Before he settled on index funds he was hunting for more volatile stock funds. He proposed things like "aggressive growth" funds and using long dated LEAPS for equity exposure. The idea was to have something with a lot of volatility, which would work with the other volatile assets as part of the portfolio.

True.  And it makes intuitive sense (the more an investment swings, the more you can profit from it by "buying low and selling high"). 

But then what do we make of recent research demonstrating that low volatility funds have actually outperformed their more volatile brethren?  Could holding some or all of the PP stock portion in a low volatility fund be a better approach? 

Thoughts anyone?

[rocketdog]

Anyone care to wager how many people will jump ship the next time the PP hits a 25% maximum drawdown?  And the number may even be larger in the future because debt deflation potential is trillions of times larger than in 1980.  Hiding behind a cult of equal weight is not adequate risk control.  No one can take a hit to their net worth of 25% unless they're emotionally dead or completely delusional.

I'll be emotional, but I can take the hit. In fact, I *have* taken quite a large hit from when I was in stocks and very little else.

Me too.  I know I took at least a 25% hit with the recession, probably more like 30%-35%.  Sucked big time, but now I'm back to where I was 5 years ago.  With retirement still 15-20 years away, I knew I had time to recover so I didn't panic and just kept dollar cost averaging into the market as it sank. 

[Pointedstick]

But then what do we make of recent research demonstrating that low volatility funds have actually outperformed their more volatile brethren?  Could holding some or all of the PP stock portion in a low volatility fund be a better approach? 

Thoughts anyone?

That's just from a buy-and-hold perspective, no? The PP relies on harvesting volatility from individual asset classes so making one of the three volatile assets into a non-volatile one would kind of break the framework. To me, low-volatility funds seem to be ideally suited to being held on their own or alongside some similarly non-volatile bond funds.

[rocketdog]

But then what do we make of recent research demonstrating that low volatility funds have actually outperformed their more volatile brethren?  Could holding some or all of the PP stock portion in a low volatility fund be a better approach? 

Thoughts anyone?

That's just from a buy-and-hold perspective, no? The PP relies on harvesting volatility from individual asset classes so making one of the three volatile assets into a non-volatile one would kind of break the framework. To me, low-volatility funds seem to be ideally suited to being held on their own or alongside some similarly non-volatile bond funds.

Hmm... then maybe keep some low volatility funds in the VP? 

[MachineGhost]

But then what do we make of recent research demonstrating that low volatility funds have actually outperformed their more volatile brethren?  Could holding some or all of the PP stock portion in a low volatility fund be a better approach? 

Low volatility funds have less fat tail risk.  Less fat tail risk, more net gain kept.  Volatility is really just a marker for a firm's credit risk.  I too have wondered if lower volatility assets would kill the PP's rebalancing capture, but the paper says only about half of gains came from that.  So low volatility stocks would have to perform at least as well as the lost rebalancing capture to be justified.  Without an index of such stocks going back many decades, theres no way to know.

However, it is a valid anomaly like momentum, value and micro-cap is an anomaly.  The PP is primarily about anti-correlation, not volatility capturing.  So a little slicing and dicing for extra gains doesn't break that framework.  All fish flock together.

[Pointedstick]

Low volatility funds have less fat tail risk.  Less fat tail risk, more net gain kept.  Volatility is really just a marker for a firm's credit risk.  I too have wondered if lower volatility assets would kill the PP's rebalancing capture, but the paper says only about half of gains came from that.  So low volatility stocks would have to perform at least as well as the lost rebalancing capture to be justified.  Without an index of such stocks going back many decades, theres no way to know.

However, it is a valid anomaly like momentum, value and micro-cap is an anomaly.

So you're saying what we really need is a momentum-weighted low-volatility micro-cap value fund? 

[MachineGhost]

So you're saying what we really need is a momentum-weighted low-volatility micro-cap value fund? 

There's even more anomalies to add onto that!  But the lack of liquidity actually precludes an investor from capturing the size effect if they don't do it themselves.  All such funds are simply too large to exploit it (<$500 million cap).

[Libertarian666]

Anyone care to wager how many people will jump ship the next time the PP hits a 25% maximum drawdown?  And the number may even be larger in the future because debt deflation potential is trillions of times larger than in 1980.  Hiding behind a cult of equal weight is not adequate risk control.  No one can take a hit to their net worth of 25% unless they're emotionally dead or completely delusional.

I have held a gold-heavy portfolio from the 1970's, so I have seen much worse drawdowns than that.

And I'm neither emotionally dead or completely delusional.

[brajalle]

I wanted to drag up this old topic in order to continue the discussion based on new information in the forums.  HB's original desire for high-volatility has always stuck around in the back of my mind whenever I'd read people recommending against Zero's.  I never thought that volatility, in the PP as a whole, and combined with some great research by forum members, got a fair shake.  While the PP has clearly been a brilliant creation, there is no reason to think that HB, in the face of more data, more investment vehicles, more market/economic condition data, and over time, would not have adjusted the PP.  With HB being sadly gone, that task seems to fall mainly to these forums.  The only reason to think he may not have updated the PP if new data warranted it, is probably for simplicity for the average investor, and well, if we're here discussing details & research - we're way past that.  I think this topic covers something he would have re-taken a look at given massive changes in investment options & costs.

First, I think MachineGhost covered optimal re-balancing bands since this topic - I think the conclusion was that the 25% band was optimal, with a 1 or 5 day check, which I believe meant a band of 0-50% in the portfolio (which I found shocking to consider).

Second, we have some new data (the last 5-6 months) for modeling - with some interesting behavior, that might shed some light on if capturing a volatility premium helps outperform.  I was struck by the coin flip simulation here as the easiest explanation and it begged the question - are experienced PPers missing out on returns even in a market in which the regular PP is down by seeking lower volatility?

Next, and this combines with re-balancing bands as well I'd assume, but rocketdog's back-testing indicated this mix was optimal - 15-20% Cash, 30-35% Bonds, 15-20% Gold, 30-35% Stock.  How does increased volatility capture and the re-balancing bands mix with this?  Did rocketdog really just stumble into something explained by balancing the underlying the underlying risk/volatility of the funds used?  Should we be volatility balancing to an extent?

Lastly, I don't think the discussion was every fleshed out a ton when it comes to suitable volatile options in the PP.  I took this away -

Cash - ??  Is there one that remotely fits, or is SHY/direct bills it?

Bonds - Zero's obviously, EDV or ZROZ - EDV's holdings average duration appears to be 25 years, ZROZ's is 27.2 years (but it has also been around for about that long - 3.8yrs!), if they maintain the longer-term though, is this superior?  It has out-performed EDV since inception by a tad.  Direct Zero's have lower volatility than the funds I believe, but carry less Japanese Malaise condition/deflation risk. 

Stocks - small cap value/micro cap value tilt?  VBR is the old stand-by but it appears to invest in too big of companies to really capture value (and likely volatility) according to an interesting discussion on Bogleheads involving L.Swedroe.  Do we need to look at things like RZV or microcap that really do invest in smaller more value-y companies?

Gold - Gold is pretty volatile on it's own, but to capture a volatility premium this suggests an ability to trade enough of it in a short time frame, this suggests some need for paper gold (plus the difficulty in holding physical gold/selling it in a retirement account) - there are all the old arguments against paper gold, that sort of leaves GTU if you want to avoid pure paper - GTU's premium/discount may help in recapturing it's slightly lagging performance when rebalancing returns, but I also discovered that CEF seems to have increased volatility vs. GTU when gold is up due to the silver component.  There are some decent arguments for silver (including by HB in the past) - is this fund a better choice for volatility?

Obviously there are going to be additional transaction and tax costs with rebalancing more often with more volatile assets.  I'm going to assume that for tax purposes it's in a tax-advantaged account to simplify matters.  In regards to transaction costs, that is always a tough one, here are my thoughts-
It appears to be about the same as a standard PP, or not a noticeable amount higher (with the following caveats) -  It would depend on how well MachineGhost's rebalancing bands apply - I believe it averaged 2 rebalances/yr @25% - this would leave a suggested yearly fee of say $92 (mixing contributions with the 2 rebalances), and a likely retirement account fee of at least $25.  $117/yr isn't too bad on average, it's alot more just starting out than after several years  - it's 0.5% in year 1 of max contributions ($18k 401k and $5.5k IRA), and goes under 0.1% by year 5 with no gains and no contribution increases.  Even if the # of rebalances increases, after the first few years, this likely fee increase ($117-> $149 in my example with 4 rebalances) doesn't mean much.  Conclusion - transaction costs are not likely to be a significant consideration long-term, but short-term it can.

Thanks in advance for any contributions.

[Kshartle]

Backtesting can't provide an optimal strategy. It can only provide it for that particular data set. Data mining for an optimal strategy is just curve-fitting and doesn't have predictive value.

If you check the results of not-rebalancing vs. rebalancing at 35/15 from Jan 1st 1980 up until today I think you find that they are equal or not re-balancing is slightly better. At least it was a week ago.

That's over 32 years. If re-balancing actually provided a certain bonus does it take longer than 33 years to prove it?

If it does provide sure-fire superior returns then there should be a theory based on logic that we can't disprove. There is no question that re-balancing dampens volitility and for a logical reason but I don't see any logical reason for re-balancing to boost returns. It will in a sideways market when some assets are moving up farther and faster than others and it will hurt when some are falling faster than others are gaining or there are major bull and bear markets that last a long time.

If not rebalancing has provided equal or slightly better returns for almost 33 years then you can't really claim it will help over any period going forward. That is if you are unconcerned with volitility which it most certainly reduces.