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David Stevenson: the Permanent Portfolio beats gold but I'm not sold

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David Stevenson: the Permanent Portfolio beats gold but I'm not sold

Those of us with enough grey hairs (mine are minimal I am assured by my partner, though I think she lies) will have heard of the Permanent Portfolio. In its very simplest incarnation this allocation is a kind of ultra-lazy portfolio for the super cautious. Here’s the mix:  

  • 25% cash
  • 25% long-term bonds
  • 25% stocks
  • 25% gold

The Permanent Portfolio was the brainchild of the late Harry Browne, then the editor of a newsletter called Harry Browne’s Special Reports. In 1996 and 2000, Browne was the Libertarian Party’s candidate for president and I think its fair to say that he was something of a hard currency, gold enthusiast. He believed there were many threats to your wealth, chief of which were what another American investment writer, William Bernstein, called the four horsemen of the financial apocalypse, namely inflation, deflation, government confiscation and civil war devastation.

Precisely because investors want to preserve their capital they should focus on physical gold (good for inflation and not bad in war), cash (very mobile) and ultra safe long duration government bonds (hardly likely to be confiscated by the government that issues them). But investors might also want some exposure to the upside of equities, thus the equities component, probably best satisfied by a diversified bunch of large-cap equities (the S&P 500 perhaps?).

These ideas about the permanent portfolio have become hugely popular amongst the more libertarian spectrum of investors (mostly in America) and we’ve seen endless attempts to replicate the idea – including in this column with my Lazy ETF version. Conveniently though Browne’s ideas have found a tangible legacy in an actual US mutual fund – you can see more details here

The fund doesn’t quite fit Browne’s easy-to-construct formula (gotta justify those fees I guess), with a current allocation of 25% in gold and silver, 20% in US stocks, 25% in US bonds, 10% in Swiss franc assets, and 20% in real estate and natural resource stocks. The box below lists the current holdings in the fund:

Holding % of portfolio
Gold bullion 11.6
Gold coins 9.7
Silver bullion 6.2
2% Swiss confederation bonds, 04-28-21 4
2.25% Swiss confederation bonds, 07-06-20 3.9
5.25% US Treasury bonds, 11-15-28 3.2
6% US Treasury bonds, 02-15-26 2.9
6.25% US Treasury bonds, 08-15-23 2.6
Texas Pacific Land Trust 2.3
Freeport-McMoRan 2.2

How’s the fund performed over the last few decades? The table below has annualised numbers for a series of periods through to 2017, compared to both US stocks and a balanced portfolio composed of 60% US stocks and 40% US government bonds. As you can see the Permanent Portfolio has underperformed for most of the period since 1978 although there have been bouts of outperformance, notably between 1978 and 1982, as well as 2001 through to 2006.

Time period Permanent Portfolio Balanced portfolio 100% US stocks
1978-1982 15.9% 13.5% 15.7%
1983-1988 9.6% 13.1% 14.6%
1989-1994 7% 10.6% 14.5%
1995-2000 8.3% 15.5% 19.7%
2001-2006 7.8% 5.2% 4.1%
2007-2012 9% 5.3% 2.7%
2013-2017 3.5% 9.5% 14.7%
1978-2017 8.7% 10.3% 11.5%

This time last year, the excellent US investment writer Mark Hulbert of MarketWatch took a deeper look at returns for this fund – and the ideas behind it. His bottom line sums it up nicely I think: 'It has handily beaten gold, only slightly beaten bonds, and significantly lagged behind the stock market'.

Digging deeper into the numbers, Hulbert found that 'it is discouraging that the fund came out behind both stocks and bonds on a risk-adjusted basis, since it means that regardless of whether you are a conservative investor or an aggressive trader, you could have made more money with stocks and bonds'.

Hulbert also tested the funds biggest 12-month loss. 'Its biggest came at the end of the financial crisis, when it was 18.6% lower than where it had stood one year previously (I calculated drawdowns using month-end values). Though this 12-month drawdown is worse than for bonds (4.3%), it is markedly better than gold’s (27.8%) and a lot better than stocks' (43.3%).'

So, in sum, this seems to be doing the job asked of it – preserving more capital than just investing direct in equities. But it does lose money in bad years, and it only marginally outperforms a simple bond portfolio.

What about day-to-day volatility? To assess this, Hulbert looked at the sharpe ratio, a measure of whether a fund adds value for the risk it takes. The sharpe ratio is a calculation based on subtracting the risk-free return, such as that delivered by government bonds, and the resulting number is dividend by the standard deviation, or volatility of the fund's returns. The higher the number, the more returns the fund is delivering for the risk it is taking. Hulbert also looked at the standard deviation in isolation, examining monthly returns between May 1986 and April 2018.

The fund's sharpe ratio was  above gold but below bonds and equities while the standard deviation of monthly returns was 2.35% compared to 1.35% for US Treasury bonds. If this all sounds technically challenging, here’s what I think is the bottom line. Over the last few decades a simple investment in a diversified basket of government bonds would have produced similar results, with less volatility compared to the permanent portfolio.

  Monthly sharpe ratio Annualised return Standard deviation of monthly returns
Permanent Portfolio 0.12% 6.2% 2.28%
Stocks 0.15% 10% 4.35%
US Treasury bonds 0.16% 5.9% 1.34%
Gold bullion 0.04% 4.4% 4.41%

Now to be fair to the Permanent Portfolio aficionados, this misses their point I think. They’d remind us that we’ve lived through an epic bout of quantitative easing which has benefited bonds mightily. When this comes to an end (assuming it does, of course), we might face a very different (nastier) economic landscape. At that point hard assets such as gold might be more appealing, as may cash. Bond investors might find they’ve bought a one-way ticket to massive losses as the US government thinks about some form of default if there’s a run on the dollar and someone (China?) starts selling US treasuries.

I have no sensible comment on this hard asset narrative except to say that I think it unlikely. But even I would concede that there is a possibility it might happen. Maybe we will all go to hell in a handcart with deflation or inflation rampant and governments in crisis? Stranger things have been known to happen. And if that does happen, presumably a permanent portfolio will be ideally positioned. In the meantime, you’re probably not being badly rewarded for investing in a mixed bunch of assets.

So, if this idea floats your boat – and I must say it doesn’t do anything for me – how could one go about building a Lazy ETF version of the permanent portfolio?

I’d suggest three simple rules.

  • Rebalance at the end of every year back to the four 25% allocations.
  • Choose the most liquid exchange-traded funds (ETFs)with the largest assets under management and lowest fees.
  • Diversify between issuers so you are not on the hook to one big ETF firm, whoever that may be.

In the table below I’ve outlined what I think might comprise a sensible set of choices for a Lazy portfolio.

I’ve focused on a physically backed exchange-traded commodity for gold, followed by an ETF which invests in money market accounts as a surrogate for cash, in this case the Xtrackers Sterling Cash fund which tracks the Sonia interbank lending rate.

For global equities I’ve picked the deepest, broadest global equity index imaginable, namely the MSCI World index, although I have also included a left field suggestion, namely a global equities basket of higher quality stocks based on a screen from analysts at Société Générale, the Lyxor SG Global Quality Income ETF.

Last but by no means least I have consciously chosen a set of sterling-based government index trackers from a range of ETF issuers – my own preference would be to go for an index-linked basket or a basket of much longer duration gilts.

Asset class % of portfolio ETF Charge Ticker
Physical gold 25 Gold Bullion Securities 0.40% GBSS
    Invesco Physical Gold 0.24% SGLD
Cash or equivalent 25 Xtrackers Sterling Cash 0.15% XSTR
Global equities 25 iShares Core MSCI World 0.20% SWDA
    SPDR MSCI World 0.12% SWLD
    Lyxor SG Global Quality Income 0.45% SGQI
Long-term bonds 25 iShares Core UK Gilts 0.20% IGLT
    iShares GBP Index Linked Gilts 0.25% INXG
    Lyxor Core FTSE Actuaries UK Gilts 0.07% GILS
    SPDR Barclays 15+ Year Gilt 0.15% GLTL

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