Today we are covering the most impact full ideas I have discovered since taking a closer look at asset allocation following the mkt downturns in the fall of ’08 and this past spring. We are going to look at 1)theory and strategy, 2)fat tails and fractals, 3) a secular market perspective and then I’ll show you the opportunities available to improve and protect a typical moderate aggressive strategic allocation portfolio of 70% equities and 30% debt.
3 The first rationale theory tied to the bell curve and market efficiency originated in 1900 in a paper called Theory of Speculation by Louis Bachelier. The paper analyzed changes in French bonds and was not considered to be a monumental work but it did receive “honorable mention” by the University of Paris. Little did Bachelier know that his theory on uncertainty would be picked up 52 yrs later by Harry Markowitz in his paper on Security Selection and Modern Portfolio Theory. Later Bachelier’s theory on probability, chance, and “fair game” would be resurrected in 1956 by MIT student Paul A. Samuelson in his thesis on option pricing. Sharpe then developed the Equilibrium Theory and CAPM. Then came Eugene Fama with his theories on the random walk of securities and the inclusion of information into security prices. Later came Fischer Black and Merton Scholes with their landmark theory on pricing options. Much of this work with the exception of Black & Scholes, has culminated in popular models and applications such as strategic asset allocation where as we know the primary risk and return focus is std dev and relative returns. From the book Unexpected Returns, Ed Easterling does a masterful job of describing SAA as a sailing approach to investing which does well during secular bull markets.
3 The main industry dialogue is the controversy surrounding CAPM, MPT and Strategic Asset Allocation derived from the harsh reality that the theory and strategy have been turned on it’s head as a consequence of market meltdowns and what some are identifying as a secular bear in equities that started in 2000. For example, our moderate plus clients with an expected time horizon of 10 years have experienced lower returns and much higher risk compared to their more conservative peers.
3 For advisors, the primary discourse today lies in the dilemma caused by an increase in correlations across asset classes during the equity market meltdowns of ’08 and ‘09. While it is true that alternatives do act like good diversifiers and reduce standard deviation over long holding periods, the reality is they proved to be of no help in the fall of ’08 when all asset classes moved down in tandem. As you can see the largest int’l bond, precious metals, bond and commodities funds had enormous spikes in their 12 month correlations. We’ll see later how Sallie Krawcheck head of BOA/Merrill’s advisors succinctly frames the new asset allocation paradigm which get’s to the heart of the correlation and drawdown issue.
3 While it may be commonly thought that treasuries would be a safe haven when equities experience drawdowns of 10% or more, these stats prove otherwise. The reality is that using a 12 mo equity/treasury correlation trigger of zero and 0.20 or below for 36 mo correlations then since ’26 you would have been wrong 38% and 42% of the time respectively for draw downs of 10% or more.
3 Watson Wyatt recently re-defined risk management. They now believe risk mgmt must identify risks beyond normal distributions and 2 std deviations.
More on the current state of asset allocation…here’s Ren Cheng, the developer and former CIO of the Fidelity Freedom funds cracking open MPT, the bell curve and emphasizing that fat tails now need to be considered more often than previously… Lynette DeWitt, research director of subadvisory markets and lifecycle funds for Financial Research Corporation (FRC) comments here on the fate of target-date funds…
3 David Blitzer from S&P comments here on the disconnect of the normal distribution bell curve and investment results during the financial crisis. Next we are going to look at theories derived from observation or what David Blitzer defines as “reality.”
3 After the carnage of the market meltdown, I decided to take a hard look at strategic asset allocation. I discovered that there is a wealth of “irrational” theories out there that are at the heart of some very successful market timing, trend following and hedge strategies. One of the oldest is the Elliott Wave Principle which was developed by Ralph N. Elliott in the late 30s who discovered through observation while studying the Dow that equity prices move in a repetitious pattern with “comprehensive exactitude.” Later on Benoit Mandelbrot who began studying income changes while working at IBM came across price data on cotton and observed that changes in cotton prices follow an imitation pattern much like the patterns found in nature. He also discovered that security price changes that fall outside of the traditional 2 std dev bell curve can be quite large and can have a devasting impact on a portfolio. Eventually Mandelbrot developed Fractal Geometry and the term Fat Tails was coined. Behavioral Economics was first developed in the 70s with 2 theories developed from observations that investors react more to price and direction irrespective of fundamentals and investors consider losses to be more painful than gains of equal nominal amounts. Then in ’78, Robert Prechter, a market technician using the Elliott Wave Principle, started making equity market calls that led to a super cycle bull market call just before the ’82 secular bull began. Prechter has since theorized that changes in equity prices proceed changes in social moods with his theory of Socionomics. All these theories can be found in use in one form or another among the following strategies of market timing/technical analysis, trend following, tactical asset allocation and hedging. All these strategies which aim to protect or mitigate drawdowns and loss of principal fall into what Easterling defines as a rowing approach to investing which are appropriate during secular bear markets.
These 4 books have had the most influence on my investment perspective with respect to fat tail risk. The first one written by former MIT professor Charles Kindleberger provides detail on what happens when a mania, panic, and crash occurs all of which mirrors the run-up in equities thru 2000 and then thru ’07 and it’s subsequent downturn. The second one was written by U. of Maryland professor, Carmen Reinhart and Harvard professor, Ken Rogoff. It does what Kindleberger’s does but in addition to narrative it also supplies the numbers surrounding financial crisis’. The third one written by Yale professor Benoit Mandelbrot centers on the fundamental risks associated with Modern Portfolio Theory and the use of the bell curve in financial modeling and engineering. The last one relates to the problems associated with humans when it comes to protecting ourselves against what Taleb defines as a black swan or an unforeseen event. The sales rank is indicated to highlight how widely read the subject of financial risk has become among readers.
Here is what professor Kindleberger discovered…
While much of the narrative on financial crises found in the Reinhart & Rogoff book is similar to what professor Kindleberger details in his book…Reinhart & Rogoff back-up their narratives with cold hard data across both developed and emerging economies. Here are 3 main points to recognize.
Professor Mandelbrot discovered… His main point is… “ We have been mis-measuring risk.” “ The odds of financial ruin in a free, global-market economy have been grossly underestimated.” “ The deepest and most realistic finance book ever published.” Nassim Nicholas Taleb on B. Mandelbrot’s The Misbehavior of Markets
RN Elliott discovered a 5 wave followed by 3 wave fractal with 11 alternative patterns in observing changes in the Dow. Considered to be the granddaddy of technical analysis, the most recent completion of a triple zig zag from the March lows is said to be the completion of wave 2 up. Wave 3 down according to the EWI people will be of historic proportions.
Taleb defines Black Swans in his widely regarded book on risk… He outlines how humans suffer from…
I find that these definitions on secular market cycles are as good as any.
In July ’09, I started to explore whether others believed we were in a Secular Bear Market. Here are some notable views. More than anything else I believe it is profound to see that all of these market participants have a technical and secular viewpoint. Note: Elliott Wave International accurately predicted the start of a secular bear 10 years ago.
Using a moderate aggressive allocation example of 70% equities and 30% debt, we’ll now look at how we can utilize some simple allocation approaches to guard against primary and secular bear mkts and to add alpha during bull mkts.
There’s plenty of existing research on how to enhance strategic asset allocation performance…however I’ve identified what I think are the best papers and factors to enhance performance. The 1 st set of papers are focused on improving performance by avoiding losses. The 1 st paper identifies the 10 month moving avg of the S&P 500 as the premier trend following factor to identify a change in a primary market cycle. We already know about the VIX however the other CBOE index that is used as a contrarian factor for measuring market extremes is the Put/Call Ratio. This factor is used typically as a secondary factor for making market timing decisions. The 2 nd set of papers focus on adding alpha. The 1 st paper identifies the real fed funds rate as a factor that can be used to overweight small/mid caps. This factor is attributable to the “Don’t Fight The Fed” rationale that was coined by Marty Zweig many years ago when he wrote his best selling book Winning on Wall Street. The book Style Investing written by the former CIO of Merrill Lynch outlines a growth value approach to equity investing. In addition to the book on style investing I discovered a paper which details how earnings growth mirrors equity returns and supports the use of “Growth At A Reasonable Price” or what is called GARP. The last paper supports using GDP for making country allocation decisions.
To measure the effectiveness of these factors in a portfolio I compared tactical allocations within a 70% equity 30% debt strategy against a strategic allocation of 70/30. For all the factors, the tactical allocations to equities was capped at 70%. What I found most appealing was the loss avoidance factors increased returns but also reduced risk and increased sharpe while the alpha factors enhanced return with small increases in risk.
While dynamic asset allocation is commonly confused with tactical, for our purposes I will consider an example of our current strategic approach with small and tactical adjustments.
Specifically, the dynamic example shifts 15% from equities to debt when all 3 loss avoidance factors are triggered. Outlined in chapter 10 of Unexpected Returns, Professor Easterling details how the need to become defensive during market downturns and describes the asset allocation approach during this period as a rowing approach.
Here’s a more granular view in which the allocation becomes defensive when the 3 rowing factors are triggered and then becomes more opportunistic when the one sailing factor, the real fed funds rate, turns negative. So when the rowing triggers are off and the real fed funds rate turns negative the small/mid cap allocation is increased from 10% to 20%. The rationale behind a lower strategic allocation to small/mid cap is to improve risk adjusted returns…historically the modest increase in return with small/mid caps is not supported by the increase in standard deviation…large caps simply have better risk adjusted returns.
Utilizing both rowing and sailing factors…below is the variation among a dynamic, strategic and 100% equities allocation over a period which includes a secular bull mkt thru July 2000 and a subsequent bear since. With a focus on ending wealth value and mitigating loss…you’ll notice the benefit of the dynamic portfolio over pure strategic and an all equity portfolio is substantial. Additionally you’ll notice significant improvements in the return and sharpe.
The dynamic portfolio outperformed strategic in this bull period by over 117 bps.
And as expected dynamic outperforms strategic in the bear period by 178 bps.
Here are the rolling return comparisons…
The key to maintaining a high Morningstar rating is primarily protecting to the downside and secondarily capturing the upside.
Sallie Krawcheck head of the BOA/Merrill retail brokerage sales force sets the bar for how her advisors and clients will now approach asset allocation…I thought it was interesting that she identified both standard deviation, the primary risk of strategic asset allocation and draw downs, the primary risk associated with dynamic and tactical asset allocation as part of the asset allocation equation.
Here we have the heads of distribution at the 4 largest broker-dealers recently spelling out what their advisors want. Followed by Strategic Insight’s summary of what product innovation means.
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