Strategic Allocation

Is there a tractable way to combine momentum investing with Modern Portfolio Theory (MPT)? In their December 2013 paper entitled “Tactical MPT and Momentum: the Modern Asset Allocation (MAA)”, Wouter Keller and Hugo van Putten present a tactical, simplified, long-only version of MPT that applies momentum to estimate future asset returns. Specifically, they:

1. Make MPT tactical by using short historical intervals to estimate future asset returns (rate of return, or absolute momentum), return volatilities (based on daily returns) and return correlations (based on daily returns), assuming that behaviors over a short historical interval will materially persist during the next month.
2. Exclude from the portfolio any assets with negative estimated returns (i.e., negative returns over the specified historical interval).
3. Simplify correlation calculations by relating daily historical returns for each asset to those for a single index (the equally weighted average returns for all assets) rather than to those for all other assets separately.
4. Dampen any errors in rapidly changing asset return, volatility and correlation estimates by “shrinking” them toward their respective averages across all assets in the universe, and dampen the predicted market volatility by “shrinking” it toward zero.

They reform the MAA portfolio monthly at the first close. Their baseline historical interval for estimation of all variables is four months (84 trading days). Their baseline shrinkage factor for all variables is 50%. Their benchmark is the equally weighted (EW) “market” of all assets, rebalanced monthly. They assume a one-way trading friction of 0.1%. They consider a range of portfolio performance metrics: annualized return, annual volatility, maximum drawdown, Sharpe ratio, Omega ratio and Calmar ratio. Using daily dividend-adjusted prices for assets allocated to nine universes (of seven to 130 assets, generally consisting of asset class proxy funds) during November 1997 through mid-November 2013, they find that: Keep Reading

Is there a simple compromise between easy-to-implement market weights and more diversified equal sector and equal stock weights? In their December 2013 paper entitled “A Simple Diversified Portfolio Strategy”, Bernd Hanke and Garrett Quigley present a stock portfolio construction approach that blends market weights, equal stock weights and equal sector weights. The objectives of the approach (relative to market weights) are: (1) higher returns (by capturing more of the diversification premium); (2) lower risk (via increased diversification); and, (3) competitive capacity and rebalancing frictions (by limiting the tilt toward small, illiquid stocks). In testing this approach, they form and rebalance annually regional (U.S., European and Japanese) portfolios of relatively liquid stocks. They ignore rebalancing frictions. They define sectors via the broadest Global Industry Classification Standard level (ten sectors). Using total (dividend-reinvested) returns, market capitalizations and sector memberships for a broad sample of relatively liquid stocks during January 1992 through March 2013, they find that: Keep Reading

Are there easily implementable life cycle investing strategies reliably superior to the conventional glidepath from equities toward bonds? In their June 2013 paper entitled “The Glidepath Illusion… and Potential Solutions”, flagged by a subscriber, Robert Arnott, Katrina Sherrerd and Lillian Wu summarize flaws in the conventional glidepath approach and explore simple alternatives that address some of the flaws. Specifically, they compare the follow six strategies:

1. 80–>20: the conventional linear glidepath from 80% stocks-20% bonds to 20% stocks-80% bonds at retirement, with market capitalization weighting.
2. 20–>80: inverse of the conventional linear glidepath.
3. 50-50: constant 50% stocks-50% bonds, with market capitalization weighting.
4. Dynamic Bond Duration: the 50-50 strategy, but: (a) hold 20-year bonds for the first 21 years; (b) shift linearly to 10-year bonds during the next ten years; and, (c) shift linearly from 10-year bonds to T-bills during the last 10 years before retirement.
5. Dynamic Value/Low Beta: the 50-50 strategy, but: (a) stocks are weighted by book value for the first 21 years (from the 1,000 U.S. stocks with the highest book value); and, (b) shift linearly to low-volatility stocks (the 1,000 largest U.S. companies by market capitalization, weighted by inverse volatility) during the next 20 years.
6. Dynamic Combined: the 50-50 strategy, but use Dynamic Bond Duration and Dynamic Value/Low Beta for bonds and stocks, respectively.

Comparison tests assume that: (1) each individual makes inflation-adjusted $1,000 annual contributions to a retirement portfolio over a 41-year career; and, (2) portfolio rebalancing is annual, frictionless and tax-free. Using simulations based on long-term samples of U.S. stock index, bond index and U.S. Treasury bill (T-bill) returns through the end of 2011, they find that: Keep Reading

Is diversification across stock and bond factors superior to diversification across asset classes? In their August 2013 report entitled “Investing in Systematic Factor Premiums”, Kees Koedijk, Alfred Slager and Philip Stork measure the gross performances of widely used stock and bond factors and pit portfolios diversified across those factors against portfolios diversified across asset classes. For equities, they examine market, size, value, momentum and low-volatility factors. For bonds, they examine market, term spread, credit spread, high-yield, short-term credit yield and short-term government yield factors. They consider both U.S. and European data as available. They take an institutional perspective and therefore restrict consideration to simple, long-only portfolios. For asset class diversification, they consider stocks-bonds and stocks-bonds-commodities-real estate. They ignore all trading frictions involved in constructing factor portfolios and in rebalancing multi-asset and multi-factor portfolios. Using monthly prices for U.S. and European stocks, bonds, Real Estate Investment Trust (REIT) indexes and a common global commodity index as available through mid-to-late 2012, they find that: Keep Reading

What is the global financial asset allocation? In their November 2013 paper entitled “The Global Multi-Asset Market Portfolio 1959-2012”, Ronald Doeswijk, Trevin Lam and Laurens Swinkels construct the aggregate portfolio of all investors encompassing market capitalizations for eight asset classes: equities, private equity, real estate, high-yield bonds, emerging markets debt, investment-grade credits (corporate bonds and mortgage-backed securities), government bonds and inflation-linked bonds. They exclude human capital (earned income streams), durable goods (such as cars), residences and family businesses. They exclude commodities because the net position in commodity futures is zero. They suggest that these aggregate allocations represent a natural benchmark portfolio for financial investors. Further, they trace the evolution of allocations to the eight asset classes during 1990 through 2012, and the evolution of allocations to equities, real estate, non-government bonds and government bonds during 1959 through 2012. Using a variety of data sources and estimation methodologies, they find that: Keep Reading

Are implied volatility futures good diversifiers of underlying indexes? Do implied volatility futures for different indexes represent a reliable pair trading opportunity? In their November 2013 paper entitled “Investment Strategies with VIX and VSTOXX Futures”, Silvia Stanescu and Radu Tunaru update the case for hedging conventional stock and stock-bond portfolios with near-term implied volatility futures for the S&P 500 Index (VIX) and the Euro STOXX 50 Index (VSTOXX). For this analysis, they use data for the U.S. and European stock market indexes, associated implied volatility futures and U.S. and European aggregate bond indexes from March 2004 for U.S. assets (VIX futures inception) and from May 2009 for European assets (VSTOXX futures inception), both through February 2012. They also investigate a statistical arbitrage (pair trading) strategy exploiting a regression-based prediction of the trend in the gap between VIX and VSTOXX during the last six months of 2012. Using daily data for the specified indexes and implied volatility futures contracts, they find that: Keep Reading

Have investors overwhelmed commercial traders in commodity futures markets, thereby depressing the value of commodity futures as a diversifier of stocks and bonds? In his November 2013 papers entitled “Implications of Financialization for Commodity Investors: The Case of Roll Yields” and “Implications of Financialization for Strategic Asset Allocation: The Case of Correlations”, Adam Zaremba examines the effects of commodity futures market financialization on the potential diversification benefit of a passive allocation to commodities. He quantifies financialization as the share of open interest in commodity futures contracts held by non-commercial traders per Commitments of Traders reports of the Commodity Futures Trading Commission. He investigates specifically the effects of financialization on: (1) roll return, the return from continually shifting from expiring to longer-term commodity futures contracts to maintain a position; and, (2) the correlations of commodity futures returns with those of stocks and bonds. Then, in a mean-variance optimization framework from the perspective of a U.S. investor, he examines how these effects alter the diversification benefit of adding a commodity futures position to stocks and bonds. Using monthly returns of index proxies for the broad U.S. stock market, U.S. government bonds and a broad set of commodity futures from the end of 1991 through 2012, he finds that: Keep Reading

How can retirees optimally segregate reliable income from risky growth? In their November 2011 paper entitled “The Floor-Leverage Rule for Retirement”, flagged by a subscriber, Jason Scott and John Watson examine a retirement allocation strategy that strictly segregates safe income-generating assets (“riskless” bonds) from potentially income-boosting risky assets (stocks). They designate the safe allocation as the floor portfolio, funded to guarantee a real income level in perpetuity. They designate the risky allocation as the surplus portfolio, which invests all remaining funds to capture a risk premium. If the risky assets perform well, the retiree periodically moves funds from the surplus portfolio to the floor portfolio and thereby increases guaranteed income. In assessing this floor-surplus approach, the authors assume that the riskless bonds generate a steady 2% annual real return and that the risky assets offer a 6% annual risk premium with 18% annual volatility (like the U.S. equity markets over the long run). Based on analysis of several case studies using these return assumptions, they conclude that: Keep Reading

Has Modern Portfolio Theory failed to deliver over the past decade because users employ long-term averages for expected returns, volatilities and correlations that do not respond to changing market environments? Do short-term estimates of these key inputs work better? In their May 2012 paper entitled “Adaptive Asset Allocation: A Primer”, Adam Butler, Michael Philbrick and Rodrigo Gordillo backtest a progression of strategies culminating in an Adaptive Asset Allocation (AAA) strategy that incorporates return predictability from relative momentum (last 120 trading days, about six months), volatility predictability from recent volatility (last 60 trading days) and pairwise correlation predictability from recent correlations (last 250 trading days). Their tests employ nine asset class indexes (U.S. stocks, European stocks, Japanese stocks, U.S. real estate investment trusts (REIT), International REITs, intermediate-term U.S. Treasuries, long-term U.S. Treasuries and commodities) and a spot gold price series. They reform portfolios monthly based on evolving return, volatility and correlation forecasts. They ignore trading frictions as negligible for “intelligent retail or institutional investors” via mutual funds or Exchange Traded Funds. Using daily returns for the nine indexes and spot gold) to test six strategies during January 1995 through March 2012, they find that: Keep Reading

Does the conventional wisdom of a declining allocation to stocks throughout retirement really work best? In their September 2013 paper entitled “Reducing Retirement Risk with a Rising Equity Glidepath”, Wade Pfau and Michael Kitces explore alternative stocks-bonds allocations during retirement. They consider retirees planning for annual withdrawals of an inflation-adjusted 4% or 5% of retirement date assets over 20, 30 or 40 years. They consider three scenarios for future stocks/bonds return statistics (see the table below): (1) assumptions prepared for the MoneyGuidePro financial planning software as of July 2013; (2) a pessimistic scenario more closely calibrated to the current low-interest rate environment, but with an historical equity risk premium; and, (3) an optimistic scenario with stock and bond returns based on historical averages for 1926 through 2011. They assume year-end withdrawals and rebalancings of residual assets to target allocations, with withdrawals covering tax obligations. If a withdrawal pushes the account balance to zero, the portfolio fails. They also consider both the potential failure magnitude and upside potential. They consider 11 at-retirement equity allocations ranging from 0% to 100% in 10% increments gliding linearly to each of 11 at-horizon equity allocations ranging from 0% to 100% in 10% increments (a total of 121 glidepaths). Using outputs from 10,000 Monte Carlo simulations for each of the 121 glidepaths for each combination of withdrawal rate, retirement horizon and future return scenario, they find that: Keep Reading