Our Best Diversified Mutual Fund Allocation?

Today we continue looking at techniques you can use to manage the risk in your mutual fund portfolio.

Last time we found that using uncorrelated funds assembled in a portfolio gave us a powerful tool to manage risk, while maintaining good portfolio returns.

But it would seem that if we were to choose funds (or more specifically a fund rotation system) that had a higher return and a lower risk to start with, the end result would be that much better. Where better to start than with our Fundztrader systems?

I won't grind the the whole selection process, but we are going to use some of the Fundztrader models (the Fidelity Select Model and the Fidelity Equity Model) instead of standalone mutual funds. Of course we have to use the backtest models since these were not in existence the entire time.

Fundztrader Mutual Fund Allocation Model

Another change: instead of a bond fund we will use Fidelity Real Estate, which has a low correlation to the overall market, and a modest correlation to the bond market, but historically much better returns than a bond fund.

We will also add Fidelity Select Health Care. This fund has a long history of low correlation to the overall market, with a reasonable return as well.

Once again we will evaluate the portfolio over the same 11 years (1995-2005) that we covered last time, again balancing between funds quarterly.

With that set of assumptions here are the results for the Fundztrader portfolio:

	Ann Rtn	MDD	Std Dev
Fundztrader Fidelity Equity Portfolio	22.5%	31.8%	16.7%
Fundztrader Fidelity Select Portfolio	22.0	21.8	17.1
Fidelity Real Estate Fund	15.0	28.2	16.4
Fidelity Select Health Care	14.1	42.2	20.7
Total Fundztrader Portfolio	19.4	17.1	12.0
Traditional Portfolio (from last time)	10.1	29.9	12.5

Ann Rtn = Annualized return over the 11 years
MDD = Maximum Drawdown (our simple measure of risk)
Std Dev = Standard Deviation of the annual returns, another measure of risk

These results are simulated, and are not a prediction of future results

Almost Twice the Returns with Half the Drawdown

That's pretty good! By combining these 4 funds, we've improved the Ann Return to MDD ratio to better than 1, and improved the ratio of total returns to standard deviation to about 2/3. Almost double the return of the standard allocation model we looked at last time, with slightly more than half the drawdown!

So, diversification leveraging high performance funds that are uncorrelated to one another is our second technique for risk management.

By a careful choice of high return, low correlation funds we can significantly reduce the overall risk in our portfolio, even though the individual funds we are using can be relatively volatile on an individual basis. To paraphrase our past President: "It's the portfolio, stupid."

This runs somewhat counter to the conventional wisdom. If we are looking to build a low risk portfolio, we don't necessarily need to focus on the risk of the individual investments. We shouldn't allow ourselves to get hung up on the individual funds performance, but understand that we can build a total portfolio with somewhat volatile investments that don't track each other very well, and still have a low risk portfolio!

How Much Drawdown Can You Stand?

But, many people would consider a 17% drawdown to be more than they could handle. It may look good on paper since it's so much better than the 50% drawdown the S&P 500 saw in 2000-2002, or the 80% the Nasdaq suffered through. Yet, even 17% can be tough to handle when it's happening right now to you.

Next time: we will take a look at one last technique to reduce our overall risk.