The proliferation of Exchange-Traded-Funds (ETFs) have made it possible to emulate relatively sophisticated investing strategies involving holding uncorrelated asset categories. What are those?

Gold and U.S. stocks don’t necessarily always move together, nor do they necessarily move in opposite directions, so they are not correlated. Same thing for bond prices versus stocks. Sometimes they move together and sometimes they go in opposite directions.

Mutual Fund Pioneer
The Permanent Portfolio mutual fund (PRPFX) that I mentioned in a recent column was one of the pioneers in terms of holding uncorrelated assets. Started in December 1982, Permanent Portfolio has recorded only four losing years: 1984 (down 13%), 1990 (down 4%), 1994 (down 3% and 2008 (down 8%). Over the past 10-years, the fund has produced average annual returns of 11%, compared to 2% for the S&P 500.

Permanent Portfolio achieved those numbers by holding never-changing percentages of unrelated assets, specifically, gold (20%), silver (5%), Swiss francs (10%), U.S. Treasuries (35%), real estate and natural resources (15%), and aggressive growth stocks (15%).

As good as the Permanent Portfolio returns are, recent research suggests that you can probably do even better by taking the strategy one step further. Instead of holding fixed percentages, hold only the strongest assets in terms of recent price action and convert the underperforming assets to cash.

Variable Uncorrelated Portfolio
Inspired by the Permanent Portfolio’s returns and by the promising results reported for the newer variations, I devised my own version, which I call the Variable Uncorrelated Portfolio. In theory, it looks promising.

I say “in theory,” because I didn’t test it in real time using real money. Instead, I backtested the strategy using ETFreplay.com (www.etfreplay.com), a mostly pay site designed specifically to facilitate such testing. If you’re not familiar with the term, backtesting is a process that allows you to, in effect, go back in time, build a portfolio based on your selection strategy, and then see how your portfolio would have fared had you actually bought the ETFs back then.

My test assumed that I started on December 31, 2006 and ended on November 27, 2010. So it covered all of 2007, 2008, 2009, and the first 11 months of 2010. As you may recall, 2007, 2008, and early 2009 were not the best of times for the market. In fact, $100 invested in the S&P 500 on December 31, 2006 would have shrunk to $84 by November 27, 2010. By contrast, $100 invested following my Variable Portfolio strategy would have grown by 50% during the test period. The maximum drawdown (loss due to a short-term downdraft) was 9% for my strategy vs. 51% for the S&P.

Here are the details.

The Portfolio
My portfolio, which is a variation of the Permanent Portfolio mutual fund’s portfolio, includes eight ETFs. Here’s the list, including the corresponding asset categories.

•  iShares MSCI Emerging Markets (EEM): Emerging Markets Stocks

•  Swiss Franc Currency Shares (FXF): Currency

•  SPDR Gold Shares (GLD): Precious Metals

•  iShares S&P Europe 350 Index (IEV) Europe Stocks

•  iShares DJ U.S. Oil Equipment & Services (IEZ): U.S. Energy Stocks

•  PowerShares Emerging Markets Bond (PCY): Emerging Markets Bonds

•  iShares Silver Trust (SLV): Precious Metals

•  SPDR S&P 500 Index (SPY): U.S. Large-Cap Stocks

Unlike the Permanent Portfolio, you wouldn’t necessarily hold all eight ETFs at any given time. Here’s how it works.

The Rules
Start by allocating equal dollar amounts to each of the eight ETFs, but only purchase ETFs that are trading above their 200-day moving-averages. If you’re not familiar with the term, a moving average is simply the average closing price of a stock or fund over a specified period. Stocks or funds trading above their moving averages are said to be in uptrends, and vice versa. I picked the 200-day moving average, which tracks relatively long-term trends, because most of the research that has been reported on this topic was based on the 200-day MA.

Instead of buying the ETFs trading below their moving averages, use the same cash to buy the iShares Barclays 1-3 Year Treasury Bond ETF (SHY). You can use Yahoo (finance.yahoo.com), or many other financial sites to determine whether the each ETF is trading above or below its 200-Day MA.

Repeat the process monthly. You don’t have to wait until the first of a month to start. Any day works as long as you are consistent and reallocate your funds on the same date of each month.

As you’ve heard so many times, “past performance is no guarantee of future results,” so don’t put all of your eggs in this basket. A better approach might be to do practice trades without using real money until you get a feel for whether the strategy works or not.

published 2/13/11