Safe Investment Asset Strategy – What Is The Safest Investment Asset? (Meb Faber Strategy Explained)

Is there a safe investment asset strategy? A while back, Meb Faber published a white paper called What Is The Safest Investment Asset. Faber wanted to answer if there is such a thing as the safest asset in the world.

In this article, we use the ideas of Meb Faber to create a safe investment asset strategy. By adding diversification we reduce risk and drawdowns, but lose some of the returns.

Today, the financial system offers many financial instruments that belong to different asset classes such as stocks, bonds, gold, commodities, REITs, etc. These asset classes can be divided into different categories (subclasses).

For example, stocks can be divided into the following categories: u.s. stocks, international stocks, small-cap stocks, large-cap stocks, emerging market stocks, value stocks, growth stocks, etc.

The main difference between different asset classes is their returns and risk. For example, bonds are considered less profitable and less risky than stocks. But not always.

Related reading: – Looking for an investment strategy? (We have plenty more)

Meb Faber on safe investment strategy

What is the conclusion from Meb Faber’s white paper about what is the safest investment asset? The conclusion is simple: there is no safe investment strategy. You always face the risk of losses because of temporary or permanent drawdowns.

Just look at the table from his white paper:

Stocks, the best asset to own over time, have proven to return very negative returns over a 10-year period.

But is there a way to avoid or at least reduce potential losses? Yes, that involves diversification. You need to combine assets to build a “minimum loss” portfolio.

Just look at the table below that shows the effect of combining assets:

If you are uncertain what 60/40 means, please read 60/40 portfolio – the historical returns of the portfolio.

The GAA portfolio consists of many asset classes. But as you can see, by combining assets, you give up some real return, but you lower max drawdown as well as the worst 1, 3, 5, and 10-year scenario.
scenarios.

If you want to read more about the GAA portfolio please read our article called Meb Faber Global Asset Allocation.

Let’s go on to explain our take on a safe investment asset strategy:

What is the safe investment asset strategy?

In our opinion, a safe asset is an asset that has the following properties and characteristics:

• An asset that has a high return-to-risk ratio. Taking into account return without risk and risk without return does not make any sense. Risk is defined as price variability and drawdowns. Return and risk are interrelated;
• Its long-term returns are clearly outpacing the inflation rate, i.e. this asset must unequivocally protect the purchasing power of money from the damaging effects of inflation. Otherwise, such an asset does not make any sense unless its diversification effects soften drawdowns significantly;
• An asset must be of high quality. If these are stocks, then the company should have a strong balance sheet and more or less stable profits. If it is a corporate bond, then additionally, the net profit of the company must be at least five times higher than the interest expense;
• An asset must be reasonably balanced and diversified. Over-diversification does not reduce risks, but on the contrary, it can increase risk because it forces you to include assets of lower quality in the portfolio. Therefore, diversification should be reasonable and justified/backtested;
• An asset must have a long history of performance. The logic is simple – if an asset could last 50 years, it will most likely last the next 50 years (the Lindy Effect). Young assets without a solid history are somewhat risky instruments, but as always, there can be exclusions.

The safest assets that 100% guarantee the safety of your funds do not exist; you need to invest in various relatively safe asset classes with a high reward-to-risk ratio.

Measuring the safety of assets

Various metrics are used to measure the returns and risk of assets, such as the Sharpe Ratio, the Sortino Ratio, the ratio of the average annual return to the maximum drawdown, etc.

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• Max drawdown – why it matters

All of these metrics have many disadvantages, so we will not use them. For example, the maximum drawdown metric is a statistically insignificant indicator because it uses only the maximum one.

However, research shows that most retail traders buy at rising prices and sell at falling prices, thus underperforming massively over time. Women have proven to be better investors because they buy and “forget” about it – they are not trying to be innovative. From a behavioral viewpoint, max drawdown matters; please read or take on investing biases.

Instead, we use average drawdown. Unlike the maximum drawdown, the average drawdown is calculated from all drawdowns, including the maximum one.

Root mean square, unlike the simple mean/average, “punishes” big/deep drawdowns, which is what we need.

As a result, we will use our own ratio of the average annual return minus the risk-free rate to the root mean square drawdown:

Reward/Risk Ratio (RR)= 100 * (Average Annualized Return – Risk-Free Return) / Abs(Root Mean Square Drawdown).

If the Reward/Risk Ratio is negative, the asset is unequivocally considered unsafe because it succumbs to inflation and does not protect the investor’s funds.

Backtesting methodology for finding safe assets

We will backtest asset classes and their categories in the form of ETFs. The backtesting methodology is as follows (read here for how to backtest an investment strategy):

• Only established ETFs with reasonable and competent diversification, high liquidity, and long-term historical performance are used;
• All ETF quotes are adjusted for dividends (for stocks) and for fixed interest payments (for bonds);
• The backtesting interval is from 2003 until today (20 years) because backtesting must be statistically significant;
• All ETFs are ranked by statistically significant RR Ratio over 20 years. The higher the RR Ratio, the safer the asset over a long-term time horizon;
• The risk-free rate is 3% (long-term average US inflation rate).

Safe assets among stocks

For the stock asset class, we have selected the following stock categories with their respective ETFs:

Asset Category	ETF Name	ETF Ticker
Large-, Mid-Cap Blend	SPDR S&P 500 ETF Trust	SPY
Small-Cap Blend	iShares Russell 2000 ETF	IWM
Large-, Mid-Cap Value	Vanguard Value Index Fund	VTV
Small Cap Value	Vanguard Small Cap Value Index Fund	VBR
Large-, Mid-Cap Growth	Invesco QQQ Trust	QQQ
Small Cap Growth	iShares Russell 2000 Growth ETF	IWO
Large-, Mid-Cap International Blend	iShares MSCI EAFE ETF, ex. USA	EFA
Small-Cap International Blend	iShares MSCI EAFE Small-Cap ETF, ex. USA	SCZ
Emerging Market Blend	iShares MSCI Emerging Markets ETF	EEM

According to the results of our backtesting over the last 20 years, the safe assets among stocks are as follows (blend stocks are both value and growth stocks):

ETF Ticker	Annual Return (%)	RMS Drawdown (%)	RR Ratio	Rank
QQQ	14.71	-14.4	81.31	1
SPY	10.03	-14.22	49.44	2
IWM	9.34	-15.9	39.89	3
IWO	9.71	-17.39	38.59	4
VBR	8.61	-15.78	35.56	5
VTV	8.36	-16.44	32.59	6
EEM	8.35	-21.75	24.59	7
EFA	6.62	-19.67	18.42	8
SCZ	3.56	-20.53	2.73	9

• Blend and growth stocks (QQQ, SPY, IWM, IWO) are the safest in our ranking, especially large-cap stocks;
• Surprisingly, value stocks (VTV, VBR) are less safe than growth and blend stocks;
• Emerging markets and international stocks (EEM, EFA, SCZ) lose out to US stocks in terms of safety;
• All stock categories can protect against inflation but be careful with stocks with the lowest ranks (SCZ).

Safe assets among bonds

For the bond asset class, we have selected the following bond categories with their respective ETFs:

Asset Category	ETF Name	ETF Ticker
Long-term Government	iShares 20+ Year Treasury Bond ETF	TLT
Mid-term Government	iShares 7-10 Year Treasury Bond ETF	IEF
Short-term Government	iShares 1-3 Year Treasury Bond ETF	SHY
Ultrashort-term Government	iShares Short Treasury Bond ETF	SHV
Corporate Investment Grade	iShares iBoxx $ Investment Grade Corporate Bond ETF	LQD
Corporate High Yield	iShares iBoxx $ High Yield Corporate Bond ETF	HYG
International Government	iShares International Treasury Bond ETF	IGOV
Emerging Markets Government	iShares J.P. Morgan USD Emerging Markets Bond ETF	EMB
TIPS (Treasury Inflation-Protected Securities)	iShares TIPS Bond ETF	TIP

According to the results of our backtesting over the last 20 years, the safe assets among bonds are as follows:

ETF Ticker	Annual Return (%)	RMS Drawdown (%)	RR Ratio	Rank
LQD	4.29	-5.67	22.73	1
HYG	4.3	-7.02	18.5	2
TIP	3.5	-4.4	11.36	3
EMB	3.82	-8.08	10.15	4
IEF	3.53	-5.93	8.92	5
TLT	4.26	-14.3	8.79	6
IGOV	-0.17	-11.37	-27.88	7
SHY	1.62	-1.11	-125.16	8
SHV	1.03	-0.07	-2899.03	9

• Traditionally considered junk, corporate bonds (LQD, HYG) are actually the safest bonds with the highest RR ratios;
• International and short-term US government bonds (IGOV, SHY, SHV) are failing to reach the top ranks, which not only does not protect against inflation, but also causes losses;
• TIPS (TIP) does a good job of protecting against inflation. They are much better than short-term treasuries.

Safe assets among REITs

For the REIT asset class, we have selected the following REIT categories with their respective ETFs:

Asset Category	ETF Name	ETF Ticker
U.S. Real Estate	iShares U.S. Real Estate ETF	IYR
International Real Estate	SPDR Dow Jones International Real Estate ETF	RWX

According to the results of our backtesting over the last 20 years, the safe assets among REITs are as follows:

ETF Ticker	Annual Return (%)	RMS Drawdown (%)	RR Ratio	Rank
IYR	8.03	-24.43	20.59	1
RWX	-0.42	-28.82	-11.88	2

• US REITs are quite safe; their annual returns are at least two times higher than the inflation rate;
• International REIT is an unsafe and unprofitable subclass that does not protect against inflation.

Safe assets among commodities

For the commodities asset class, we have selected the following commodities categories with their respective ETFs:

Asset Category	ETF Name	ETF Ticker
Diversified Commodities	Invesco DB Commodity Index Tracking Fund	DBC
Base Metals	Invesco DB Base Metals Fund	DBB
Energy	Invesco DB Energy Fund	DBE
Agriculture	Invesco DB Agriculture Fund	DBA
Precious Metals	Invesco DB Precious Metals Fund	DBP

According to the results of our backtesting over the last 16 years, the safe assets among commodities are as follows:

ETF Ticker	Annual Return (%)	RMS Drawdown (%)	RR Ratio	Rank
DBP	4.77	-34.28	5.15	1
DBC	0.32	-54.63	-4.9	2
DBE	-0.83	-65.66	-5.83	3
DBA	-0.65	-47.56	-7.67	4
DBB	-0.96	-37.47	-10.57	5

• Only precious metals (DBP) are safe asset that can protect against inflation;
• Rest commodities are “useless junk” with deep drawdowns and near-zero or negative returns.

Safe investment asset strategy portfolio – backtest, returns, and performance

Let’s make a portfolio somewhat similar to Meb Faber’s based on the Global Asset Allocation portfolio (GAA) as described above. We have picked the best assets from each asset category. The only change we have made is to include gold in the portfolio mix.

We make the following weightings into different assets and asset classes:

Asset/ETF	Weight
QQQ	10
SPY	10
EFA	15
EEM	7
LQD	20
TIP	5
EMB	15
IYR	6
DBP	6
GLD	6

How has this strategy performed since 2003?

This is what the equity curve looks like:

The annual returns are 7.5%, and max drawdown is 36% – significantly lower than S&P 500’s. However, the portfolio suffered a drag from poor international performance.

Safe investment asset strategy – conclusion

The results of our backtesting show that the following popular and established opinions might be false:

• Myth (?): Corporate bonds are junk bonds and treasury bonds are safe bonds. This is not true based on our RR Ratio. Corporate bonds are the most reliable and highly profitable, while short-term treasury bonds are unprofitable and unsafe;
• Myth (?): Value stocks are better than growth stocks, and small-cap stocks are better than large-cap stocks. This is not true based on our RR Ratio. Value stocks are less safe than growth stocks and blend stocks. Large-cap stocks are safer than small-cap stocks.

You can make your investment strategy safer by eliminating known unsafe assets in advance. However, keep in mind that just because an asset has been flawless and safe in the past does not mean it will perform similarly in the future.

FAQ:

How does diversification contribute to a safe investment asset strategy?

Diversification is a key strategy to reduce risk and drawdowns in an investment portfolio. While it may lead to a sacrifice in returns, combining assets can create a “minimum loss” portfolio. The financial system offers various asset classes, including stocks, bonds, gold, commodities, REITs, etc. Each of these classes can be further divided into categories or subclasses based on their characteristics and risk-return profiles.

How does the suggested safe investment asset strategy portfolio perform?

The suggested portfolio, including assets like QQQ, SPY, EFA, EEM, LQD, TIP, EMB, IYR, DBP, and GLD, has an annual return of 7.5% with a maximum drawdown of 36%. Despite a drag from poor international performance, it shows lower drawdowns compared to the S&P 500.

What myths about investment safety are debunked by the backtesting results?

The backtesting results challenge common myths, such as the perception that corporate bonds are junk and treasury bonds are safe. It suggests that corporate bonds are reliable and highly profitable, while short-term treasury bonds may be unprofitable and unsafe.