The Rise of Dynamic, Market-Sensitive Portfolios
NAOI Dynamic Investments blur the line between single investments and investment portfolios. A single DI that holds ETFs tracking different asset classes in its DEP can be the only investment that a person holds. Such a DI is fully company diversified and asset diversified. You saw the performance comparison shown below on an earlier page of this presentation:
Who would not have wanted to own the simple NAOI Core DI as opposed to a traditional 60% Stock / 40% Bond MPT portfolio during this volatile period?
But the NAOI knows that investors are often uncomfortable holding only one ETF at a time with 100% allocation of money which is the way Dynamic Investments work. For this reason and others, explained below, we have developed an entire new environment for the creation of dynamic portfolios that can hold multiple ETFs at one time. Below I describe how.
DI Portfolio Building Block Types
The NAOI has defined four DI "types" that can be used as Dynamic Building Blocks (DBBs). DI types are determined by the nature of the ETFs included in their DEPs as illustrated in the discussion below.
Type 1: Multi-Asset DBB
This type of DBB contains ETFs (or mutual funds) in its Dynamic ETF Pool (DEP) that track different asset classes. Thus, it rotates the ETF held between or among the major assets based on which is trending up most strongly at the time of a Review. The asset classes used will be mainly Stocks and Bonds but could also include Real Estate, Commodities, Emerging Markets, etc. The table below shows an example of a multi-asset DBB that holds a Stock ETF and a Bond ETF, how many days each was owned during a test period and the DBB’s performance for that period.
Type 2: Asset Focused DBB
This DBB type holds ETFs in its DEP that are primarily focused on one asset class - Stocks in the example shown in the table below. In today's MPT-based world a portfolio designer who wants to add stock exposure to a portfolio must decide which type(s) of stocks to include. There are many stock “type” choices such as large-cap, medium-cap, small-cap and then growth or value for each market cap. Most designers simply include a Total Stock Market ETF or mutual fund and move on. By doing so they can leave a lot of positive returns on the table as different stock types can perform better than the total stock market. A “Dynamic Stock Investment” solves this problem as illustrated in the table below. Also note that this DBB type has an "Escape Valve" that is a Bond ETF shown in red at the bottom of the table. The Bond ETF is purchased if the entire stock market is trending down, in which case history tells us that Bonds should be trending up. A Bond focused DBB would have a Stock ETF as it Escape Valve.
Simply buying and holding SPY for this period would have resulted in an Average Annual Return of + 8.5% with a Sharpe Ratio of 0.43.
Market Focused DIs
The type of DBB is used when a portfolio designer or investor wants exposure to a specific area of the market for example China Stocks (ETF symbol FXI). This type of investments can be very risky in an MPT buy-and-hold portfolio. The problem is solved by including FXI in a DEP along with a Stock and Bond ETF as shown in the DEP below. Here FXI will only be purchased and held for one period if it is trending up in price more strongly than either Stocks or Bonds. In the below example FXI was held for less than one third of the time during the backtest period, and only when it was trending up. At all other times the DBB held either a Stock or a Bond ETF. You can see from the performance numbers that the “Dynamic China DBB” was far more profitable and less risky than simply buying and holding FXI during the period.
There are several important points to be made related to the performance of this example DBB.
In the first quarter of 2008, EDV was selected to be owned. It then fell by 18% in price during the holding period. But EDV was protected by a Trailing Stop Loss order set a 10% below the purchase price. So the DBB automatically sold EDV when that limit was hit and thus lost only 10% instead of 18%. The DBB was then “out of the market” until the next quarterly Review event.
In the third quarter of 2015, FXI lost 23% of its value. But FXI’s Trailing Stop Loss order sold it at a 10% drop and was then out of the market until the next quarterly Review event.
These are the reasons why the “Days Held” numbers do not add up to 2518; the total number of trading days in the period.
Simply holding FXI for the entire period would have resulted in an average annual return of 0.2% with a Sharpe Ratio of 0.15. You can see that Market-Focused DBBs enable portfolio designers to capture the upside of risky markets while being protected from their downside.
Mixed Focus DIs
The final DBB type defined by the NAOI is one having a DEP that holds ETFs for at least two assets class - for example Stocks and Bonds - and for at least one of these asset classes it holds ETFs tracking multiple "types" of the asset. An example is shown in the table below.
Remember, the MARKET is selecting the one ETF to own at all times. In this example the market not only selects the Asset Class that is trending up most strongly but also the “type” of that asset that is showing the better performance.
A New Era of Portfolio Design
You can see that by using Dynamic Building Blocks a portfolio designer need only define a group of ETF candidates for the portfolio, the market will decide which to actually buy depending on the price trends of each. This is far different than the way MPT portfolios are created today where designers must select specific investments to buy and then just hold them for the long term. The effects of selecting losing investments to buy using the MPT portfolio process can be felt for a long period of time. Losing investments selected in the DIT portfolio process are quickly sold and replaced with winning investments. You can see how the use of Dynamic Investments as portfolio building blocks makes portfolio design easier, quicker and far more profitable than working with standalone ETFs or Mutual Funds.
Dynamic Portfolios (DIs Only)
NAOI Dynamic Building Blocks can be combined in a portfolio using the familiar Core and Explore design model. This is essentially a portfolio of portfolios that changes the ETFs owned with market trends. And, depending on the ETFs in each DBB, the example portfolio shown below can hold from one to four ETFs at a time. Allocation of money made to each DBB are not the “make-or-break” decisions that they are for a buy-and-hold MPT portfolio. Dynamic Portfolios change their allocations automatically in response to market trends.
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 defined 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. We call this an MPT / DIT Hybrid Portfolio.
In this example portfolio, 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. On the Web page at this link, I show how NAOI Hybrid Portfolios can be the perfect 401(k) default investment.