The Evolution of Portfolio Design:
Creating Market-Sensitive Portfolios

By Leland B. Hevner
President, National Association of Online Investors (NAOI)

Investment portfolio design methods used today are rapidly becoming less and less effective. The industry standard is a design methodology called Modern Portfolio Theory (MPT) that was first introduced over six decades ago in 1952! While equity markets have changed significantly since then, MPT has barely changed at all and it can’t cope with modern market volatility.

MPT dictates that portfolios be designed to match the risk profile of each investor using asset allocation techniques. Then the investor is advised to simply hold the portfolio for the long-term with periodic adjustments to maintain the original allocation percentages.

There are multiple problems here; chief among them is that MPT portfolios are static investments in a dynamic market. They have no sensitivity to market changes and, as a result, their value moves up and down at the whims of the market. They are also dangerously vulnerable to market crashes as we saw in 2008. And because they are designed to hold both winning and losing investments at all times, MPT portfolios are not able to take full advantage of positive market returns potential.

It is time to rethink how investment portfolios are designed and managed. I discuss an innovative and higher-performance approach in this article.

Using NAOI Dynamic Investment

Investment portfolios of the future will be dynamic; capable of detecting market trends and automatically signaling trades to take advantage of them. To do so, portfolios will be built using NAOI Dynamic Investments (DIs) as described in Article 1 and Article 2 of this Series.

To review, DIs are a new derivative investment type created by the NAOI that are capable of changing the equities (either ETFs or Mutual Funds) they hold based on a periodic sampling of market trends. The main components of all DIs are as follows:

• Dynamic Equity Pool (DEP) – Here is where DI Designers place multiple ETFs that track areas of the market where the DI will search for price uptrends. These are purchase candidates. Only one ETF will be held at a time.

• Review Period – This is how often the DEP will be “ranked” to find the ETF in it that is trending up most strongly in price – quarterly is an example. The top ranked ETF is purchased (or retained if already owned) and held until the next Review Event.

• Trend Indicator – This is the indicator that is used to rank the ETFs in the DEP at a Review Event. The NAOI has found a simple one the works exceptionally well. We are willing to share it with interested parties.

• Trailing Stop Loss (TSL) Order – The value of a DI is protected at all times with a TSL Order

DIs are active investments that are passively managed. Investors simply buy and hold them while the DI’s internal intelligence signals trades based on the objective observation of market data; eliminating the use of subjective human judgments that are a major source of risk in how we invest today.

Introducing Dynamic Portfolios

A single Dynamic Investment can be used as a complete portfolio as you learned in Article 2 of this Series where I dissected an example DI. There I showed how a simple DI, by being market-sensitive, earned an average annual return of over 24% with relatively low risk during the volatile period from the start of 2008 to the end of 2017.

But allocating all of one’s money to just one ETF at a time can be hard for new DI users to stomach. NAOI students who have learned about Dynamic Investments and are currently working with them prefer to use DIs as building blocks in a structure that we call Dynamic Portfolios.

DI Building Block Types

The NAOI has defined three types of DI portfolio building blocks as discussed below. The “type” is determined by the ETFs (or mutual funds) placed in the DI’s Dynamic Equity Pool (DEP).

Multi-Asset DIs

These DIs hold ETFs in their DEPs that track multiple, uncorrelated asset classes – typically Stocks and Bonds. Thus, they are capable of changing the asset class they hold based on market trends. The DI discussed in Article 2 of this Series is an example of a Multi-Asset building block. It holds the following ETFs in its DEP and rotates between them based on the price uptrend strength of each:

• EDV: Vanguard Extended Duration Treasury Bonds (25+yr)

• SPY: SPDR S&P 500 Stock Index (LargeCap Value Stocks)

• RZG: Invesco S&P SmallCap 600 Pure Growth Stocks

You saw in Article 2 that this simple DI earned an average annual return of +24% from the start of 2008 to the end of 2017 with a Sharpe Ratio of 1.05. An MPT portfolio holding these same ETFs with an equal allocation to each earned less than 10% per year during the same period with a Sharpe Ratio of 0.80.

Asset-Focused DIs

This type of DI building block has ETFs in its DEP that track multiple asset class “types”. For example, a Stock-Focused DI might hold ETFs that track the Total Stock Market (e.g. SPY), Small Cap Growth Stocks (e.g. RZG), Large Cap Value Stocks (e.g. RPV), etc. This DI will only select for purchase the ONE stock type that is trending up most strongly in price at a quarterly Review. Using a Stock-Focused DI, a portfolio designer simply selects stock-type purchase candidates. The market selects which type of stock to buy and when. Asset-Focused DIs also have in their DEPs what we call an “Escape Valve” ETF, which in the case of a Stock-Focused DI is an ETF that tracks the Bond Market.

Target Market-Focused DIs

This type of DI building block enables designers to include focused markets in a portfolio they are designing in a manner that takes advantage of their upside returns potential without exposure to their full downside risk. Examples of Target Market DIs would be those focused on markets such as Technology, Internet, Finance, Emerging Markets, etc.

Thus, an Emerging Market Focused DI might have the following ETFs in its DEP:

• EEM – iShares Emerging Markets ETF

• EDV: Vanguard Extended Duration Treasury Bonds (25+yr)

• SPY: SPDR S&P 500 Stock Index (LargeCap Value Stocks)

This DI would purchase EEM only when it is trending up in price more strongly than either Stocks or Bonds at a quarterly review. This structure enables an investor to take advantage of the periodic higher returns potential of EEM without being exposed to the risk of simply buying and holding it.

An Example Dynamic Portfolio

The diagram below shows how a Dynamic Portfolio can be constructed using Dynamic Investment Building blocks in a traditional “Core and Explore” design model.

This portfolio can hold up to four ETFs at one time and thus be more acceptable to investors who are accustomed to holding multi-equity, MPT portfolios. But keep in mind the differences. Each of these dynamic building blocks will strive to hold only ETFs that are uptrending at the time of purchase. This enables far higher performance than MPT portfolios that are designed to hold both winning and losing equities at all times.

MPT / DIT Hybrid Portfolios

The NAOI understands that the switch from MPT portfolios to DI-based portfolios will not happen overnight. For this reason, we have developed a strategy that enables the gradual transition from static MPT portfolios to dynamic DI portfolios. This is done by simply including one or more Dynamic Investments in a traditional MPT, asset-allocation portfolio as illustrated in the diagram below.

Hybrid Portfolio Example

When Stocks are trending up this portfolio will have a 75% allocation to Stocks and a 25% allocation to Bonds. When Bonds are trending up the allocations will be 75% Bonds, 25% Stocks. The change is signaled automatically without human subjective decisions involved.

In this configuration the DI would act as both a returns enhancer and a risk reducer for the portfolio. The higher the allocation to the DI segment, the better will be the performance of this Hybrid Portfolio that can easily be implemented today with NAOI training.

It Is Time for Change

It is time to rethink how portfolios are designed. We must break out of the six-decade old “MPT box” in order to enable portfolios to take full advantage of the positive returns potential available in modern markets and to protect portfolio value from market downtrends and crashes. In this short article I have presented Dynamic Portfolios as an innovative design approach that meets these goals. The NAOI believes that they, not MPT portfolios, will dominate the future of investing. And organizations that offer them first will profit the most. The NAOI offers training classes on how to design optimal Dynamic Investments and Dynamic Portfolios as discussed here.

More Information

A more extensive discussion of Dynamic Portfolios can be found on this site at this link.

Next Up: How Dynamic Investments Will Make ETFs Mainstream Investments

Today Exchange Traded Funds (ETFs) are mostly unknown to the investing public. As a result, their sales potential is not close to being fully realized. Dynamic Investments unleash the full power and value of ETFs. The next article in this Series shows how. To be notified when this new article is posted, sign up to the NAOI email list on the bottom of the page at this link.