By Joseph Y Calhoun III, President of Alhambra Investments
The Fortress Portfolio is our original asset allocation strategy. It is the genesis of our company, the very reason I founded the firm. It was designed at the request of a client back around the turn of the century.
I was a stockbroker for 15 years, starting in 1991 at Dean Witter and ending at Oppenheimer & Co. in 2006 when I founded Alhambra Investment Management (AIM). Although most of my brokerage career was spent on the institutional side – mostly trading options for hedge funds – AIM was founded specifically to work with individuals. I did have individual clients as a broker, people who were referred to me mostly by family and friends. But they didn’t come to me for asset allocation advice; throughout the ‘90s I was what is known in the business as a stock jock. I traded stocks and options on individual securities.
In 2000 a client – one of my very first – came to me with a request. He was happy with how his portfolio had performed during the 1990s – who wasn’t, right? – but he was about to retire and wanted to shift his portfolio to something less volatile than owning all stocks. His criteria for this portfolio were pretty tough though. In his words, he wanted to “make a double-digit return and never have a down year”. My initial reaction was, well of course, that’s what everyone wants; that doesn’t mean it’s possible. But this was a loyal client who had been with me for almost a decade and a friend too, so I told him I’d do some research on asset allocation and get back to him. I have to admit, I thought it was a waste of time.
At the time I didn’t know much about asset allocation. I knew about Modern Portfolio Theory of course, but only in a general way. I knew how to define “efficient frontier” but I had no idea how to generate one. Mean-variance optimization sounded more like a medical procedure than a way to generate a portfolio. What I had been taught by the industry, the firms I worked for, was more a reflection of their desires than the client’s needs. That desire was, quite simply, to sell stocks and bonds. Since 1926 the standard Wall Street 60/40 stocks/bonds portfolio produced a decent return but also lost money in almost a quarter of those 90 years. Conventional approaches didn’t seem to hold out much hope of achieving my client’s goal.
The drawdown restriction – no down years – imposed by my client pushed me to consider alternative asset allocation techniques. One early intriguing candidate was the Permanent Portfolio developed by Harry Browne. Browne’s portfolio divides your assets equally among stocks, long-term Treasury bonds, cash and gold and connects the portfolio to four economic observations:
- Prosperity is good for stocks and bonds.
- Recession is good for cash.
- Deflation is good for bonds and cash.
- Inflation is good for gold.
The performance was good – about 10% a year since 1972 – and overall volatility was fairly low but the returns were not consistent. The portfolio had some fairly long periods of good double-digit performance but that was offset by similar periods of poor performance. And it had suffered three down years from 1972 to 2000 (it has added four more since). The Permanent Portfolio was good but it didn’t meet my client’s goals.
Browne’s idea of connecting the portfolio to economic environments was an important insight though. Achieving a consistent return requires that one either know how to predict the future economic environment or build a portfolio that thrives in all environments. The latter option seemed a more promising avenue for research but Browne’s approach obviously needed some refinement to meet my client’s consistency goal.
First, I made some changes to Browne’s description of economic conditions:
- Prosperity and recession became growth in relation to expectations.
- Inflation and deflation became falling dollar and rising dollar respectively.
These more accurately reflect the potential economic environments we must deal with as investors. It isn’t mere growth and recession that moves stock prices; it is better-or-worse-than-expected growth that moves stocks. It isn’t consumer inflation that affects gold and other asset prices; it is the change in the value of the dollar affecting asset prices and consumer prices. The dollar impact goes well beyond mere consumer inflation and gold.
Second, I expanded the list of assets that perform well in each of those economic environments.
- Better-than-expected Growth: Stocks, Commodities, Corporate Bonds, Real Estate
- Worse-than-expected Growth: Treasury Notes and Bonds
- Rising Dollar: Domestic Stocks, Nominal Bonds (Treasury & Corporate)
- Falling Dollar: Foreign Stocks, TIPs, Gold, Commodities, EM, Real Estate
I developed this matrix as a visual representation of the potential environments and the securities that perform well in each:
The goal was to create a portfolio that was constant, one that worked no matter what befell the economy, one that required no ability to see the future to succeed. This was intended to be a passive, strategic portfolio. With that in mind I felt the ideal portfolio would be as simple as possible, holding as few assets as absolutely needed to accomplish the goal. The more assets required to accomplish the risk/reward goal the more likely the portfolio was to be a fluke, a data mining accident. It seemed to me that there were really only a very few really different, distinct assets:
- Equity of Large, Established Companies
- Equity of Small Companies
- Real Estate
That’s really all there is in the world. Everything else is a derivative of one of those big asset classes. Some are a combination; mortgage bonds are derived from real estate but also fit the bond category. Domestic stocks, International stocks, Japanese stocks and private equity are just different forms of equity. Gold, oil, and copper are all commodities. Treasury notes or corporate bonds just changes the borrower; they are both bonds.
Over time, all these broad assets will appreciate. The key to the success of the portfolio is that they don’t all appreciate at the same time or the same rate. As we rotate among various economic environments, different asset classes come to the fore and drive the value of the portfolio. A weak dollar favors the real asset side of the ledger (real estate and commodities) while a rising dollar favors equity. Rising growth favors corporate bonds while falling growth benefits Treasuries.
As I began to test various allocations, trying to find the combination that unlocked my client’s desired portfolio, I made some early discoveries. I had always been taught that allocations to REITs and commodities should be kept small. This is particularly true of commodities which were considered by everyone in the industry to be too volatile for the average client. What I discovered was that this bias against real assets was a fatal flaw in the Wall Street asset allocation paradigm. Essentially the typical Wall Street 60/40 model only worked in half the potential economic environments.
Using the returns from the representative indexes from 1978 to 2000, I was able to construct a portfolio that met my client’s standards. Ironically the portfolio still had 40% in bonds. The big difference came on the risk side of the portfolio. The standard 60/40 model has 60% in equity but this portfolio split the risk side between equity and real assets. The allocation to large and small cap stocks is almost exactly the same as the allocation to real estate and commodities. The average annual return was over 10%, standard deviation was less than 10 and the portfolio had not had a down year during the period for which I had data (1978-2000). Mission accomplished!
The result was what we now call the Fortress Portfolio:
Unfortunately, the original incarnation of the Fortress Portfolio was mostly a theoretical exercise. It was constructed with indices and while I could easily invest in the S&P 500 or the Russell 2000, the REIT, commodity and Treasury pieces were more difficult. No ETFs or mutual funds existed for those indices. There were ways to implement the strategy but in its purest form, only at the institutional level.
By 2006, however, all the pieces were in place with ETFs available for each asset class. I founded Alhambra the same year. I matched the broad asset classes with investable assets:
Equity – Large Company – I sorted equity into Large and Small companies because they have very different characteristics. Large cap is represented by the S&P 500. SPY is the SPDR version and IVV is the iShares version.
Equity – Small Company – I use the Russell 2000 Value index in a bow to MPT and Fama/French. Small cap and value stocks outperform the market over the long term. The iShares version of this index ETF is IWN.
Real Estate – My original research was done using the NAREIT All Equity index because it had the longest data record. Unfortunately, no ETFs existed for that index. The DJ REIT (IYR – iShares) and MSCI REIT (VNQ – Vanguard) indexes have similar returns.
Commodities – The original research was done with the Goldman Sachs Commodity Index (GSG – iShares). Powershares DB Commodity Index Tracking fund (DBC – PowerShares) offers similar exposure.
Bonds – It became obvious early in the research that the bond allocation would have to be a Treasury index to minimize the correlation to stocks. The original study used the 1-3 year Treasury index (SHY) but we have since moved to using the 3-7 year index (IEI). It adds some return without adding much in the way of volatility.
The Fortress Portfolio has evolved since its first incarnation. I’ve been able to source older data and now have returns back to 1972 for the indexes. The long-term average return is a bit lower, due to the bear market in 1973-4, but is still near my client’s goal of double digits (9.9%). As I mentioned, we now use the 3-7 year Treasury index instead of the 1-3 year index. That added some volatility but also some return. More data and longer duration bonds means the long-term track record now includes four down years: 1974 (-8.5%), 1994 (-0.4%), 2008 (-17.25%) and 2015 (-3.43%)*.
Achieving my client’s original goal of double-digit returns with no down years isn’t possible using these assets or any combination we’ve tested. We can get one or the other but not both. Still, four down years over a 44-year period should be acceptable to most investors. And 9.9% isn’t double digits but it is very close. We have used some form of this portfolio since I opened the doors in 2006.
The Fortress Portfolio was designed to produce a consistent return with low volatility. It is simple in design and execution – elegant one might say – and not overly engineered. It is not a portfolio that depends on the performance of one asset class as does the standard 60/40 portfolio. It doesn’t require that we predict the future course of the economy or markets to be effective. It provides what most people need; a reliable strategic investment approach that they can hold no matter what’s going on with the world. It is a Fortress, a stronghold for your core assets.