Strategic Allocation

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

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

Which risk-based asset allocation method is best? In their January 2013 preliminary paper entitled “Generalized Risk-Based Investing”, Emmanuel Jurczenko, Thierry Michel and Jerome Teletche present a general framework for risk-based asset allocation depending on two parameters: (1) level of sensitivity to asset return variance and correlation estimates; and, (2) level of tolerance for assets with high return volatilities. Popular strategies such as Minimum Variance (MV, which assumes assets have equal expected returns), Maximum Diversification (MD, which assumes assets have equal expected Sharpe ratios), Equal Weight (EW, which makes no assumptions about expected asset returns or volatilities) and Risk Parity (RP, which assumes assets have equal expected Sharpe ratios and pairwise correlations) are special cases of this general framework. They investigate the theoretical properties of this class of strategies, categorizing them by volatility, market beta, market tracking error, concentration and turnover. They illustrate theoretical conclusions with empirical findings for portfolios reformed monthly based on analysis of a two-year rolling window of individual stock returns. Using mathematical derivations and a large sample of developed market stocks (based on MSCI World composition) during January 2002 through October 2012, they conclude that: Keep Reading

How should investors measure the value of tactical deviations from a strategic asset class allocation? In their December 2012 draft paper entitled “A Framework for Examining Asset Allocation Alpha”, Jason Hsu and Omid Shakernia decompose sources of alpha for a diversified portfolio. Their decomposition assumes prior determination of the strategic asset allocation (policy portfolio), consisting of indexes that proxy for broad asset classes. They define tactical asset allocation (tactical portfolio), also consisting of indexes, as deviation from the strategic allocation. They define manager selection (implemented portfolio) as the set of tradable assets used to implement the tactical allocation. Total alpha is the return of the implemented portfolio in excess of that for the policy portfolio, a combination of excess returns from tactical allocation and manager selection. The excess return of the tactical portfolio over the policy portfolio is the asset allocation alpha, the focus of the paper. Based on prior research, they conclude that: Keep Reading

Does combining different portfolio performance enhancement concepts actually improve outcome? In their December 2012 paper entitled “Generalized Momentum and Flexible Asset Allocation (FAA): An Heuristic Approach”, Wouter Keller and Hugo van Putten investigate the effects of combining momentum, volatility and correlation selection criteria to form an equally weighted portfolio of the three best funds from a set of mutual fund proxies for seven asset classes, as follows:

1. To follow trend, rank funds from highest to lowest lagged total return (relative momentum).
2. To suppress volatility, rank funds from lowest to highest volatility (standard deviation of daily returns).
3. To enhance diversification, rank funds from lowest to highest average pairwise correlation of daily returns.
4. To avoid drawdown, replace with cash any selected fund that has a negative lagged return (intrinsic or absolute momentum). 

Their seven asset class proxies are index mutual funds for U.S. stocks (VTSMX), developed market stocks outside the U.S. and Canada (FDIVX), emerging market stocks (VEIEX), mid-term U.S. Treasuries (VBMFX), short-term U.S. Treasuries (VFISX), commodities (QRAAX) and real estate (VGSIX). They use a default lagged measurement interval of four months for all four selection criteria. Their method of combining rankings for relative momentum, volatility and correlation is simple weighted average (with default weightings of 1, 0.5 and 0.5, respectively). They assume momentum calculations occur at the end of each month, with portfolio changes at the beginning of the next month. Using daily closing prices in U.S. dollars for the seven mutual funds from mid-1997 through mid-December 2012, they find that: Keep Reading

Does mean-variance optimization enhance the performance of currency carry trades (long currencies with high interest rates and short currencies with low interest rates)? In their November 2012 paper entitled “On the Risk and Return of the Carry Trade”, Fabian Ackermann, Walt Pohl and Karl Schmedders compare a dynamic mean-variance optimal carry trade strategy to naive ones. Specifically, they consider a series of monthly investments that are long (short) those of the following currencies with the highest (lowest) associated interest rates: U.S. dollar (base currency), Swiss franc, Euro, Japanese yen, British pound, Australian dollar, Canadian dollar, Norwegian krone, Swedish krona, Singapore dollar and New Zealand dollar. For monthly mean-variance optimization, they estimate currency correlations based on the last 250 days (one year) of daily data and set an annual excess return target of 5% (relative to the risk-free rate), the approximate excess return on the S&P 500 Index over the same period. For naive portfolios, they consider 1 long/1 short currencies, 3 long/3 short equally weighted currencies and the S&P 500 Index total return. Using daily currency values and monthly S&P 500 Index data during January 1989 through June 2012 (using the first year for initial optimization), they find that: Keep Reading

Is equity market liquidity useful as an asset allocation signal? In their November 2012 paper entitled “Liquidity-Driven Dynamic Asset Allocation”, James Xiong, Rodney Sullivan and Peng Wang examine the performance of a dynamic stocks-bonds allocation strategy with weightings based on equity market liquidity. For liquidity measurement, they focus on monthly changes in Amihud illiquidity (aggregating individual responses of stock prices to trading volume), calculated daily for a broad sample of U.S. stocks, averaged over the past six months and detrended. They also consider a similarly calculated monthly change in aggregate stock market turnover as an alternative liquidity measurement. For each measurement, they define high and low expected liquidity premium conditions based on a fixed liquidity threshold. They then use this threshold to define a dynamic asset allocation (DAA) strategy for a simple portfolio consisting of stocks (four U.S. style indexes, a REIT index and MSCI EAFE as separate proxies) and bonds (proxied by the Barclays Capital 1-3 Year Government/Credit Index). The benchmark strategic asset allocation (SAA) is 50% stocks and 50% bonds, rebalanced monthly. The DAA strategy each month allocates 60% (30%) to stocks and 40% (70%) to bonds when the expected equity liquidity premium is high (low), with monthly trading friction 0.1% of the value of the portfolio turned over. Using liquidity calculation inputs since January 1963 and portfolio asset total monthly returns since December 1980, both through September 2010, they find that: Keep Reading

What is the aggregate posture of all investors or, said differently, the asset class allocation of the average investor? In their November 2012 paper entitled “Strategic Asset Allocation: The Global Multi-Asset Market Portfolio 1959-2011”, Ronald Doeswijk, Trevin Lam and Laurens Swinkels estimate the crowd-sourced relative market valuations of investments in ten asset classes: equities, private equity, listed and unlisted (commercial) real estate, high-yield bonds, emerging market debt, non-government bonds (mostly corporate bonds and mortgage-backed securities), government bonds, inflation-linked bonds, commodities and hedge funds since the beginning of 1990. They also estimate the relative valuations of four core asset classes (equities, commercial real estate, non-government bonds and government bonds) since the beginning of 1959. Using annual market valuation estimates from a variety of sources during 1990 through 2011 across all ten asset classes, and during 1959 through 2011 for the core subset, they find that: Keep Reading

How can a risk parity allocation strategy, equally weighting portfolio components by expected risk contribution, not really spread risk? In their October 2012 paper entitled “The Risk in Risk Parity: A Factor Based Analysis of Asset Based Risk Parity”, Vineer Bhansali, Josh Davis, Graham Rennison, Jason Hsu and Feifei Li examine the essential return and risk drivers embedded in a risk parity diversification strategy applied to multiple asset classes. They apply principal component analysis to extract independent (essential) risk factors from return streams for nine conventional asset classes: U.S. equities; international developed market equities; emerging market equities; real estate investment trusts (REIT); commodities; global bonds; long-maturity U.S. Treasuries; investment-grade corporate bonds; and, high-yield bonds. They then test four commercially available risk parity strategy implementations for dependence on the top two essential risk factors, interpreted as risks to global economic growth (proxied by S&P 500 Index returns) and global inflation (proxied by 10-year Treasury note returns). Using returns for the risk factor proxies and the four commercial risk parity portfolios from portfolio inceptions (ranging from January 1990 to July 2009) through May 2012, they find that: Keep Reading

How can positions in emerging equity markets benefit investment portfolios? In their October 2012 paper entitled “How Large are the Benefits of Emerging Market Equities?”, Mitchell Conover, Gerald Jensen and Robert Johnson examine the returns of emerging equity markets with focus on: (1) performance measures that account for return distribution risk and abnormalities; (2) performance by region; and, (3) effects of global economic/monetary environment on returns and diversification power. Using monthly local-currency and dollar-denominated stock index returns and annual GDP estimates for 20 emerging markets as available, along with monthly returns for MSCI developed market MSCI indexes (including MSCI World and MSCI USA) for comparison, during January 1976 through December 2010, they find that: Keep Reading