The permanent portfolio: Harry Browne's strategy

THE portefeuille permanent, conçu par Harry Browne dans les années 1980, représente une approche originale de l'investissement à long terme. Cette stratégie d'allocation d'actifs vise à créer un portefeuille robuste capable de performer dans toutes les conditions économiques. Découvrons les principes et la méthodologie de cette stratégie d'investissement qui continue d'intéresser de nombreux investisseurs.

The permanent portfolio: fundamental principles

The Permanent Portfolio (PP) philosophy is based on the idea that no investor can predict with certainty the evolution of financial markets. This approach recognizes four distinct economic environments: growth, recession, recession and recovery.inflation and deflation.

Harry Browne developed this strategy on the premise that each asset class reacts differently to different economic conditions. The aim is to build a portfolio that is sufficiently diversified to prosper in any situation.

PP is based on strategic rather than tactical diversification. The aim is not to time the market or make frequent arbitrages, but to maintain a constant allocation over the long term.

This approach favors capital preservation while aiming for moderate but steady growth. It is particularly suited to investors seeking stability and minimizing the risk of major losses.

The four pillars of Harry Browne's strategy and the corresponding ETFs

The first pillar is equities, which excel in times of economic prosperity. Equities represent growth and capture corporate value creation. As we have already seen in our previous backtests, L'ETF SPY is the best choice.

The second pillar comprises long-term bonds, which perform particularly well in times of deflation. They offer regular income and protection against falling interest rates. The TLT ETF (20+ year US government bonds) is the one that best meets Browne's criteria. However, we will also test a portfolio variant with CSBGC0 (medium-maturity Swiss government bonds).

Gold is the third pillar, providing protection against inflation and geopolitical crises. This precious metal has historically served as a safe haven in times of uncertainty. GLD and IAU ETFs are the best choices. The following backtests will focus on GLD, but the results would be identical with IAU.

The fourth pillar is represented by cash (or cash equivalents), which offer stability in times of recession and enable you to seize investment opportunities as they arise. For this asset, you can simply hold cash in the currency of your choice, or resort to ETFs based on cash or very short-dated bonds, such as US Treasury Bills. For the backtests, we'll be using the FXF (CHF cash) and BIL (Treasury Bills 1-3 months) ETFs, which best match Browne's criteria. We will also test a variant with SHY (Treasury Bonds 1-3 years).

Correlations

These four assets have been very wisely selected by Harry Browne. Their correlation with each other is low or even negative. This ensures portfolio resilience in times of crisis.

Balanced distribution: 25% for each category

The equal distribution between the four asset classes is a fundamental feature of the permanent portfolio. Each component receives exactly 25% of the total allocation.

This fair distribution reflects humility in the face of the markets and the impossibility of predicting which economic environment will dominate in the future. It also avoids the behavioral biases associated with overweighting a particular asset class.

The simplicity of this allocation facilitates portfolio management and reduces transaction costs. It also makes it easier for investors to understand the strategy.

The balance between the various components creates an optimal diversification effect, where the positive performance of one asset class can offset the negative performance of another.

Annual rebalancing: maintaining proportions

Rebalancing is an essential component of the permanent portfolio. It consists of regularly bringing each asset class back to its target weighting of 25%.

This operation, generally carried out once a year, enables us to maintain the desired level of risk and benefit from the effects of diversification. It also forces us to sell assets that have outperformed and buy those that have underperformed.

Annual rebalancing helps maintain investment discipline and avoid emotional decisions. It contributes to systematic portfolio management.

This methodical approach to rebalancing makes it possible to capitalize on the volatility markets while maintaining constant exposure to different asset classes.

Advantages and limitations of the permanent portfolio

Major advantages include ease of implementation, low maintenance requirements and reduced stress associated with investment decisions. It also reduces the impact of behavioral biases.

The strategy is remarkably stable. It offers excellent protection against various economic risks and strong resilience in times of crisis:

However, the permanent portfolio also has its limitations. The large proportion allocated to unprofitable assets such as cash can weigh on overall performance during periods of strong economic growth.

The strategy may also seem too conservative for younger investors or those with a very long investment horizon and a higher risk tolerance.

Portfolio valuation ratios

For our backtests, we're going to slightly expand our usual indicators. Indeed, the primary quality of the permanent portfolio is its defensive nature. Even if this can be seen in part through the Sharpe ratio (which measures the profitability of a portfolio in relation to the risk incurred), we need a few more specific indicators.

PP's past performance shows its ability to generate steady returns while protecting capital, although these returns may be lower than those of a more aggressive portfolio during periods of market surge. We'll measure this with our usual ratios: the compound annual growth rate (CAGR) and the Sharpe ratio we mentioned in the previous paragraph.

Diversification across four loosely correlated assets helps to limit volatility as well as the maximum losses of a permanent portfolio. To assess volatility, we use the standard deviation (in %), also known as "standard deviation" (SD). A high SD indicates greater variability of returns, suggesting a higher level of risk. On the other hand, a low SD indicates more stable and predictable returns.

To measure maximum losses, we use the "Max Drawdown" (MDD) indicator. This indicator represents the largest loss a portfolio has suffered in relation to its previous peak, expressed as a percentage. MDD is an essential tool for assessing an investment's downside risk, as it illustrates the scale of recent setbacks experienced by the portfolio.

Finally, to assess the portfolio's ability to perform in all economic conditions, we use a ratio that measures the number of years with losses over the analysis period (in %). I call this indicator the Years Lost Ratio (YLR).

Backtests

We're going to break down the backtests into three batches, each covering distinct periods and instruments.

1978 - 2024 (asset classes)

As the 1st ETF (SPY) was created "only" in 1993, we're going to focus in this first part on asset classes, so as to be able to backtest the permanent portfolio over a longer period. We'll be comparing the portfolio to the S&P 500 as well as to the 60/40which, like the PP, has a defensive vocation.

Findings

• The Permanent Portfolio's CAGR is lower than that of the S&P 500, as expected. On the other hand, the result is also lower than that of the 60/40, quite significantly so.
• PP's relatively low CAGR has a direct impact on the Sharpe ratio, which lags behind the other two approaches. In passing, we note the nice result of the 60/40 against the S&P 500, which confirms what we had mentioned in the findings (4th point) of batch no. 4 of the last article.
• PP, on the other hand, is by far the least volatile of the portfolios. In fact, its volatility is more than twice that of the S&P 500.
• The Max Drawdown results are even more impressive, with a maximum successive loss that is more than three times smaller than that of the S&P 500 and almost twice as small as that of the 60/40.
• Over the period analyzed, 17% of PP years were losers. For a strategy whose aim is to perform in all economic conditions, this is somewhat disappointing. With a single asset class (equities), the S&P 500 achieves the same result. The 60/40 does even better with just two asset classes.

The strength of PP lies above all in its ability to absorb shocks, as can be seen in its volatility and Max Drawdown. On the other hand, it comes at a high price in terms of profitability. A further illustration of this phenomenon: PP is 91% above the S&P 500 in bear markets, but only 17% in bull markets. As bull markets are (fortunately) more frequent than bear markets, this is directly reflected in the CAGR.

Please note that the above results are given in US dollars. In Swiss francs, they would be slightly worse, given the greenback's long-term weakness against the CHF. In future retrospective tests with ETFs, we'll see what happens with the Swiss franc.

1995 - 2024 (ETFs: SPY, GLD, TLT, SHY)

In this lot, we'll be using the following ETFs: SPY (S&P 500), GLD (gold), TLT (long-dated US bonds) and SHY (US government bonds - maturity 1-3 years). The latter replaces cash. SHY doesn't quite fit Browne's criteria. The original PP is based on either cash or bills (government bonds with maturities of less than 1 year). We'll see later, however, that this doesn't make much difference to the results (they're actually quite favourable to SHY). As indicated in the previous paragraph, the CHF is now used as the reference currency.

Findings

• Overall, the results are identical to those of the previous backtest: once again, PP is able to absorb shocks, as confirmed by SD and MDD. On the other hand, this is to the detriment of CAGR and Sharpe ratio. What's more, almost one year in four is a loser, like the S&P 500, compared with one in five for the 60/40.
• The biggest difference from the last retrospective test comes from the change in reference currency: due to the weakness of the dollar, the MDD is significantly lower.

2006 - 2024 (ETFs: SPY, GLD, TLT, BIL, FXF, SHY, CSBGC0)

For this last batch, we will introduce several other ETFs:

• pour les obligations : en plus de TLT, CSBGC0 (obligations de la Confédération suisse 7-15 ans)
• for cash (and cash equivalents): in addition to SHY, BIL (Treasury Bills 1-3 months) and FXF (an ETF that replicates a CHF cash position)

Findings

• Regardless of the PPs analyzed, they all appear, unsurprisingly, below SPY's CAGR. Once again, the result of this indicator is worse than a 60/40 portfolio.
• As I mentioned in Batch 2 (1995-2024), the results of the original PP (SPY/GLD/TLT/BIL) are very similar to the one with SHY instead of BIL. In fact, the results of the latter are slightly better over the analysis period.
• Between 2007 and 2024, using CSBGC0 instead of TLT gives better results in terms of CAGR. This confirms the results already observed with 60/40.
• The Swiss franc (via the FXF ETF) offers a better Sharpe ratio than BIL or SHY.
• PPs with CSBGC0 also show a more favorable Sharpe ratio than those with TLT.
• Using Swiss francs (FXF) and Swiss bonds (CSBGC0) together gives the best Sharpe ratio (including against both benchmarks), with the lowest volatility and the smallest MDD.
• All backtested PPs lost money more than one year in four, compared with just over one year in five for the S&P 500.

The Swiss PP 50% (with CSGC0 and FXF) is therefore the best permanent portfolio tested. With minimal volatility (6.04%) and a perfectly acceptable MDD (-12.45%), it is ideally suited to risk-averse investors. However, as with all permanent portfolios, this comes at the price of a significantly lower return than the market.

Conclusion

Harry Browne's Permanent Portfolio represents a prudent, balanced approach to long-term investing. Although it may underperform more aggressive strategies in certain market conditions, its ability to preserve capital, particularly in times of crisis, makes it an attractive option for investors seeking serenity in their investment journey.

In our next article, we'll explore several ways of going beyond the permanent portfolio proposed by Harry Browne, by using other asset classes. We'll see if this allows us to increase CAGR while keeping risk under control.