By: Larry MacDonald

Mark Yamada’s firm PŮR Investing Inc. puts together portfolios of exchange-traded funds (ETFs) for investors (see previous post for his  ETF screener tool). One thing unique about their approach is the use of “risk budgeting” to select asset allocations.

Risk budgeting is employed by “sophisticated pension plans seeking to maximize their potential returns.” Instead of using a fixed asset mix, they use “constant risk rebalancing” to manage asset allocations.

“Traditional money management often ignores the fact that markets are sometimes more risky than at other times,” notes Yamada. During the tech bubble, those investors guided by a fixed asset mix were trimming equity weights back to a preset allocation such as 60% stocks and 40% bonds. But those guided by risk budgeting would be cutting back on stocks even more and taking stock allocations below 60%.

PŮR’s risk budgeting approach uses volatility as an indicator to make “subtle shifts in the portfolio.” Volatility may be defined as the 252-day moving average of standard deviations of daily changes in the S&P 500 Index. The CBOE Volatility Index (VIX) may also be OK to use “in a pinch,” but has greater variation.

“Before the “tech wreck” the technology sector was 8% of the S&P 500 Index and at the peak it was over 30%! At the same time, the 252-day moving average of the S&P 500 volatility moved from about 12.5 to over 15,” says Yamada.

“When volatility, as defined above, is falling or stable, a more positive market is suggested. More importantly, when volatility is rising, assuming less portfolio risk is indicated.”

Adds Yamada: “We think timing the market is generally a ‘mugs’ game. It’s expensive and hard to do consistently. However, as a form of insuring a portfolio against big negative downdrafts, volatility is an interesting indicator.”

His firm is also investigating use of the ‘VIX ETFs’ (VXZ and VXX) in this context too.