The Resilient ETF Strategy for Deep Market Protection
A resilient investment strategy
Years ago, I encountered a cockroach in my less-than-ideal student dorm. Much to my surprise, this little creature showcased remarkable tenacity. This moment inspired what I now refer to as ‘The Cockroach Portfolio.’ In essence, this is a defensive five-ETF blend that has consistently outperformed traditional investments like the S&P 500 and a classic 60/40 portfolio on a risk-adjusted basis.
This portfolio stands out because it does not rely on costly hedges or complicated derivatives meant to shield investors from downturns. Instead, it offers a blend of diversified ETFs that strategically minimize risk. By spreading investments across a range of assets that don’t correlate with one another, this allocation effectively dampens potential losses.
Understanding the stock allocation
The core of the strategy hinges on a 60% allocation to stocks. Instead of opting for broad market exposure, this percentage is thoughtfully divided among three sector-specific ETFs, each receiving 20% of the allocation. Surprisingly, these funds maintain a low expense ratio of only 0.09%:
- The Health Care Select Sector SPDR Fund (NYSE: XLV)
- The Utilities Select Sector SPDR Fund (NYSE: XLU)
- The Consumer Staples Select Sector SPDR Fund (NYSE: XLP)
These ETFs are directly linked to the S&P 500, which provides intrinsic benefits of quality earnings, liquidity, and overall market presence. However, the selection of these three sectors is intentional. Historically, during economic downturns, these sectors exhibit much lower volatility and drawdowns compared to the broader market.
The reason for this resilience lies in the steady demand for the products and services offered by these sectors:
- Healthcare is an essential service that remains in demand regardless of economic conditions.
- Utilities are vital for daily life, ensuring a consistent need for electricity and water.
- Consumer staples consist of everyday necessities, ensuring those companies continue to thrive.
As evident through beta values, these sector ETFs have lower fluctuations compared to the broader market. For instance, the Health Care Fund (XLV) has a beta of 0.64, while Consumer Staples (XLP) is at 0.57 and Utilities (XLU) sits at 0.74. Each of these figures indicates that these investments will tend to move less dramatically than the overall market, delivering relative stability.
Incorporating bonds for security
The bond segment of this portfolio consists of 20% allocated to the iShares U.S. Treasury Bond ETF (NYSE: GOVT), which comes with a modest expense ratio of 0.05%. The rationale for including bonds in this strategy revolves around diversification.
Due to their low correlation with stocks, bonds tend to perform well when equities decline. They react differently to market triggers like earnings, market sentiment, and interest rates, providing a balanced risk-return profile that complements stock investments.
This is where GOVT becomes particularly advantageous; it encapsulates exposure to U.S. Treasuries with maturities spanning from 1 to 30 years by following the ICE U.S. Treasury Core Bond Index. My aim is not to speculate on what may happen with interest rates, but simply to ensure safety and stability through Treasury exposure.
GOVT enjoys moderate interest rate sensitivity with a duration of 5.76 years and presently boasts a yield to maturity of 4.42%. This reflects expected total returns if the bonds are held to maturity.
Opting for Treasury bonds specifically allows the portfolio to sidestep the credit risk associated with corporate bonds. During market crises, Treasury bonds provide the safest investment avenue, barring a default from the U.S. government.
The role of gold in the portfolio
Finally, the remaining 20% is devoted to gold, a precious asset historically recognized for its safe-haven qualities. Despite common criticisms—namely that gold generates no cash flow—it plays a vital role as a diversification tool during turbulent financial periods.
Gold’s low correlation with both stocks and bonds makes it an essential addition to any portfolio. It serves as a protective asset when both mainstream investment classes experience declines, much like during significant market downturns.
Holding physical gold can often create challenges, including issues with storage and security. This is why I advocate for the SPDR Gold MiniShares ETF (NYSE: GLDM), which has an expense ratio of 0.1% and manages around $10.2 billion in assets. This ETF provides an efficient method to gain exposure to gold without the burdens associated with physical holdings.
Assembling the portfolio
Managing this portfolio is straightforward. Simply allocate 20% to each of the five ETFs, rebalance quarterly, and reinvest all dividends. This streamlined approach makes it accessible for a broad range of investors.
It is notable that, based on total returns from past performance data, The Cockroach Portfolio has not outpaced the S&P 500 (10.63%) or the traditional 60/40 portfolio (8.36%), with a CAGR of around 8.28%.
Yet, on a risk-adjusted basis, it offers compelling advantages. The Sharpe ratio of 0.65 significantly eclipses the S&P 500’s 0.51 and the 60/40 portfolio’s 0.57. Additionally, the annualized volatility is much lower at 9.21%, contrasted with the more fluctuating S&P 500 (18.32%) and the 60/40 (10.92%).
One of the most critical observations arises from the maximum drawdown measurement during the tumultuous 2008 financial crisis. The Cockroach Portfolio exhibited a drawdown of just 22.16%, far less severe than the S&P 500’s staggering -55.26% and even lower than the 60/40 portfolio’s -35.97%.
Visual representations highlight this stark contrast in volatility and drawdowns. In summary, while younger investors might focus solely on returns, those who understand the nuances of risk might find immense value in this portfolio strategy.
Frequently Asked Questions
What is the Cockroach Portfolio?
The Cockroach Portfolio is a defensive investment strategy consisting of five sector-specific ETFs designed to withstand market volatility and minimize losses.
How is the portfolio allocated?
The portfolio is structured with 60% in stocks (20% in each of three sector ETFs), 20% in bonds, and 20% in gold.
Why include gold in the portfolio?
Gold is a low-correlation asset that acts as a safe haven during economic downturns, providing additional protection against market volatility.
What is the main goal of this investment strategy?
The primary aim is to reduce deep, prolonged losses and achieve stable growth rather than chasing high returns.
Why are Treasury bonds chosen over corporate bonds?
Treasury bonds are selected due to their low credit risk and historical flight-to-safety appeal during market downturns, making them a stable choice for protection.
About The Author
Contact Dominic Sanders privately here. Or send an email with ATTN: Dominic Sanders as the subject to contact@investorshangout.com.
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