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A Few Notes on Adaptive Asset Allocation

Posted in Strategic Allocation

In the introductory text for Part I of their 2016 book, Adaptive Asset Allocation: Dynamic Global Porfolios to Profit in Good Times – and Bad, Adam Butler, Michael Philbrick and Rodrigo Gordillo state: “…we have come to stand for something square and real, a true Iron Law of Wealth Management: We would rather lose half our clients during a raging bull market than half of our clients’ money during a vicious bear market. …some of you might already be on the verge of change, carrying with you the emotional scars of a turbulent and ongoing battle with the markets. If so, there’s a decent chance that you lost faith in the traditional investment process some time ago and have struggled to find an alternative. We wrote this book for you.” Based on their experience and research, they conclude that:

From Part I, “The Philosophy of Successful Investing”

  • “The only benchmark that you should care about is one that indicates whether or not you’re on track to accomplish your financial goals. …Risk is measured as the probability that you won’t meet your financial goal. Investing should have the exclusive objective of minimizing this risk.”
  • “…many simple models performed with with substantially better calibration than the experts…”
  • “As we live in a probabilistic world, basic statistics allows us to quantify the level of precision around our estimates.”
  • “…great portfolios are not so much the result of superb individual securities, but rather putting together securities that are mutually complementary. …it is significantly more important to understand how the different parts of your portfolio work together than it is to understand the different parts themselves.”

From Part II, “Saving and Withdrawing from Portfolios”

  • “Where volatility gremlins really punch above their weight class is when portfolio distributions come into play…any money taken out of a portfolio when its value is down can’t be used to to regrow the portfolio… …it is far more beneficial to focus on the consistency and stability of returns regardless of the market environment.”
  • “…realize how big a factor luck has been and will continue to be in determining the market regimes that you are subject to throughout your life.”
  • “You must know something about the range of returns around [the] average so that you can create a plan that is resilient to bad luck. The same is true of other critical inputs into the retirement equation like lifespan…and inflation.”
  • “…volatility and sequence of returns matter tremendously. Volatility determines the range of potential outcomes as well as the amount of income that can ultimately be drawn out of the portfolio. Sequence of returns matters because the returns achieved while a portfolio is near its largest value–which is generally in the years leading up to and early on in retirement–disproportionately impact whether investors will achieve their financial goals.”

From Part III, “Current High Valuations Mean Lower Future Returns”

  • “The best forecast for future real equity returns integrating all available valuation metrics is essentially 0% per year over horizons covering the next 10 to 20 years.”
  • “…we can confidently say that there will be a much better opportunity to buy quality stocks down the line when prices are significantly lower than they are today. When the market’s day of reckoning finally arrives, it will be much better to have missed the crash than to have missed some gains along the way to it.”

From Part IV, “An Investment Framework for Stability, Growth, and Maximum Income”

  • “…different types of assets react in different but logical ways to each of the [four] different economic regimes. …A robust investment universe contains assets that do well in each of the marjor regimes. …a portfolio won’t be stable if most of the assets in the universe are favorable to just one or two regimes.”
  • “…robust risk parity methods [considering expected volatilities and correlations] have the potential to outperform both the equal weight and naive risk parity [inverse volatility].”
  • “Examining our 10-asset universe, the probability that a top half six-month performer (in other words, one of the best five performing assets over the previous six months) will deliver returns in the top half over the subsequent month is 54 percent using a sample period from January 1995 to the present. Those odds might seem minor, but the spread is statistically significant and provides a meaningful edge over time.”
  • …by integrating all three dynamic portfolio parameters [expected volatilities, correlations and returns], this approach delivers an impressive Sharpe ratio of 1.60. The maximum drawdown is a paltry -8.8 percent, and portfolio volatility is a stable 9.4 percent. On top of these impressive risk controls, returns also improve to 15 percent…”

From Part V, “Why You Should Trust the Research”

  • “By using a global asset class-based approach with minimal degrees of freedom tested over multiple economic regimes, we maximize the odds that future outcomes will resemble the past.”
  • “It is clear that investors who dismiss tactical alpha as a source of active returns are ignoring a meaningful source of excess risk-adjusted performance.”

In summary, investors may find Adaptive Asset Allocation a useful guide to constructing a portfolio that exploits diversification across economic regimes (asset classes) with risk-based weighting and a momentum boost.

Cautions regarding conclusions include:

  • The financial world may not be confidently probabilistic. Conventional statistical methods presume reasonably well-behaved inputs. The internal and external interactions of complex financial systems may generate wild return distributions that confound statistical interpretation.
  • Using indexes to estimate returns of exchange-traded funds (ETF) before their introduction may understate impacts of the management and administrative costs of maintaining liquid funds. Such modeling also ignores feedback of ETF trading on markets.
  • There may be some data snooping bias inherited from prior research in selection of a six-month measurement interval for asset return momentum. There may also be some snooping bias in asset universe selection (perhaps mitigated by testing asset return behaviors across economic regimes). Snooping bias inflates expected performance.
  • To the extent that complexity of the proposed investment strategy drives an investor to retain an investment advisor or manager, the investor loses some marginal performance to fees.
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