Re-Thinking Asset Allocation
Exploring the benefits of a tactical approach to asset allocation
Highlights:
By: Braden G. Botkin, CFP ®
The secular bear market of the last decade has brought about vicious debates
between those advocating a tactical, active approach to asset allocation, and
those advocating a static, passive
approach. This paper highlights attributes of
By: Braden G. Botkin, CFP®
each approach and attempts to highlight why we believe a disciplined, active
approach to asset allocation and portfolio management can add value to an
investor’s portfolio.
Static Asset Allocation (Buy-and-Hold)
Static asset allocation has been the darling of the investment community since
Harry Markowitz published “Portfolio Selection” in 1952. The concepts of
“efficient” portfolios and mean variance optimization came to be known as
Modern Portfolio Theory (MPT), and are still used by investment firms today.
Proponents of MPT believe that the historical return and variance of returns on
an investment will be its average return and variation of returns in the future.
Once an investor’s risk tolerance was determined, an “efficient” portfolio could be
constructed for the highest possible returns and the least possible risk. Today, an
investor can create an “efficient” portfolio instantly online or with the help of asset
allocation software that is expected to provide a given rate of return and given
level of volatility over a long enough time horizon. Changes are only made to the
portfolio to rebalance it with its initial allocation. Asset valuation, momentum, and
macroeconomic risks or opportunities are not considered in portfolio construction.
Chart 1: Sample Strategic Asset Allocation
Aggressive
Moderate
Conservative
Modern Portfolio Theory
fails to effectively define the
frequency and severity of
extreme market events.
Secular bull markets provide
a risk/reward environment
condusive to a passive asset
allocation with a relatively
large allocation to stocks,
but secular bear markets
require a prudent, active
approach to diversification
and risk management.
Selecting clearly defined
benchmarks aligned with
an investors investment
objectives may help
investors better understand
the risk/reward profile of
a portfolio.
Standard deviation alone is
an inefficient measure of risk
for individual investors
Proponents of MPT believe
that the historical return and
variance of returns on an
investment will be its average
return and variation of returns
in the future.
Static Summary:
Return: 6.8%
Risk: 18.5%
Return: 5.5%
Risk: 9.6%
Return: 5.5%
Risk: 9.6%
Source: http://www.aaii.com/asset-allocation
Modern Portfolio Theory has been built on the foundation that the price movements of assets like stocks and bonds can be measured or described by a
normal distribution or bell curve with a given mean (average) and standard
deviation. MPT also makes the assumption that investors are all rational, risk
averse, and care primarily about their portfolio value at the end of a given time
horizon, rather than its value along the way.
Historical return, volatility,
and correlation can be
expected to remain the same
in the future.
Rebalancing to fixed asset
allocations is the best risk
management strategy
Movements of asset prices
can be described by a normal
distribution (bell curve)
Investors are rational
Increasing allocations to
stocks will increase returns
Tactical Asset Allocation
Tactical asset allocation is an active approach to managing risk and opportunity
in an investment portfolio. It is skill-based and seeks consistent, positive returns
with minimal volatility. Practitioners of tactical asset allocation may take price,
value, momentum, economic or geopolitical factors into account when selecting
securities for a portfolio.
Tactical strategies recognize that the correlations, returns, and volatility of asset
classes can change, and historical measures of these parameters are not
representative of their values in the future. Instead of rebalancing a portfolio to
a fixed asset mix or allocation, tactical strategies focus on adjusting the portfolio
mix or asset allocation as market conditions and asset class risk/reward profiles
change. Practitioners of tactical strategies believe stock market returns can be
more accurately described by a slightly skewed distribution with much “fatter”
tails, and that the frequency and severity of extreme market events are
increased by the instinctive and often irrational responses of investors to fear
and greed impulses.
Why Tactical Asset Allocation?
We have seen that during market shocks, asset classes that have historically
generated relatively high, stable rates of return can become highly volatile and
highly correlated, effectively eliminating the benefits of traditional diversification.
For example, during for financial crisis of 2007-2009 the Morningstar Moderate
Index, a static index of 60% global stocks and 40% global bonds, experienced a
35% peak to trough decline as nearly every asset class lost value. While this
performance was positive relative to a 50% decline for stocks, it was extremely
disappointing on an absolute basis. The asset mix of a traditional moderate
allocation has changed very little, if at all, over the last few decades. As market
conditions change, shouldn’t your asset allocation change too? Consider a
football team that runs the same play regardless of the team they are playing,
time on the clock, or yards to the end zone…how successful are they likely to
be?
We are troubled by the fact that despite empirical data proving that asset class
returns do not conform to a normal distribution, modern static asset allocation
models still make this assumption. This lulls investors into a false sense of
confidence that future market risks are highly predictable, explainable, and
endurable, when they are really massively underestimating the probability of
extreme events that could have a profound impact on their financial health.
We recognize that if investors were perfectly rational, bubbles would not exist
because an investor would never over-pay for an asset – prices would always
accurately reflect intrinsic value. The bubbles in technology stocks and real
estate in the US since 2000 should be proof enough that investors predictably
make irrational decisions when they herd in and out of asset classes in response
to fear and greed impulses.
We also believe that investors view drawdown, rather than standard deviation,
as the primary measure of portfolio risk, and that a portfolio focused on reducing
drawdowns while providing a reasonable real (inflation adjusted) return can
result in reduced risk of outliving assets.
“
Tactical strategies recognize
that the correlations, returns,
and volatility of asset classes
can change, and historical
measures of these parameters
are not representative of their
values in the future.
Tactical Summary:
Historical return and
volatility ≠ future return
and volatility
Allocation should change
as risks and opportunities
change
A normal distribution does
not accurately describe
movements of asset prices
Investors are irrational
“
During market shocks, asset
classes that have historically
generated relatively high,
stable rates of return can
become highly volatile and
highly correlated, effectively
eliminating the benefits of
traditional diversification.
During market shocks,
asset classes decline together
Market shocks happen
fairly regularly
Trends, cycles, and
bubbles exist
Investors may need income
from their assets and view
drawdown as a primary risk
“
A portfolio focused on
reducing drawdowns while
providing a reasonable real
(inflation adjusted) return can
result in reduced risk of
outliving assets.
Does it Depend on the Cycle?
Stock market cycles have been covered in great detail by a number of analysts
and authors (Unexpected Returns and Probable Outcomes by Ed Easterling are
wonderful reads for those seeking in-depth information on the subject). Secular
cycles are long-term cycles lasting many years or decades. Cyclical cycles are
shorter-term cycles within secular cycles. While cyclical movements may be
bullish or bearish, cyclical trends will ultimately be magnetized to the long-term
secular trend. During secular bull markets, stocks move up over long periods
of time while only experiencing minor setbacks along the way. In contrast,
during secular bear markets, stocks can produce negative returns over many
years or decades.
Chart 2: Dow Jones Industrial Average Returns by Market Cycle
40.00%
30.00%
20.00%
10.00%
0.00%
-10.00%
-20.00%
-30.00%
-40.00%
19011920
19211928
19291932
19331936
19371941
19421965
19661981
19821999
Source: Ed Easterling “Unexpected Returns
Stock market cycles have been covered in great detail by a number of analysts
and authors (Unexpected Returns and Probable Outcomes by Ed Easterling are
wonderful reads for those seeking in-depth information on the subject). Secular
cycles are long-term cycles lasting many years or decades. Cyclical cycles are
shorter-term cycles within secular cycles. While cyclical movements may be
bullish or bearish, cyclical trends will ultimately be magnetized to the long-term
secular trend. During secular bull markets, stocks move up over long periods of
time while only experiencing minor setbacks along the way. In contrast, during
secular bear markets, stocks can produce negative returns over many years or
decades.
Benchmarking
Much of the public discussion around tactical and static asset allocation seems
to revolve around whether tactical asset allocation can outperform the S&P 500
over long periods of time. Why should a strategy be evaluated on the basis of
whether it can outperform stocks? Said differently, what effect will outperforming
or underperforming stocks over your lifetime have on your financial future?
Investors who outperformed the S&P 500 during the current secular bear market
may have still underperformed inflation and lost purchasing power.
“
Secular bull markets and
secular bear markets have
vastly different risk/reward
profiles.
“
Chart 3: S&P 500 and Inflation 2000 - 2010
Large drawdowns sustained
during or immediately before
drawing income from a
portfolio can have a profound
impact on the portfolios ability
to provide sustainable income
over an investor’s lifetime.
$14,000
$13,000
S&P 500
$12,000
Inflation
$11,000
$10,000
$9,000
$8,000
$7,000
$6,000
$5,000
$4,000
10
20
09
20
08
20
07
20
06
20
05
20
04
20
03
20
02
20
01
20
00
20
Source: Yahoo! Finance, Inflationdata.com
Maintaining purchasing power is crucial for investors, especially when drawing
on a portfolio for income. As such, we believe that targeting a fair margin of
return in excess of inflation is a more effective long-term benchmark, similar to
the CPI +6.5% that Rob Arnott targets for the PIMCO All Asset All Authority fund.
On a shorter term basis, investors should benchmark themselves against an
allocation that accurately represents their portfolio when fully invested. The S&P
500 may be a good short-term benchmark for an investor with an US stock
portfolio, but an investor with a more diversified asset mix may choose a the
Morningstar Moderate Index or Morningstar World Allocation Index as a more
appropriate short-term benchmark.
Drawdown statistics (largest peak to trough loss over a given period of time)
should also be a major factor in analyzing an investment strategy. Large drawdowns sustained during or immediately before drawing income from a portfolio
can have a profound impact on the portfolios ability to provide sustainable
income over an investor’s lifetime. Investors should seek strategies that have
demonstrated the ability to effectively manage drawdowns while producing
reasonable returns similar to their long and short-term benchmarks.
Conclusion
The debate between those advocating tactical asset allocation and static asset
allocation is likely to continue for some time. We believe in a prudent, tactical
approach to portfolio management that focuses on broadly diversifying among
asset classes that have positive risk/reward characteristics, while diversifying
away from asset classes don’t. Narrow, static asset allocation (buy-and-hold)
strategies diversifying among stocks and bonds are likely to continue to be
challenged by the current secular bear market or any presence of an inflationary
shock, and we believe that investors should consider adding tactical asset
allocation strategies designed to maintain purchasing power, avoid catastrophic
portfolio drawdowns, and provide fair absolute returns.