In this Post I discuss a portfolio type that is rapidly gaining traction among investment designers and the investing public called a Market-Biased Portfolio. This is a portfolio with one “asset” being an NAOI Dynamic Investment (DI). The DI component enables this ultra-simple portfolio construct to significantly outperform virtually any traditional MPT-based by a large margin.
A Review of Dynamic Investments
To understand Market-Biased Portfolios you need to understand NAOI Dynamic Investments (DIs). If you haven't already done so go to this link to learn how they work or read a quick summary just below.
In short, Dynamic Investments (DIs) are a new investment type created by the NAOI that are capable of automatically changing the ETF they hold based on a periodic sampling of market trends. This makes them market-sensitive and able to capture the returns made available by market uptrends while avoiding the losses of market downtrends.
DIs are a remarkable investment type. They are fully company-diversified by the use of ETFs. They can be asset-diversified by including ETFs that track different assets in their Dynamic ETF Pool. And, they are “time-diversified” by having the internal intelligence to automatically and periodically change the one ETF they hold at any on time.
Time diversification is an element that static, buy-and-hold MPT portfolios do not have. It not only reduces risk, it also enhances returns and gives DIs the power to outperform MPT portfolios by a wide margin.
As just one example, the NAOI has designed a Core DI that rotates only between stock and bond ETFs based on which is trending up most strongly at the time of a quarterly review. During the period from 2007 to 2016 this simple DI earned an average annual return of 30.6% with low risk and no active management required.
The Basic Market Biased Portfolio
The introduction of Dynamic Investments fundamentally changes how we invest today. And owning only one DI in a portfolio can be a very smart and profitable decision. But the NAOI knows that change does not come easily or quickly to the world of investing. While we believe that single DIs and DI portfolios will be the future of investing, a transition period is needed along with a transition investment type.
Therefore, when we teach DIT methods to the public or work with financial organizations to enhance their product strategies with innovative solutions, we start by suggesting the use of a Market-Biased Portfolio (MBPort), an example of which is illustrated just below. This investment holds a Dynamic Investment and two standalone ETFs in an MPT, asset-allocation, construct.
This portfolio contains three investments as follows:
- A Total Stock Market ETF with a 25% fixed allocation
- A Total Bond Market ETF with a 25% fixed allocation
- The Core Dynamic Investment with a fixed 50% allocation
The DI rotates between a stock and bond ETF based on a quarterly sampling of the price trend of each. Only the ONE ETF trending up most strongly is bought and held for the next quarter. Obviously if the currently held ETF “wins” again, no trade is needed and more often than not this is the case.
The Automatic Market Bias
The Core MBPort is biased toward the asset type that is moving up in price most strongly at quarterly reviews at which time the DI component buys either a bond or stock ETF. You can see that when Bonds are trending up the DI owns a Bond ETF which, when added to the 25% fixed Bond allocation results in a portfolio allocation of 75% Bonds and 25% Stocks - e.g. a Bond "bias". When the DI review shows that Stocks are trending up, the DI owns a Stock ETF and the portfolio is biased toward Stocks with a 75% allocation of money.
The trades needed to change the asset bias of the MBPort are signaled automatically based on objective observations of asset price trends and not on the subjective judgments. And history shows that the market is a better predictor of future price movements than any advisor or analyst can hope to be.
Thus, once purchased, an investor can simply buy-and-hold this investment, confident in the knowledge that it constantly monitoring the market and automatically changing its stock/bond bias to both take advantage of uptrends and avoid downtrends.
The Basic MBPort Performance from 2007 to 2016
The logic makes sense but does the performance validate its use? Let’s take a look.
The following table shows the average annual returns for the Basic MBPort as compared to a typical MPT portfolio for the past decade, from the start of 2007 to the end of 2016. Also shown for each portfolio type is its Sharpe Ratio which is a measure of the amount of return earned for each unit of risk taken – the higher the better and anything above 1.0 is seen as a superior investment.
It is obvious that the MBPort is the superior portfolio with almost three times the return and with significantly less risk. Even skeptics who would argue that higher, short-term capital gains tax would negate any increase in return, would have to admit that the returns of the MBPort will remain significantly higher even after such taxes are deducted.
Portfolio Designer Variables
The NAOI has designed what we feel to be an optimal Basic MBPort by identifying the ETFs to include in the portfolio for both stocks and bonds along with values for the other DI components discussed above. The NAOI offers training classes that show both individuals and organizations how to create optimal MBPorts. They are discussed at this link.
The other variable that can be changed is the percent allocation to each portfolio building block. The following discussion addresses this topic.
The MBPort as a Transition Vehicle
As mentioned earlier, a 100% allocation to just the DI produces the best performance. But most of our students feel more comfortable with the 50% DI, 25% Stock, 25% Bond allocation option as just discussed. Yet as our field testers, year after year, see the superior performance of the DI, most gradually increase its allocation. The table below shows what happens when they do so.
In the table, the first three columns show different allocations to each asset in the MBPort. The last two columns show the Average Annual Return (AAR) for each allocation set along with its Sharpe ratio, a measure of return received for each unit of risk taken and the higher the better.
You can see that the MBPort is the perfect vehicle for transitioning from the way we invest today to how we will invest in the future, using only Dynamic Investments. This transition can take place at a pace with which the investor and/or the advisor is comfortable without disrupting current revenue streams for the financial services industry or being too big of a “leap” for individuals indoctrinated in outdated MPT portfolio design methods.
The Perfect Retirement Default Vehicle
We have found that the MBPort is exactly what is needed as the default investment for 401(k) and other tax-deferred retirement plans for multiple reasons. Among them are the following:
- The logic of Market-Biased Portfolios is simple; minimal investor education is needed
- There is no tax penalty for trading in tax-deferred accounts
- No subjective human decisions are involved in signaling trades – the “market” decides when trades need to be made via empirical observations of market trends
- Trades are signaled automatically – there is no active management required
- An MBPort can be bought-and-held for the long-term while its internal intelligence signals trades that take full advantage of market trends – dependence on a subjective “management strategy” is eliminated
- This unique investment type provides high returns with minimal risk and absolute protection from market crashes through the simple use of stop-loss orders
- The MBPort is appropriate for ALL investors, regardless of their risk tolerance
401(K) plan providers who offer this option will dominate this multi-billion dollar industry. The NAOI can show them how. Click here for more information on this application of MBPorts.
By breaking the shackles of outdated MPT portfolio design rules, the NAOI was able to create a portfolio structure that is superior in every way to the portfolios in common use today. As you have read in this article, the NAOI Market-Biased Portfolio is market-sensitive and time-diversified, two elements not present in MPT portfolios that enable returns with low risk that are impossible with portfolios used today. And this higher performance is produced with no active management required. This is a major advance in the evolution of the world of investing. Dynamic Investments completely eliminate the Chaos of Investing discussed at the link provided.
The NAOI is teaching Dynamic Investment Theory and the use of Market Biased Portfolios via our college classes and our book The Dynamic Investment Bible. When the public learns about the performance of DIs and MBPorts they will demand them. Financial organizations that meet this demand will thrive moving into the future of investing. Those that don't will lose clients at an alarming rate.
More Information and Staying Up-to-Date
More information about Dynamic Investments is found at www.DITheory.com. You can stay current with DIT developments by signing up to the DIT Updates Email list found at the bottom of this and each page of the site.
Visit this Author's Blog periodically to view new applications of existing DI products. And you can always contact Leland Hevner directly with feedback, comments and questions at LHevner@naoi.org. He can also be followed on Twitter at: https://twitter.com/LelandHevner