Few years back, I wrote a post where I constructed the efficient frontier curve based on a combination of 2 assets: biotech stocks (large cap and mid cap) and US treasury bills (see here). The sample included the returns of the two asset types between the period June 2007 – December 2016. In this updated version, I have made the following modifications:
- Extended the period to November 2019
- Mid cap: the mix has been slightly changed to include companies with market cap between $2B and $10B (as of November 2019) and excluded companies that have been acquired. Therefore, this basket consists of: Alkermes, Jazz Pharmaceuticals, OPKO Health, United Therapeutics, Exelixis, Neurocrine Biosciences, Alnylam Pharmaceuticals, ACADIA Pharmaceuticals, Vertex Pharmaceuticals, Sarepta Therapeutics, Lexicon Pharmaceuticals, Assertio Therapeutics, and Emergent BioSolutions
- The S&P 500 / TBill combination has been included
Incorporating the changes above, the following efficient frontier graph is produced:
It is clear that over the 13-year period, the clear portfolio winner is LargeCap in combination with MidCap and Treasury bills. Maximum return with minimum risk is achieved with an allocation of 60% LargeCap, 20% MidCap and 20% Treasury Bills. The S&P 500 seems to significantly underperform LargeCap and MidCap biotech, possibly because the time period covered in the sample includes the 2008 crisis where the S&P took more than 4 years to recover. So what would the graph look like if crisis period is excluded?
Excluding the financial crisis period from the sample significantly improve the long-term returns of the S&P 500. But what can be inferred from these results? Essentially, Biotech is more resistant to any market downturns as the need for innovative medicines is always there and therefore a crisis would have less of an effect in the risk / return correlation. In opposite, the S&P 500 is a well diversified index that includes equities from various industries most of which would be impacted in a financial meltdown. Drawing upon recent events, a similar conclusion can be drawn between how a tech stock portfolio behaved in the midst of the COVID crisis vs. the performance of the S&P.
But is it realistic to exclude the crisis period from the sample? Isn’t a crisis part of the economic cycle? This is where active portfolio management comes into play. Holding any optimum portfolio combination passively, and in the long-term, will return about 8% to 14% (based on risk preference – see the 1st graph). Understanding the market (but not timing it – as no one can actually time it) and its signals can help you optimise your portfolio along the way. No one could predict the 2008 crisis but there were signals that something was off.
Many say that there is a stock market bubble right now. While the pandemic made short-term market corrections the S&P 500 recovered (but also hit new records) very quickly on the expectation that a vaccine will be widely available soon, there are now signals that the market is currently overvalued. This perception is probably driven by tech stocks, which have a significant weighting on the market.
Assuming that one holds an S&P 500 weighted portfolio since its last recovery from the previous crisis i.e. from 2013, and does believe that a market crush is inevitable in a year or so, he/she could liquidate all or part of the portfolio and weight it towards equities that are more resistant to market crushes (one of which is biotech).
Overall, there is no single optimal allocation strategy. A well constructed portfolio can be weighted on the S&P 500 or on equities that have low correlation with overall market performance, but this should be revised if there are signals of a market downturn.