Are You Ready for This “BR-OLATILITY”?

So Brexit happened, or is happening, or will happen effectively very soon.

This is what the US equity markets are waking up to, and despite the massive flow of information, no one really knows what the effects will be of what is happening.

Markets respond negatively to surprises and lack of clarity with huge spikes and volatility that can eliminate six months of returns in a single day. Today, the Volatility Index is opening up about 20% on Brexit.

The question on all investor’s minds right now is “what do we do?”. We will answer that later, but I want to start with what we have done at Toroso to prepare for events like this in our portfolios.

Our planning process begins with what we consider to be the most important investment question: what are your goals, needs and priorities as a client and which Phase are you in life?

As you can see from the chart below, the Toroso investing glide path differs from traditional MPT risk based allocations in that we combine goals based portfolios of Growth, Wealth Preservation and Income to target a client’s true time horizon and risk tolerance.

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Once we understand your goals, the immediate question arises: “How much of your assets need to be available in a time of distress?”

untitledWe allocate that “always available amount” to our core wealth preservation strategy, the Toroso Neutral Allocation Strategy, to preserve wealth and compound returns. All Toroso strategies are designed through a combination of alternative asset allocation and in-depth fundamental ETF security selection. More specifically, the asset allocation for the Toroso Neutral Allocation Strategy is based on Harry Browne’s permanent portfolio allocation, which has historically provided returns of about 8% with 1/3 of the volatility of US equities. The allocation is predicated on equal weighting of four asset classes (25% per asset class): Equities, Commodities and other alternatives, Cash equivalents and Bonds that independently thrive in one of four possible economic environments: prosperity, inflation, recession and deflation.

Next, we build our portfolio through a process of in-depth fundamental security selection. We exclusively use ETFs and attempt to find themes that will provide excess returns to the core benchmarks that represent each asset category. So far, the equity component is showing significant volatility to Brexit pressures. Fortunately the cash and bond positions appear to be holding value. Additionally, the commodity allocation is heavily weighted toward gold, which is rallying substantially in reaction as a safe haven investment.

After answering the first question, we ask investors is “Do you need current income from investments?” As you can see from the glide path chart above, we believe the Income Portfolio is usually appropriate for retirees in the distribution phase of their investing life cycle.

Our Target Income Strategy employs a barbell approach to balance two components: the portion of the strategy in higher yielding securities meant to drive the majority of the yield, and the low risk portion of conservative, cash equivalents which allows for the opportunity to tactically increase allocations to higher yielding securities when markets permit. Currently 5% Target Income model is 51% allocated to safety component with very little exposure to European bonds or dividend paying preferred stocks. We feel well positioned to mitigate the volatility expected in the high yield market from Brexit.

The third question we ask is “Do you prefer a moderate or aggressively diversified growth portfolio?” In our glide path above we allocate all assets not in wealth preservation or income to one of our two growth strategies: Sector Opportunity or Global Alpha.

The Sector Opportunity Strategy seeks to outperform the S&P 500 Index while maintaining lower volatility than the market. We strive to quantitatively select superior sectors – those better positioned to outperform the market using job figures, relative profitability, and GDP impact – for 80% of the portfolio, while allocating the remaining 20% to volatility based ETFs using historical and forward-looking market volatility trends. Through tactical rebalancing, this volatility component strives to opportunistically enhance up and down market capture, or collect the implied volatility premium during sideways markets.

Coming into the Brexit vote the volatility portion was positioned in a very conservative manor: one third cash, one third Wisdomtree CBOE Put Write ETF (PUTW), and one third Quantshares Anti Beta ETF (BTAL).
The three most important take a ways from our positioning are:

1. No current VIX short exposure (The VIX is opening up about 20% on Brexit)

2. BTAL is designed to provide positive returns when the market drops violently

3. We exited the Financial Equity sector ETF two months ago

Our other growth portfolio is the Global Alpha Strategy, which has the most exposure to Europe. It is an equity ETF portfolio that strives to outperform the MSCI All World Index (ACWI) while maintaining similar volatility. The portfolio maintains geographical diversification similar to ACWI, but employs smart beta and active strategies to encompass securities usually absent or underweighted in traditional indexing and is designed to produce a high level of active share.

In the last few weeks we have positioned this portfolio more conservatively. We exited, with substantial gains, our position in VanEck Vectors Morningstar Wide Moat ETF (MOAT) in search of more diversification and protection, which we believe we found in Rex Gold Hedged S&P 500 ETF (GHS). Gold can be an important part of a diversified investment portfolio because its price historically increases in response to events that cause the value of paper investments, such as stocks, bonds and fiat currencies, to depreciate. The REX Gold Hedged S&P 500 ETF (GHS) provides equal simultaneous exposure to many of the benefits inherent to gold and large US equities.

We did not anticipate a Brexit. We simply prepared for volatility in general, through a concise glide path combined with goals-based asset allocation and intelligent security selection.

We feel we were prepared, so now we can answer the question on everyone’s mind our way: “What do we do now?” We wait to buy. When positioned properly, panic is opportunity.