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Rebalancing resurrected
We have poked a lot of fun at Strategic Asset Allocation (SAA) and Modern Portfolio Theory (MPT) over the years, so this white paper is somewhat of an olive branch to the traditional investment community. It should be noted that in fact we do not, of course, take issue with Markowitz' elegant mathematical relationship between risk, return and inter-asset correlation, but rather with the standard implementation of the concept: Strategic Asset Allocation. Strategic Asset Allocation is the process of evaluating an investor's tolerance (both emotional and financial) for risk, and then creating an allocation to stocks, bonds and cash which theoretically maximizes an investor's expected return given his or her specific risk tolerance. For example, upon visiting an Investment Advisor, an early Baby Boomer investor, age 65, with average risk tolerance might be instructed that an appropriate asset allocation would include 50% bonds and 50% stocks. This paper will revisit the concept of SAA first by illustrating how the traditional SAA approach violates the most basic precepts of common sense by discussing the concept of 'informed bias'. We then move on to discuss several evolutions of the concept, and demonstrate how an evolved form of SAA can work quite effectively in a portfolio framework. Finally, we revisit the concept of informed bias with a practical implementation.
Traditional strategic asset allocation makes sense about 40% of the time
Our frustration with traditional SAA is rooted in the following: 1. There are superior long-term allocation strategies for investors with much more predictable return distributions. 2. Traditional SAA explicitly ignores conditional intermediate-term return probabilities. For example, an investor who describes himself as 'Aggressive' would, under traditional SAA, be advised to invest 100% of his capital in stocks regardless of extreme levels of stock market valuations, such as at the stock market peak in 2000. This despite the fact that in early 2000 stocks were the most expensive they had every been, and therefore returns to stocks from that peak were likely to be low and volatile, and certainly less prospective than government bond returns. Let's put it another way: If you were stopped by a couple in Bangkok and asked to recommend appropriate attire for their trip to Toronto, what would you recommend? Do you have all the information you need to make a reasonable recommendation? Could you make a recommendation without knowing what month they would be visiting? Would your recommendation change if they were coming in July versus January? If they were visiting in April, May, June or September, you would perhaps be more circumspect and suggest they pack lighter clothes, but a few warm items just in case. However, if they were visiting in July or August you would advise them to pack shorts, and if they were traveling in December, January or February you would advise them to pack a parka and boots. This is called an informed bias, as we are able to favorably bias our advice based on better information. In the same way, if markets are mildly cheap or mildly expensive, future returns are likely to approximate the long-term average. However, if markets are extremely cheap (bottom 20% of all valuation periods) or extremely expensive (top 20% of all valuation periods), then the evidence clearly shows that allocations in portfolios should be raised or lowered accordingly. Expensive markets should receive a smaller allocation, and inexpensive markets should receive a larger allocation as a result of our new and meaningful information. It isnt very helpful to advise a traveler to lug a parka and snow boots to Toronto in July. Neither is it very helpful to advise clients to have a full allocation to stocks at periods of peak valuations.
The table at the bottom may require some explanation. For our purposes, you want to focus on the following data: CAGR (second from the top on the left): This is the annualized return to the portfolio over the entire duration of the test. This strategy delivered a CAGR of 7.29% per annum. Sharpe (third from the top on the left): This is perhaps the most common measure of the 'efficiency' of a portfolio, and in this case it measures the annualized return to the strategy divided by the standard deviation, which is the most common measure of portfolio risk. The higher this ratio the better. This strategy had a Sharpe ratio of 0.73. Max Daily Drawdown (six from the top on the left): This is the worst drop in the portfolio from peak-to-trough measured from the highest closing high to the highest closing low. It is a measure of how much loss an investor had to bear when investing in this strategy. This strategy had a Max Daily Drawdown of -26.01%. % Winning Months (top right): This is the percentage of months in which the strategy delivered positive absolute returns. This strategy delivered positive returns in 66% of months.
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Let's contrast the performance of this 50/50 SAA portfolio with the return to a 100% stock portfolio over the same time frame: Case 2. S&P 500 Buy and Hold
Note that stocks alone over this period delivered 5.89% annualized returns, with a Sharpe ratio of 0.30, a Max Daily Drawdown of 56% (!!), and delivered positive returns in 61% of months. Incredibly, a simple SAA portfolio with 50/50 stocks/bonds delivered 50% more total growth (262% vs. 176%), with over twice the efficiency (Sharpe ratio of 0.73 vs. 0.30), half the investor pain (Max Daily Drawdown -26% vs. -56%), and more winning months (66% vs. 61%). Even simple SAA with regular rebalancing does much better than stocks alone over the long-term.
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Note that the objective of this portfolio is to keep the risk constant by reducing allocations to assets when they are exhibiting risky behaviour (high trailing volatility), and increasing allocations to assets when they are exhibiting low risk behaviour (low trailing volatility). In traditional SAA, the focus is on maintaining a fixed allocation. In contrast, and in keeping with the broader objective of SAA, this risk-weighted approach is focused on maintaining a fixed level of risk. This approach delivers much more efficient performance than the traditional SAA approach. While the annualized returns to this strategy improve by just 0.6% per year, the real benefit is clear from the risk metrics. The Sharpe ratio for this approach is 0.98, which represents 35% greater efficiency than traditional SAA, and over 300% more efficiency than a pure stock portfolio. Of even greater interest for most investors, the Maximum Daily Drawdown drops to 14% from 26% for traditional SAA and 56% for stocks, an improvement of 85% and 370% respectively. Not bad for a simple and intuitive twist on an old idea.
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Informed bias
In our discussion about the pitfalls of traditional approaches to SAA, we introduced the concept of informed bias when we discussed whether an investor should be fully invested in any asset class, in proportion to his risk tolerance, when there is a strong likelihood that returns to that asset class will be low or negative over the individuals investment horizon. We used the example of expensive markets at the peak of the technology bubble as an example of where introducing informed bias to the allocation decision could add substantial value. In that case, we might have considered biasing portfolios away from equities because they were fundamentally expensive, and therefore future returns were likely to be low. Thus the portfolio would be skewed toward bonds until equity valuations returned to more normal levels, at which point we might neutralize our asset allocation. However, valuation is not the only tool at our disposal to produce an informed bias. In prior articles, we have spilled a great deal of ink on the power of price momentum to forecast future price performance. Conceptually, price momentum resembles the idea of physical momentum, which is a derivative of Newton's First Law: an object in motion will stay in motion unless acted upon by an external force. Similarly, we know from voluminous financial literature that the prices of stocks, commodities, bonds, industry sectors, markets, houses, commercial real-estate, art, wine, and virtually every other asset one could own, display trending behaviour whereby strong prior price performance predicts strong subsequent price performance. In other words, we know that past winners are much more likely to be future winners, and past losers are more likely to be future losers, at least over a forecast horizon of a few weeks to several months. Suppose we apply a momentum filter to produce a simple informed bias to our relative volatility adjusted SAA given the same portfolio of stocks and bonds. Specifically, we will allocate 25% more risk to the asset class that has demonstrated the stronger and more consistent price momentum relative to the other asset class, while the weaker asset class is penalized with 25% less share. For example, when stocks have performed strongly and persistently over the past 1 to 3 months, we will allocate 25% more to stocks, and vice versa.
Case 4: Relative Volatility Rebalanced SAA with Momentum Bias, 50/50 stocks/bonds
You can see that by introducing a simple informed bias to skew allocations toward the asset class with more prospective returns (based on historical price momentum only), we increase returns by 47% (421% vs. 287% total return), increase our Sharpe ratio by almost 10% (1.07 vs. 0.98), and increase our % Winning Month ratio (66% vs. 65%). As a bonus, we have further reduced our Maximum Daily Drawdown by 25% (-10.5% from -14.2%).
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With such a long-term downtrend, even traditional SAA with quarterly rebalancing couldnt salvage Japanese investors portfolio from near-zero returns, as illustrated in the following Case example. Of course, the 50/50 portfolio did much better than stocks on their own.
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Traditional SAA with rebalancing delivered 1.5% annualized per year in Japan over the past 18 years. Whats worse, Japanese investors experienced two entire bull/bear cycles over this period where they saw their wealth begin to grow again only to watch it collapse over and over. This must have been psychologically excruciating. While a traditional 50/50 allocation with rebalancing struggled to deliver returns (but delivered an abundance of hope and despair), relative volatility weighting provided investors with tolerable, if not robust, results of 4.4% annualized over the period, with a reasonable Sharpe ratio of 0.72. Further, the portfolio never experienced a loss greater than 15.44% from peak to trough.
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Not surprisingly, the same informed bias momentum strategy applied in the U.S. example above also worked well in Japan, improving returns by 23% (154% versus 125%), and the Sharpe ratio by almost 10% versus the already impactful relative volatility SAA approach.
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Case 8: Relative Vol Rebalanced SAA with Momentum Bias, 50/50 Japanese stocks/bonds
The evidence strongly suggests based on examples from both secular bull and bear markets that volatility adjusted portfolio rebalancing delivers better and more efficient returns, regardless of the long-term bullish or bearish regime.
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*Butler|Philbrick and Associates is part of Macquarie Private Wealth Inc. This material is provided for general information and is not to be construed as an offer or solicitation for the sale or purchase of securities mentioned herein. Past performance may not be repeated. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please seek individual financial advice based on your personal circumstances. However, neither the author nor Macquarie Private Wealth Inc. (MPW) makes any representation or warranty, expressed or implied, in respect thereof, or takes any responsibility for any errors or omissions which may be contained herein or accepts any liability whatsoever for any loss arising from any use or reliance on this report or its contents. No entity within the Macquarie Group of Companies is registered as a bank or an authorized foreign bank in Canada under the Bank Act, S.C. 1991, c.46 and no entity within the Macquarie Group of Companies is regulated in Canada as a financial institution, bank holding company or an insurance holding company. Macquarie Bank Limited ABN 46 008 583 542 (MBL) is a company incorporated in Australia and authorized under the Banking Act 1959 (Australia) to conduct banking business in Australia. MBL is not authorized to conduct business in Canada. No entity within the Macquarie Group of Companies other than MBL is an authorized deposit-taking institution for the purposes of the Banking Act 1959 (Australia), and their obligations do not represent deposits or other liabilities of MBL. MBL does not guarantee or otherwise provide assurance in respect of the obligations of any other Macquarie Group company. Macquarie Private Wealth Inc. is a member of the Canadian Investor Protection Fund and IIROC.
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