Investing with just 5 ETFs: the permanent portfolio 2.0

THE Permanent Portfolio of Harry Browne is to the stock market what the all-season tire is to the car. It theoretically allows you to generate profits in any situation, thus aiming for almost always positive profitability and low volatility. The idea of its creator is that in each type of economic cycle, there is a type of asset that manages to stand out.

According to Browne, asset class performance varies with the economic cycle and consumer price trends. Stocks love growth, cash loves recession, gold loves inflation and bonds revel in deflation.

As it is difficult to anticipate these periods, Harry Browne recommends placing 1/4 of one's assets in each of these assets and rebalancing once a year.

Does the Permanent Portfolio deliver on its promises?

To be sure, I compared in my book the PP results to an approach that simply consists of placing all of its assets in real estate. Over the very long term, real estate in fact displays a performance close to that of stocks (7% excluding inflation), with a volatility close to that of long-maturity treasury bonds.

My backtests indicated that the PP did not provide any added value compared to the 100% real estate approach. In addition, it should be noted that the PP has been experiencing quite serious difficulties for a decade. Despite its reputation as an "all-season" tire, it has suffered four negative years since 2013., which is worse than real estate and even a portfolio consisting only of stocks.

So why bother with the permanent portfolio when a single real estate ETF (like VNQ) is enough? In the long term, this last strategy certainly works better. However, since the subprime crisis, at least in the USA, this investment has also lost its luster, since its profitability has fallen even as its volatility has increased. We will see later in detail what this gives in terms of figures.

Alternatives to H. Browne's portfolio?

As a result, I sought to build a new permanent portfolio, with the goal of achieving performance as good as the stock market, with much more acceptable volatility, like that of Treasury bonds. All with as few ETFs as possible.

In Browne's original portfolio, one asset poses particular problems: cash. In times of galloping inflation, it is heresy to keep a quarter of one's assets in cash.

Swiss investment analyst Marc Faber ("Dr. Doom") has suggested replacing the cash portion with real estate, which would slightly increase profitability without worsening volatility. However, as we have seen, real estate has also been lagging for quite some time.

What to replace cash with?

I managed to get around this problem by increasing the equity allocation and replacing it with sector ETFs, rather than targeting the entire market. To do this, the sectors targeted had to be both profitable in the long term, but also be as low volatility as possible and/or poorly correlated with other assets in order to reduce the overall volatility of the portfolio.

Based on research done in my work, as well as for the determining portfolio, I therefore set my sights on:

• Consumer Staples ETF (VDC)
• Health Care (ETF XLV)

This duo is completed by the Nasdaq 100 (ETF QQQ), mainly focused on the technology sector, but also including consumer services, public health, consumer goods and a little industrials.

Permanent Portfolio 2.0

To these 3 ETFs, we add gold (GLD) and treasury bonds (TLT), already present in H. Browne's portfolio. We distribute everything in an equivalent manner, i.e. 20% for each position (rebalancing once a year):

I had fun changing the respective weightings, to try to optimize the portfolio. However, it is difficult to do really better than the simple allocation in equal parts, without worsening the profitability to the detriment of the volatility (or vice versa). The Sharpe ratio, which indicates the profitability in relation to the risks incurred, is thus almost maximal with an allocation in equal parts.

With PP 2.0, we obtain a profitability very slightly higher than the market, with a volatility barely higher than the original permanent portfolio. (we will see the statistics in more detail later).

PP 2.0 is a very simplified version of the determining portfolio without Trading Auto Signal.

Permanent Portfolio 2.1

For investors who are particularly resistant to volatility, it is possible to further reduce the volatility obtained with PP 2.0, while preserving profitability as much as possible. To do this, an additional ETF is added, or rather, it is subtracted by short selling the EFA ETF. The latter represents the MSCI EAFE index, i.e. the stocks of developed countries outside North America.

The EFA ETF is thus shorted, at a rate of 50% of the PF value. The proceeds of the sale remain cash. All other positions remain identical to PP 2.0.

This means that almost the entire equity position (60%) is covered by the short position. We will see in detail below the implications in terms of performance and volatility.

I also tested the variant that invests the proceeds of the short sale not in cash, but in other ETFs. This slightly increases profitability, but excessively in relation to the risks incurred (the Sharpe ratio melts).

PP 2.1 represents a very summary version of the determining portfolio with Trading Auto Signal.

Comparison of permanent portfolios

In a backtest from January 2005 to April 2023, I compared the three permanent portfolios above to real estate and the stock market. The results are as follows:

THE PP 2.0 is the most efficient. It even surpasses the stock market (S&P 500), while it only has 60% of shares. It also has the best Sharpe ratio, thanks to volatility which remains under control in relation to the profitability displayed.

THE PP 2.1 is the least volatile. Its Sharpe ratio is also excellent, thanks to a profitability that remains very good compared to the volatility displayed. The most remarkable thing about this portfolio is its almost zero correlation with the market, thanks to the coverage used (short sale of EFA). It therefore perfectly assumes its role as an "all-season" portfolio, since During the 18 years of observation, only one was negative. Even in the case of the latter, the loss remained reasonable, with -5.64%. On the other hand, the profitability, although better than that of the original PP or real estate, is lower than the market. With just over 5% (excluding inflation), this is insufficient to achieve financial independence. I explain why in "The determinants of wealth".

THE Original PP is clearly the least efficient. He doesn't even compensate for this with what is expected of him: to cope with all situations. As we have already pointed out, in fact, Browne's portfolio has suffered four negative years since 2005.

The case of real estate

As we can see, real estate was catastrophic during the backtest period. Be careful, however, because here we are talking about the American index, via the VNQ ETF, which suffered particularly between 2007 and 2009 (with a maximum successive loss of 68%). TheSwiss real estate for example, via the SRFCHA ETF, shows a slightly higher performance excluding inflation, around 5% this period. Above all, volatility, during the same time, remained around 8%, which is almost 3 times less than that of the American index, in line with other permanent portfolios.

SRFCHA is therefore a very good alternative, if you are looking to invest in buy-hold on a single ETF., which I recommend for beginners and investors with small capital (less than 25,000 bucks). To be comprehensive on real estate, let's also note that if we use a tactical asset allocation strategy (rather than buy-and-hold), as in the determining portfolio, the results are paradoxically better with VNQ than with SRFCHA.

Objective achieved?

PP 2.0 is interesting because it meets the objectives set: profitability at least equivalent to the market with a much more acceptable volatility (close to that of treasury bonds). The performance of PP 2.1 is slightly less good, but this is compensated by a particularly defensive behavior and an absence of correlation with the market.

What reduces the profitability of PP 2.1 compared to PP 2.0 is precisely what gives it its resilient virtues: its coverage. In a way, the short position on EFA behaves like insurance: you pay when everything is going well and you profit when everything is going badly.. Since the indices only go up in the long term, the short line on EFA is necessarily always a loser in the end. This is the insurance premium.

Comparison with the determining portfolio

We have seen that these two wallets represent a very basic version of the determining portfolio. Let's see the main differences.

• The equity ETFs (VDC, XLV, QQQ) of PP 2.0 and 2.1 are replaced by direct securities, through the QVM and Blue Chips strategies. The latter mix stocks of Quality, Value and Momentum companies with other very high-level companies that benefit from a dominant position in the market, with a competitive advantage. These securities complement each other according to their characteristics in terms of profitability, volatility and low correlation, in order to optimize the overall result of the portfolio.
• Coverage is used only when necessary, using the Trading Auto Signal. This allows you to win on both counts, not only when the market is down, but also when it is up. This avoids generating a losing line over the long term, just to reduce the volatility of the portfolio.
• Gold and bonds are complemented with other alternative assets, such as real estate and cryptocurrencies. Tactical asset allocation, via technical and economic indicators, is used to take positions there.

According to my backtests, by doing this, we obtain for the determining portfolio (with Trading Auto Signal) a

• annual performance excluding inflation of 17%
• with a volatility of 12%
• either a Sharpe ratio of 1.4.

In this case, it is certainly appropriate to tolerate a slightly higher volatility than with permanent portfolios (but still less than that of the market). In addition, the determining portfolio has more positions and therefore involves more trading and monitoring. But ultimately, The result is worth the effort, as it leaves all the other approaches mentioned above far behind in terms of performance.

Ok for backtesting, but what about in real life?

For the past 10 years, and particularly over the last three years, the performance results of PP 2.0 and 2.1 have been worse than the market. However, relative to the risks involved (Sharpe ratio), they still remain higher than the market.

The determining portfolio, introduced in 2020, is no exception to this rule. Until the end of last year, it thus has a delay of 5% on the market, or 1.9% per year. This is mainly due to the year 2021, marked by a strong rebound in stock indices, particularly large-cap growth stocks. However, portfolio volatility is almost twice as low. This has materialized not only at the beginning of the pandemic in 2020, but even more during the year 2022, with a loss of -17% on the Swiss market, against -3.9% with the determining portfolio.

These results are perfectly in line with those observed for PP 2.0 and 2.1: for the moment, profitability remains slightly lower than the market, but with significantly less risk, i.e. a better Sharpe ratio.

It should also be noted that the performance of the determining portfolio is referenced against the Swiss franc. Between the beginning of 2020 and the end of 2022, the latter gained 5% against the dollar, 10% against the euro and 30% against the yen, three currencies that are strongly present in the PF and which are dragging its performance down. This phenomenon of currency fluctuation loses its importance in the long term in favor of the intrinsic value of the assets, but in the shorter term it also explains the differences between the performances achieved and the backtests.

A question of perspective

This relative underperformance is quite easily explained. For more than ten years, we have been living in a major bull market caused by a catch-up due to the lost decade of 2000-2010, associated with an ultra-accommodating policy of central banks. The phenomenon was further exacerbated by massive state interventions and big financiers following the pandemic.

In fact, despite a few minor jolts during this period, there was no major sustained bear market during this period, as in the early 2000s or in 2008. Each time, the firefighters intervened very quickly and with significant resources. The fire was thus always contained. Under these conditions, any portfolio not containing 100% of stocks (in particular large growth companies) had no chance of beating the market.

The backtests carried out are based on very long observation periods, including recessions, financial crises and major bear markets. Above I went back to 2005. Those I relied on in the "Determinants of Wealth" go much further still: the majority rely on figures going back to 1970 and some even back to 1930.

Over a relatively short observation period, actual results may therefore differ. To judge the full potential of these strategies, as with Browne's original permanent portfolio, one must experiment with all possible combinations of economic cycles (growth/recession), consumer prices (inflation/deflation) and stock market (bullish/bearish).  

In fact, we have not experienced a lasting recession since 2009, which is a historical anomaly (I am not counting the COVID crisis which not only was too short, but above all, in hindsight, played a procyclical rather than countercyclical role).

A crystal ball?

No one can predict the future. A recession can happen within a few months. But it can take longer. Stock markets can also fall without a recession.

The virtue of permanent portfolios is that they don't try to guess the future, just to be ready, whatever happens. The challenge is to be ready, while still enjoying the party. That’s exactly what PP 2.0 and 2.1, as well as the Determinant Wallet, offer you.