Using Robert Lichello's Automatic Investment Management (AIM) System in a Multi-ETF Portfolio
Books Written by Robert Lichello
In our first article titled, “Back-Testing the Robert Lichello Automatic Investment Management (AIM) System for Timing the Stock Market” we explained the basics of Robert Lichllo’s Automatic Investment Management (AIM) system. From that article we learned that AIM can be used to outperform a buy-and-hold investment strategy and to take the emotion out of investing in the stock market. In our second article titled, “A Sensitivity Analysis of the Robert Lichello Automatic Investment Management (AIM) System” we dove a little deeper into the AIM algorithm with a detailed analysis of performance across three different exchange traded funds (ETF). From that article we learned that the type of ETF and the percentage of total money initially invested in the ETF will significantly affect your rate of return. For this article, we want to leverage what we learned so far and use the original AIM algorithm in a scenario that is similar to the way most investment portfolios are set up.
AIM and the Typical Portfolio Structure
Most investors’ portfolios are typically structured so that their money is invested into multiple equity holdings (stocks, mutual funds, or ETFs) and a single Money Market account to hold and distribute cash. Is it possible to do the same thing using AIM? It turns out that it is relatively simple to use the AIM algorithm in this scenario. The main thing to consider is that we have to keep the AIM buy/sell decisions separate for each equity holding, we do not want to “pool” all equity balances into a single decision point. We get an added bonus by pooling all cash from the sale of shares into a single money market account as we should be able to minimize the chance of running out of cash when buying opportunities arise.
More Information on Exchange Traded Funds
Sector ETFs vs. Broad Market Index Funds/ETFs
For this analysis we will illustrate how to use the AIM algorithm to control the buy and sell decisions in a single portfolio containing the State Street Select Sector SPDRs ETFs. Recall from our previous AIM articles we learned that different Sector ETFs provide additional price volatility that is not available in broad stock market ETFs like the S & P Depository Receipts (ticker symbol SPY). State Street Global Advisors sell ETFs that divide the S&P 500 into 9 sectors (Consumer Discretionary-ticker symbol XLY, Consumer Staples-XLP, Energy-XLE, Financial-XLF, Health Care-XLV, Industrial-XLI, Materials-XLB, Technology-XLK, and Utilities-XLU). These nine ETFs will be the foundation of our hypothetical portfolio.
Helpful Websites Focused on Using AIM
Simplifying the AIM Portfolio
In order to keep this illustration simple we will put all nine sector ETFs into a single hypothetical portfolio. For this example we will use an imaginary $10,000 and split it between any single ETF and the money market account, which means we will start with a total of $90,000 in the portfolio. We will also vary the amount initially invested in the ETFs, the different scenarios are shown in the table titled Initial Conditions.
$ Invested per ETF
Total $ Invested in ETFs
Total $ in Money Market
Objectives of This Analysis
So, to summarize, there are two questions we want to answer with the results of this analysis. First will a portfolio of 9-sector ETFs perform better than a portfolio with a single broad market ETF, the S & P 500 ETF (ticker SPY)? Second, can we reduce the risk of running out of cash by pooling all cash from the sale of shares into a single money market account?
Assumptions for This Analysis
It is always necessary to document the assumptions when doing an empirical analysis, here are the assumptions for this analysis:
Total Initial investment amount is $10,000 per ETF/Money Market combination for a grand total of $90,000.
Initial purchase is based on the open price on 12/22/1998.
AIM decisions are based on the closing price on the last trading day of the month.
Buy or sell price is the open price of the stock on the next trading day following an AIM decision.
Buy or sell orders are triggered only if AIM market order is +/- 5% of the current equity value of the portfolio.
Buy or sell commission is $7.95 per transaction.
Cash shortfalls will be funded and the money market account will be set to zero until an ETF sell order is executed.
Rate of return on cash reserve the money market account is 0.5% APR.
Dividends are reinvested in additional shares.
Results of This Analysis
In order to compare results for each portfolio scenario, we will capture the Internal Rate of Return from 12/22/1998 to 9/30/2014 for each portfolio. Fortunately, Microsoft Excel™ has a built in function (XIRR) that we will use to standardize the calculation. In addition to the internal rate of return we will capture the ETF balance, cash balance, total portfolio value, and total cash shortfall during the test period. Finally to make the comparisons more robust we will perform the same exact analysis using a portfolio with just the S & P 500 ETF (ticker SPY).
A summary of the analytic results is presented in the table titled Results. Let’s look closer at these results, first thing that jumps out is that the aggregated portfolios consistently outperformed the portfolio with a single SPY holding. Additionally, we see that the only cash shortfall in the aggregated portfolio occurred when we invested 80% of our money in the equity portion. That cash shortfall was less than half the shortfall experienced with the single SPY portfolio with initial equity investment of 80%. The SPY-only portfolio fell short of cash in two of the four scenarios, 70% and 80% initial equity investments.
The aggregated portfolio outperformed the single SPY portfolio showing a difference in rate of return that ranges from 1.1 to 1.3%. This may seem like a minor increase in isolation, however, when compared to the underlying performance, it really is not trivial. For example, a 7.1% annualized ROR compared to a 6% annualized return is an impressive 18.3% improvement. To further translate this improvement let’s say it takes an extra hour per month to update the 9-ETF AIM portfolio, there are 189 months in the analysis period, and the difference in portfolio value is $17,345. This translates into an equivalent $91.77 per hour payback for our efforts, not a bad wage.
But, let’s see if there is some value to investigating whether a better rate of return in the aggregated portfolio could be gained. Let’s start by looking at how the individual equity holdings performed (note these results take into account the rate of return for ONLY the ETF portion of the portfolio no money market gains are considered). Looking at the table titled Individual ETF Performance we see that the Consumer Staples (Rate of return ranged from 5.6-5.8%), Utilities (7.4-7.5%), Health Care (7.3%), and Financial (7.7%) sectors performed well but actually dragged down the overall rate of return. The Consumer Discretionary (8.8-8.9%) sector had nice moderate returns, but the true shining stars were the Industrial (9.7-9.8%), Materials (10.6-10.7%), and Energy (13.6-13.8%) sectors..
Intuitively from a macroeconomic point of view this makes sense. Economic growth (or decline) is driven by industrial activity (or inactivity) which produces (reduces production of) consumable goods. For industries to produce goods, raw materials are necessary, and to convert those raw materials into revenue producing goods they need energy. Hence, the industrial, materials and energy sectors perform well. Probably an over simplified explanation, but it seems to help explain why these sectors perform better than others.
Now, the next obvious question to ask is, how would a portfolio of just the three best sector ETFs perform? Let’s do a new analysis, one where we have a portfolio that only includes the XLB, XLE, and XLI. This means that the initial amount available to invest is $30,000 ($10,000 per ETF/money market combination). Similarly, we will compare the results to a single SPY portfolio with $30,000 to start with. The results of this analysis are presented in the table titled 3-ETF Results.
From this “cherry-picked” portfolio of three sector ETFs we see that the rate of return increases significantly and ranges from 8.9% to 12.3%, much more impressive than the return with all 9 sector ETFs in the portfolio. Graphically this is shown in the chart labeled Portfolio Rate of Return. Compared to the single-SPY portfolio the difference in rate of return ranges from 3% to 3.9%.
Additionally, we eliminated the risk of running out of cash in the 3-ETF portfolio as there was NO cash shortfall. In the single-SPY portfolio we experience the same risk of running out of cash as a shortfall occurred with initial equity investments of 70% and 80%.
Based on the analytic results we conclude that it is possible to increase the rate of return using AIM to control a portfolio of all 9 sector ETFs vs. an AIM portfolio with a single diversified ETF. However, putting all 9 sector ETFs into a single AIM portfolio we have essentially “averaged out” the high-performing ETFs with the lower-performing ETFs.
Further analysis reveals a set of three sector ETFs (XLB-Materials, XLE-Energy, XLI-Industrial) that have a rate of return between 9.7% and 13.8%. If we put just these three ETFs in a single AIM portfolio the rate of return jumps dramatically into the 8.9-12.3% range, which is a significant improvement.
We find that the single ETF AIM portfolio has a high risk of running out of cash when initial equity investment is 70% or greater. The 9-sector AIM portfolio has less risk as we only observed a cash shortfall with 80% initial equity investment. Best of all, the risk of running out of cash is eliminated in the 3-ETF AIM portfolio.
Finally, to wrap up everything we have learned from this analysis and the two previous analyses, first, we know that using AIM with the S & P 500 ETF (ticker SPY) we can outperform a buy-and-hold investment strategy. Second, we can improve our rate of return even further by decoupling the SPY into an AIM portfolio of its 9 major components. Third, and last, we can push our rate of return into the double-digit realm with an AIM portfolio of the three highest performing ETFs.
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