Objective research to aid investing decisions

Value Investing Strategy (Strategy Overview)

Allocations for August 2022 (Final)

Momentum Investing Strategy (Strategy Overview)

Allocations for August 2022 (Final)
1st ETF 2nd ETF 3rd ETF

Strategic Allocation

Is there a best way to select and weight asset classes for long-term diversification benefits? These blog entries address this strategic allocation question.

Most Diversified Portfolio Performance

Is there a portfolio diversification approach that beats widely used mean-variance optimization and risk parity approaches? In their July 2011 paper entitled “Properties of the Most Diversified Portfolio”, Yves Choueifaty, Tristan Froidure and Julien Reynier compare the performance metrics of their Most Diversified Portfolio (MDP) to those of portfolios based on market capitalization (MKT), equal weight (EW), equal risk contribution (ERC) and minimum variance (MV). They define MDP for a given set of assets as the long-only portfolio with the maximum diversification ratio (weighted average portfolio component volatility divided by aggregate portfolio volatility). They constrain all competing portfolios to be fully invested, long only and unleveraged. For empirical testing, they reform all portfolios semi-annually from the top half of stocks the MSCI World Index by market capitalization. They use a one-year rolling historical window of daily returns to estimate asset volatilities and pairwise correlations as inputs for the MV, ERC and MDP allocations. Using daily and monthly returns for the specified MSCI World Index stocks and contemporaneous monthly Fama-French risk factors (market, size and book-to-market ratio) during 1999 through 2010, they find that: Keep Reading

Performance and Risk of Equity Strategy Indexes

How do “passive” stock indexes constructed from widely researched allocation rules fare against market capitalization weighting? In their March 2013 paper entitled “An Evaluation of Alternative Equity Indices – Part 1: Heuristic and Optimised Weighting Schemes”, Andrew Clare, Nick Motson and Steve Thomas compare the behaviors of eight alternative stock indexes formed from a common universe of relatively liquid U.S. stocks. They consider five heuristic (rules of thumb) and three formally optimized weighting schemes. The heuristic weighting schemes are: (1) equal; (2) diversity (a compromise between market capitalization and equal weights); (3) inverse volatility (based on standard deviations of monthly returns); (4) equal risk contribution (based on past return volatilities and correlations); and, (5) risk clustering (similar to equal risk contribution, but based on ten statistically similar clusters of stocks constructed from 30 industries). The formal optimization weighting schemes are: (6) long-only, constrained minimum variance (lowest expected volatility on the mean-variance efficient frontier); (7) long-only, constrained maximum diversification (designed to maximize portfolio Sharpe ratio); and, (8) constrained risk efficient (designed to maximize the ratio of portfolio downside deviation to standard deviation of returns). They reform indexes at the end of each year, using five preceding years of monthly data to calculate weighting parameters. They also consider a set of ten million randomly selected/weighted portfolios, reformed annually. Their benchmark is market capitalization weighting. Finally, they test the effectiveness of using a 10-month simple moving average (SMA) rule to generate timing signals for each index. Using monthly total returns for the 1,000 largest U.S. stocks re-selected annually during 1963 through 2011, they find that: Keep Reading

MPT Cannot Beat Equal Weight?

Why do optimal portfolios derived from Modern Portfolio Theory (MPT) often lose to simple equal-weight portfolios? In the March 2013 version of their paper entitled “Why Optimal Diversification Cannot Outperform Naive Diversification: Evidence from Tail Risk Exposure”, Stephen Brown, Inchang Hwang and Francis In explore why mean-variance optimal diversification (giving more weight to those assets driving mean-variance efficiency) do not outperform naive diversification (equal-weight). They consider portfolios formed from each of two sets of assets: (1) factor-based sorts of U.S. stocks (effectively equity style indexes); and, (2) individual U.S. stocks. Unlike prior research, they focus on return distribution tail exposures of test portfolios rather than errors in forecasts of mean returns and return covariances for assets used to construct optimal portfolios. They rebalance competing portfolios monthly. For mean-variance optimization, they use a 10-year rolling history to forecast required parameters. They evaluate both long-short and long-only mean-variance optimal portfolios. Using monthly returns for 20 factor-based U.S. stock sorts from Ken French’s library and for a broad sample of individual U.S. stocks during January 1963 through December 2011 (588 months), they find that: Keep Reading

Intrinsic Momentum Across Asset Classes

Is intrinsic (time series) momentum effective in managing risk across asset classes? In his April 2013 paper entitled “Absolute Momentum: a Simple Rule-Based Strategy and Universal Trend-Following Overlay”, Gary Antonacci examines an intrinsic (absolute or time-series) momentum strategy that each month holds a risky asset (U.S. Treasury bills) when the return on the risky asset over the preceding 12 months is greater (less) than the contemporaneous yield on U.S. Treasury bills. He applies the strategy separately to eight risky asset classes: two equity indexes (MSCI US and MSCI EAFE); three bond/credit classes constructed from Barclay’s Capital Long U.S. Treasury, Intermediate U.S. Treasury, U.S. Credit, U.S. High Yield Corporate, U.S. Government & Credit and U.S. Aggregate Bond indexes; the FTSE NAREIT U.S. Real Estate Index; the S&P GSCI; and, spot gold based on the London PM fix. He also evaluates intrinsic momentum strategy performance for a 60%-40% MSCI US-Long U.S. Treasury portfolio and a portfolio consisting of five equally weighted assets, both rebalanced monthly. He assumes a friction of 0.2% for switching between a risky asset and U.S. Treasury bills (T-bill). Using monthly total returns for the eight asset classes as available and 90-day T-bills yields during January 1973 through December 2012, he finds that: Keep Reading

Formal Asset Allocation with Price Trending

Should investors consider a broader framework to encompass trend-following/momentum investing strategies? In his March 2013 paper entitled “Asset Price Trend Theory: Reframing Portfolio Theory from the Ground Up”, Robert Dubois presents a portfolio allocation strategy that explicitly includes an assumption that asset prices trend (exhibit return autocorrelation or intrinsic momentum). His approach augments risk management by including stop-loss protocols to exit allocations to some assets/strategies based on their trends relative to specified thresholds. He defines three strategic allocation segments: (RB1) risk-free assets; (RB2) liquid risky assets/strategies subject to stop-loss exits at the asset and/or portfolio level; and, (RB3) both liquid and illiquid risky assets not subject to stop-loss exits. All three segments are subject to asset/strategy selection, position sizing and entry rules. RB2 arguably allows strong risk management (containment) via trend-related removal of exposure to risky assets with below-trend performance. Elaborating on this framework, he concludes that: Keep Reading

Why the Efficient Frontier Is Unstable?

How stable is the mean-variance efficient frontier specified by Modern Portfolio Theory (MPT), and what drives changes to it? In his March 2013 paper entitled “Principal Component Analysis of Time Variations in the Mean-Variance Efficient Frontier”, Andreas Steiner applies principal component analysis to explore sources of the variability in the efficient frontier. He uses weekly data and rolling 52-week intervals to calculate the efficient frontier (via asset returns, volatilities and correlations) for a long-only, unleveraged portfolio of 22 Swiss stocks. He next discovers purely statistical independent linear factors needed to describe efficient frontier variability (using ten sample points along each efficient frontier curve). He then measures the relative importance of the factors and relates them to common investment performance statistics (average returns, volatilities and correlations). Using weekly returns for the specified stocks during late June 2002 through December 2012 (549 weeks), he finds that: Keep Reading

Lifecycle Funds Guard Against Upside Volatility?

Are target‐date (glidepath) funds that periodically decrease (increase) allocation to stocks (bonds and cash) as the investor ages competitive with alternative strategies? In his February 2013 paper entitled “The Glidepath Illusion: An International Perspective”, Javier Estrada evaluates three alternative types of strategies, all based on a working life of 40 years with annual retirement fund contributions of $1,000 (inflation‐adjusted for a cumulative contribution of $40,000 in real terms):

  1. Lifecycle strategies with initial stock-bond allocations (in percent) of 100‐0, 90‐10, 80‐20, 70‐30 and 60‐40, and respective final allocations of 0-100, 10‐90, 20‐80, 30‐70 and 40‐60. Allocation adjustments are annual on linear glidepaths.
  2. Mirror image strategies that start with 0-100, 10‐90, 20‐80, 30‐70 and 40‐60 allocations and end with 100‐0, 90‐10, 80‐20, 70‐30 and 60‐40 allocations.
  3. Five alternative strategies: fully invested in stocks throughout the 40‐year working life (100×40); fully invested in stocks for the first 20 or 30 years, then shifting annually and linearly out of stocks and into bonds for the remaining 20 or 10 years to end with a 50‐50 stock‐bond allocation (100×20 or 100×30); and, a constant stock-bond allocation of 50‐50 or 60‐40 over 40 years, rebalanced annually.

For each of the World, Europe and 19 developed countries, he generates terminal wealth statistics for 71 overlapping 40-year intervals, the first spanning 1900-1939 and the last spanning 1970-2009. Using real total returns for individual countries (in local currencies adjusted by local inflation) and for the World and Europe (in dollars adjusted by U.S. inflation) during 1900 through 2009, he finds that: Keep Reading

Safe Retirement Withdrawal Rate?

In the current environment of low bond yields, what is a safe investment withdrawal rate during retirement? In their January 2013 paper entitled “The 4% Rule is Not Safe in a Low-Yield World”, Michael Finke, Wade Pfau and David Blanchett model the risk of exhausting wealth for different retirement durations, withdrawal rates, stocks-bonds portfolio mixes and assumptions about future market conditions (stock and bond returns). They model retirement portfolio dynamics via Monte Carlo simulations applied to log-normal return distributions, based on an inflation-adjusted withdrawal rate set at a percentage of investment portfolio value at retirement and annual rebalancing to a target asset allocation (with failure whenever a withdrawal results in a zero balance). They assume withdrawals cover any taxes due and ignore any portfolio fees/frictions. They focus on a 30-year retirement under current market conditions, with bonds yielding an average annual real return of -1.4% (based on current yields for 5-year Treasury Inflation-Protected Securities) and stocks yielding an average annual real return of 4.6% (6.0% equity risk premium over the bond yield). They also consider a case based on 1926-2011 average annual real returns of 2.6% for bonds and 8.6% for stocks, and cases for which current low returns revert to historical averages five or ten years into retirement. Using the specified modeling assumptions and parameters, they find that: Keep Reading

Diversifying Across Tactical Asset Allocation Strategies

How should investors choose among alternative tactical asset allocation strategies? In their January 2013 paper entitled “Rethinking the Asset Allocation Approach for Plan Sponsors”, Pranay Gupta and Sven Skallsjo present a multi-strategy tactical asset allocation framework for very large (institutional) investors. They assume that the strategic asset allocation (portfolio policy) is to maximize capital appreciation with “the highest efficiency” and 90% confidence that annual drawdown will not exceed 10%. In developing their allocation framework development, they consider recent statistics describing the performance and interaction of eight asset class indexes, each able to absorb large investments/rebalancing actions (four global regional equities, global government bonds, global corporate bonds, global high-yield bonds and gold). Using illustrations based on monthly asset class index returns during September 2000 through September 2012, they conclude that: Keep Reading

University Endowment Research Summary

What research is available on investment approaches, allocations and results for U.S. university endowments? In their January 2013 paper entitled “A Survey of University Endowment Management Research”, Georg Cejnek, Richard Franz, Otto Randl and Neal Stoughton summarize available research on university endowment money management and performance. They identify four streams of research: (1) governance structure and investment policy statement; (2) asset allocation; (3) performance; and, (4) spending. Based on this research, they conclude that: Keep Reading

Daily Email Updates
Filter Research
  • Research Categories (select one or more)