How to Construct a Low-Cost Conservative Portfolio

How to Construct a Low-Cost Conservative Portfolio

By Geoff Considine May 7, 2013

One of the greatest challenges for investors today is constructing low-risk portfolios that provide the best returns using low-cost funds or exchange-traded funds (ETFs). Doing so requires advisors to define risk as the potential for retirees to fail to achieve their financial goals, instead of as volatility, as it is traditionally measured. I will show how to construct a low-cost portfolio that minimizes this definition of risk while generating a reasonable real return.

Market conditions are challenging the notion of what a conservative portfolio looks like. Bond yields are historically low and the expected real yield of Treasury inflation-protected securities (TIPS) is below zero for short-term maturities. Burton Malkiel argued that Treasury bonds are actually a very risky asset class in present conditions. A number of influential money managers have been making this point for years, and the ongoing decline in yields means a small increase in interest rates could make the real yield of bonds negative.

Before discussing what a conservative portfolio looks like, let's consider what such a portfolio means in terms of risk of loss. Conservative does not mean risk free. Investors who require a near-zero real return will be safest in a 100% TIPS portfolio. For those who need their portfolios to deliver a positive real return, what is the low-risk alternative?

A standard way to describe the risk level of a portfolio is in terms of the worst 12-month loss that can reasonably be sustained without impairing the ability of the investor to meet his or her goals. A survey of pension plan consultants conducted by PIMCO's defined contribution group suggests a consensus view that 65-year-olds can sustain a maximum one-year loss of no more than 5% of their portfolios and still meet long-term goals. For a 55-year-old, the consensus maximum acceptable loss level came in at between 5% and 10%.

I will begin by discussing the requirements of a conservative portfolio, and then compare today's conservative allocation funds to a baseline stock/bond mix. I will develop a conservative baseline portfolio based on an estimated range of potential loss levels associated with a number of traditional safe asset allocations, in light of current market conditions. I will then show how a better portfolio can be constructed using a series of broadly diversified ETFs.

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Features of a safe portfolio

A conservative portfolio must meet four criteria:

1. Have an acceptable loss potential. 2. Provide meaningful income to reduce the need to sell in a declining market. 3. Maintain a neutral or positive correlation to interest rates. 4. Offer a positive expected real return.

Let's assume an acceptable portfolio has a maximum expected loss of 10% over a 12month period. This is the lowest level that allows the portfolio to have a reasonable chance of generating meaningful positive real returns, as I will demonstrate.

One key risk is the need to sell in a declining market. A conservative portfolio must generate meaningful income to defend against this scenario.

A conservative portfolio needs to target positive, or at least neutral, correlation between its returns and changes in bond yields and other measures of interest rates.

Loss potential of traditional asset allocations

One of the striking findings from PIMCO's research was that many asset allocations that have traditionally been considered fairly safe actually had loss potentials much higher than plan consultants indicated were prudent. PIMCO's researchers concluded that many target-date funds had potential loss levels considerably worse than the acceptable levels suggested by plan consultants. This problem was especially acute within 10 years of expected retirement, when investors expect to be taking the least risk.

My research has provided risk projections that have been fairly accurate. In 2007, for example, the risk projections generated by Quantext Portfolio Planner (QPP), the Monte Carlo-based portfolio management tool that I designed, correctly predicted that market volatility would increase substantially.

Let's start by showing risk projections for a range of traditional asset allocation benchmarks and for mutual funds that are specifically classified as conservative.

All statistical models, including Monte Carlo simulations, are of limited value for estimating the probability of extreme events, not least because the historical record contains few occurrences of those events. When I compared the projected risk levels from Monte Carlo simulations in 2007 to what actually occurred in 2008, the magnitude of losses in equities was three standard-deviation events ? with a probability of only 0.15% in a 12-month period. We have no way of knowing how probable 2008's outcomes were, given conditions

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in 2007. As Moshe Milevsky pointed out in 2009, however, it is far more important to estimate the worst possible outcomes (and to make sure that these are survivable) than to worry about whether the estimated probability of this outcome is accurate. Extreme events will occur more frequently than models suggest and it is prudent to plan for them. I will use an estimated three-standard-deviation outcome as the basis for estimating maximum potential losses.

Below are the current projected risk levels for a number of stock/bond allocations. These values are generated by QPP, based on the last five years of return data

Monte Carlo estimates of 12-month maximum loss potential and 2008 returns

S&P500 (SPY)

Aggregate Bond Index (AGG)

Estimated 12Month / 3 Standard

Deviation Loss

2008 Return

100%

0%

-37.0%

-36.8%

80%

20%

-29.4%

-27.9%

60%

40%

-22.1%

-19.1%

40%

60%

-15.2%

-10.2%

20%

80%

-9.9%

-1.3%

0%

100%

-8.1%

7.6%

The estimated worst-case loss potential for the S&P500 is -37%, remarkably close to the actual loss in 2008. In the case of bond returns, 2008 was not an example of what a worst case looks like now. In 2008, bonds were a safe asset class, with AGG delivering a 7.6% return.

Given the increased risk in bonds today that QPP predicted, relative to 2008, I verified its results. I calculated a two- and three-standard-deviation loss, given the current yield as the expected return and using the option-implied volatility as the expected standard deviation of return. According to Morningstar, the current implied volatility for at-the-money put options on the longest-dated options on AGG is 6.1%. With a 12-month yield of 2.4%, a two-standard-deviation loss results in a return of -9.8%. Even though we have not experienced substantial losses in bonds in recent memory, we must still plan for the possibility.

Given that the 100% bond portfolio (100% AGG) has the lowest risk among these portfolios, why not simply treat a 100% bond portfolio as the default conservative portfolio? The answer is that yields are near historical lows, and investors cannot afford to have portfolios so vulnerable to interest rate risk.

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To provide additional insight into low-risk portfolios, the table below shows the estimated risk levels, 2008 returns, trailing 12-month yields and correlations of a range of bond funds and conservative asset allocation mutual funds.

Aside from three bond ETFs (IEF, BSV, and LQD), these are all mutual funds that are classified as "conservative allocation" by Morningstar. The 80% AGG / 20% SPY portfolio is included as a reference.

Projected loss potential, yield, and interest rate exposure for conservative

allocation funds

Estimated 12

Correlation to

Month

Trailing 12

Fund Name

Ticker / 3 Standard

Month

10 Year

Deviation

Yield

Treasury

Loss

Bond Yield

iShares Barclays 7-10 Year Treasury

Bond

IEF

-14%

1.7%

-96%

Vanguard Short-Term Bond iShares iBoxx $ Investment Grade Corp Bond

BSV LQD

-5% -19%

1.5% 3.8%

-64% -41%

Vanguard Wellesley Income

VWINX

-14%

3.0%

-9%

Vanguard LifeStrategy Income

VASIX

-10%

2.2%

-6%

Touchstone Strategic Income Nationwide Investor Destinations Conservative Vanguard LifeStrategy Conservative Growth

BlackRock Conservative Prepared

Vanguard Tax-Managed Balanced

T. Rowe Price Personal Strategic Income

Berwyn Income

Wells Fargo Advantage Diversified Income Builder GuideStone Funds Conservative Allocation

MXIIX

GIMCX

VSCGX BICPX VTMFX

PRSIX BERIX

EKSYX

GFIYX

-22%

-7%

-17% -19% -17%

-21% -14%

-25%

-11%

4.7%

2.2%

2.2% 2.5% 2.2%

2.1% 2.5%

4.5%

2.6%

7%

14%

14% 21% 23%

26% 28%

30%

33%

80% AGG / 20% SPY

-10%

2.3%

-27%

2008 Return

17.9% 8.5%

2.4% -9.8% -10.5% -20.7%

-5.9%

-19.5% -21.3% -18.3%

-20.4% -10.2%

-29.1%

-13.0% -1.3%

These results highlight the tradeoffs between portfolio loss potential and interest rate exposure. Funds with low loss potential tend to have high sensitivity to changes in interest rates. Risk-averse investors have traditionally held large allocations of Treasury bonds, but this type of portfolio tends to be adversely affected by rising rates. To illustrate interest-rate exposure, I show the correlation of fund returns to the 10-year Treasury bond yield using the last five years of data.

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While it is a good bet that Treasury bond yields must eventually go up, the timing is unknown. We could end up with a decade-long period of extremely low interest rates and bond yields, similar to Japan. The most conservative approach is to create low-risk portfolios with fairly neutral exposure to interest rates. A portfolio for which returns have zero correlation to Treasury bond yields would be insensitive to changes in interest rates.

The Vanguard Life Strategy Income fund (VASIX) is attractive in this regard, with a modest -10.5% correlation between its returns and the 10-year Treasury bond yield, along with an estimated 12-month maximum loss of -10%. The Nationwide Investor Destinations Conservative fund (GIMCX) also looks relatively attractive. The one drawback of these funds is that their yields are low; both have 12-month yields of 2.2%.

The Vanguard Wellesley Income fund (VWINX) has a 12-month yield of 3%, but it has a potential worst-case 12-month return of -14%. Given that this estimated loss level is notably worse than the fund's 2008 return and that my model has inherent uncertainties, VWINX is attractive for risk-averse investors despite its higher projected loss potential.

The 20% SPY/80% AGG portfolio has a projected worst-case return of -10% over a 12month period and a -27% correlation to Treasury bond yields. The various conservative allocation funds do a better job of managing interest-rate risk than the 20/80 portfolio does, but their estimated potential losses are worse.

Building a better portfolio

In light of estimated risk levels and interest-rate exposures, what alternatives exist to traditional asset allocations and conservative allocation funds? I started with a series of index ETFs representing a range of asset classes and added the conservative allocation funds above. I used QPP and an optimizer to create a portfolio with zero correlation to the 10-year Treasury bond yield, an estimated 12-month three-standard-deviation return of no worse than -10% and maximum yield given those constraints. I allowed unlimited exposure to a short-term bond fund (BSV) but constrained the maximum allocation to any other fund to 15%.

Model conservative portfolio

Fund Name

Ticker

Weight

Trailing 12 Month Yield

Vanguard Short-Term Bond ETF

T. Rowe Price Tax-Free High Yield

GuideStone Funds Conservative Allocation Wells Fargo Advantage Diversified Income Bldr

BSV PRFHX GFIYX

38% 15% 15%

EKSYX 12%

1.5% 4.2% 2.6%

4.5%

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