Raining On All-Weather?

The Permanent Portfolio was devised decades ago by Harry Browne as diversified approach that favored defense and tried to ensure that no matter how bad things got, at least one holding was working. It equal weights stocks, long term bonds, gold and cash. Any back testing you might do or find will probably look pretty good because of the fantastic 40 year run that long bonds had up until the end of 2021.

Comparing it to the Vanguard Balanced Index Fund (VBAIX) a proxy for a 60/40 portfolio, you see it does give up some return going into year end 2021 but with a significantly lower standard deviation. It also did very well through the financial crisis, the Permanent Portfolio was actually up a few basis points in 2008. In 2022 it dropped 12.09%, 476 basis points better than VBAIX and this year it is trailing by 475 basis points. With the 40 year bull market in bonds over, I don't think it makes sense to have 25% in long bonds. Either yields continue to go higher which is bad for long bonds or they take on equity beta and starts to correlate more closely to equities. For now, you can get better yields with much less volatility at the short end. Here's a link to a chart that shows long bonds are now more volatile than gold.

Blogger Nomadic Samuel Tweeted out what he thinks is a better version of the Permanent Portfolio that uses low volatility equity exposure instead of market cap weighted (MCW) and managed futures instead of cash.

This back test can only go back to 2012 and you can see that VBAIX blows the other two away. The return profile of the original Permanent and Sam's low vol/managed futures version are almost identical until 2022 when thanks to managed futures, Sam's version outperformed the original by over 1000 basis points. The CAGR's of Portfolios 1 and 2 really drop off considerably when compared to the 60/40 blend in VBAIX but both clearly offered all-weather like protection in 2022 and 2008. 

A little over a year ago we looked at an even more conservative, all-weather portfolio called the Dragon Portfolio. One of the aims with this one was to :preserve generational wealth" but it's really very conservative. Here's how it can be mimicked. 

With that mix, you have a lot of things that negatively correlate to equities and the CAGR reflects that when compared to Sam's version of the Permanent in Portfolio 2 and VBAIX in Portfolio 3.

The Dragon and Sam's version have the almost the same standard deviation so between the two you'd have gotten much higher returns for the same volatility in Sam's portfolio.

At some point all-weather protection becomes too defensive. A 1.33% CAGR over that many years doesn't really preserve wealth. If 1.33% is anywhere close to correct with what they actually get then obviously it isn't keeping up with inflation. 

If Dragon goes too defensive as a permanent-ish portfolio, we have looked at ways to get long term market returns that land in between equities and 60/40 using alternatives. The key though is not some huge weight to one alternative. Putting 20 or 25% into managed futures, much as I believe in them, doesn't seem to be prudent risk management. We saw earlier this year, managed futures got whipsawed badly because of a very fast, short term reversal in interest rates. That whipsaw was sort of covered up in bottom line returns because equities were moving up pretty well. But there is nothing that says something like that whipsaw couldn't have been bigger and lasted longer during a year like 2022. It's not even that  managed futures didn't work, they tend to have a negative correlation to equities, equities were going up and managed futures went down but they went down a lot, very quickly. 

Diversifying your diversifiers spreads the risk...by definition. The idea of a simple 3 fund portfolio that has good upcapture while protecting against the downside is intellectually appealing but requires making an unnecessarily big bet on whatever...managed futures, long volatility, some sort of arbitrage or any of the other that appeal to you. 

We've done a lot of these, if you want to play around with it yourself on Portfoliovisualizer, but something like 65% or 70% in equities blended with small slices to negatively correlated diversifiers and a couple of cash proxy or horizontal line diversifiers will probably back test to show a slightly higher CAGR than VBAIX with a similar or slightly lower standard deviation. Play around with it, let me know what you come up with. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.