Adaptive Asset Allocation:

A True Revolution in Portfolio Management

By Adam Butler and Mike Philbrick

May 14, 2012

Due to the outstanding response we have received from our article series over the past week (see
links to prior articles at the bottom of this post) we have decided to schedule a webinar to
elaborate on the concepts and answer some of the more common questions that we have
received. The webinar will occur at 2pm ET on Wednesday, May 23rd and will consist of a 1
hour presentation and a 30 minute Q&A. To register in advance, please click here. After
registering you will receive a confirmation email containing information about joining the
webinar. Note that there is a maximum of 100 participants, so please register early.

Modern Portfolio Theory (MPT) has been derided by practitioners, academics, and the media
over the past ten years because the dominant application of the theory, Strategic Asset
Allocation, has delivered poor performance and high volatility since the millennial technology
crash.

Strategic Asset Allocation probably deserves the negative press it receives, but the mathematical
identity described by Markowitz in his 1967 paper is axiomatic in the same way Pythagoras'
equations describe the properties of right triangles, or Schrodinger's equations describe the
positional probabilities of electrons.

The math is the math.

Bear with me!

Modern Portfolio Theory requires three parameters to create optimal portfolios from two or more
assets:

1. Expected returns
2. Expected volatility
3. Expected correlation

Strategic Asset Allocation applies MPT using long-term averages of these parameters to create
diversified portfolios that theoretically maximize the excess returns of the portfolio per unit of
volatility.

The problem with Strategic Asset Allocation is not the math of MPT - the problem is with the
assumption that the best estimates for returns, volatility and correlations are the long-term
averages.

Garbage In: Garbage Out (GIGO)

GIGO: Returns

The magnitude of this error in assumptions cannot be overstated because long-term averages
hide enormous variability over shorter periods which can be observed and utilized for better
portfolio assembly.

Consider the following chart, which shows the range of real returns to U.S. stocks over rolling
20-year periods from 1871 through 2009. While 20 years or so approximates a typical retirement
investment horizon, it exceeds, by multiples, the average psychological horizon of most investors
which is much closer to 3 or 4 years.

Source: Shiller, DarwinFunds.ca

You will note that, even over horizons as long as 20 years, annualized real returns to stocks
range from -0.22% right before the Great Depression crash, to 13.61% during the 20 years
ending in March of 2000.
Strategic Asset Allocation, this amount of variability in returns means the difference between
living on food stamps after 10 years of retirement and leaving a deca-million dollar legacy for
heirs. In other words, a retirement constructed using long-term average return estimates is
analogous to a game of retirement Russian Roulette, where luck alone decides your fate.

Garbage long-term average estimates in: garbage portfolio results out.

GIGO: Volatility

There is a great deal going on under the surface with volatility estimates too. For example, while
long-term daily average volatility is around 20% annualized for stocks, and 7% for 10-year
Treasury bonds, the following two charts show how realized volatility fluctuates dramatically
over time for both stocks and bonds.

S&P 500 60-Day Rolling Standard Deviation (Index points)

10-Year Treasury 60-Day Rolling Standard Deviation (Index points)

Source: Stockcharts.com

Incredibly, you can see that the volatility of a bond portfolio can fluctuate by over 1000% over a
60 day period, and the volatility of a U.S. stock portfolio can fluctuate by almost 1500%.

This has a dramatic impact on the risk profile of a typical balanced portfolio, and therefore on the
experience of a typical balanced investor. Most investors believe that if a portfolio is divided
60% into stocks and 40% into bonds, that these asset classes contribute the same proportion of
risk to the portfolio.

However, as the next chart shows, for a portfolio consisting of 60% S&P500 and 40% 10-year
Treasuries, the stock portion of the portfolio actually contributes over 80% of total portfolio
volatility on average, and over 90% of portfolio volatility about 5% of the time. In late 2008 for
example, a 60/40 portfolio generally behaved as though it was over 90% stocks!

Garbage long-term average estimates in: garbage portfolio results out.

Source: Yahoo Finance, DarwinFunds.ca

GIGO: Correlation

By now it probably comes as no surprise that the correlation between asset classes fluctuates
substantially over time as well. While the long-term correlation between U.S. stocks and
Treasuries, and U.S. stocks and gold, are low or even negative over the long-term, the actual
realized correlation between these assets oscillates between strong and weak over time.
Source: Stockcharts.com
From the charts, notice that the long-term average 60-day rolling correlation between stocks and
Treasuries over the 12-year period shown is -0.42, and the correlation between stocks and gold is
+0.22.

However, the stock/Treasury correlation varies between -0.82 and +0.27 over the period, and the
stock/gold correlation varies between -0.84 and +0.91. You could fly a 747 through those ranges,
and the current correlation has an enormous impact on portfolio volatility.

Source: DarwinFunds.ca

In fact, as you can see from the chart above, the volatility of a 50/50 stock/bond portfolio
increases by 100% as correlation increases from -0.8 to +0.2, holding all else constant.

Garbage long-term average estimates in: garbage portfolio results out.

Return, volatility and diversification estimates vary widely from their long-term averages over
the short and intermediate terms. Managers who do not monitor and adjust portfolios to these
changes risk substantial deviation from stated portfolio objectives, and are almost certain to
deliver a sub-optimal experience for investors.

The Objective of Portfolio Optimization

One of the most important axioms in finance is that the best estimate of tomorrow's value is
today's value. Our prior articles in this series clearly demonstrate this important concept for
returns, volatility and correlation.

Which begs the question: If we can measure the value of these variables over the recent past, and
they are better estimates over the near-term than long-term average values, why don't we use
current observed values for portfolio optimization instead? Why would we choose to hold a static
asset allocation in portfolios when it is possible to adapt over time based on observed current
conditions?

It is worth noting that the overall objective of asset allocation is to deliver the highest returns per
unit of volatility. In finance, this is called the 'Sharpe ratio'*.

You may wonder why we don't we just focus on returns. Well, one reason is that higher risk
portfolios are much more difficult to stick with. While we may know logically that stocks deliver
reasonable long-term returns, we may find it difficult to ride out sustained losses of 50%, 60% or
greater on the way to our promised long-term growth. Under such circumstances most of us will
cry 'Uncle' at the wrong time and permanently harvest a large loss.

That's why in our examples below we also highlight a measure called 'maximum drawdown',
which describes the maximum peak-to-trough daily loss of each portfolio over the period under
investigation. Between volatility and maximum drawdown we capture a substantial portion of
meaningful risk.

For those in or near retirement, when evaluating the tests below remember that higher returns
alone will not improve retirement income or sustainability. For retirees drawing income, or those
within 5 years of retiring, the most important measure of portfolio performance is the
returns/volatility ratio: the higher this ratio, the higher the sustainable retirement income from a
portfolio.

Introducing Adaptive Asset Allocation

To illustrate the revolutionary advantage that accrues from using recent observed portfolio
parameters to regularly adapt portfolios to changing market conditions, consider a portfolio
consisting of 10 major global asset classes:

U.S. stocks
European stocks
Japanese stocks
Emerging market stocks
U.S. REITs
International REITs
U.S. intermediate Treasuries
U.S. long-term Treasuries
Commodities
Gold
Going back to 1995, if we held this basket of assets in equal weight, and rebalanced monthly, we
would have experienced the following portfolio growth profile [Example 1].

Example 1: 10 Assets, Equal Weight Rebalanced Monthly

Source: Yahoo finance, DarwinFunds.ca

We saw above in GIGO: Volatility above how volatile assets like stocks dominate the total risk
of a typical portfolio, and the chart above provides further proof. But what happens if we observe
the actual volatility of each asset in the portfolio over the past 60 days, and adjust the allocations
at each monthly rebalance period so that each asset contributes the same 1% daily volatility to
the portfolio, to a maximum of 100% exposure [Example 2]?

Example 2: 10 Assets, Volatility Weighted Rebalanced Monthly

Source: Yahoo finance, DarwinFunds.ca

By simply sizing each asset in the portfolio so that it contributes the same 1% daily volatility
based on observed volatility over the prior 60 days, the return delivered per unit of risk (Sharpe)
almost doubles from 0.66 to 1.23 versus the equal-weight portfolio, and the maximum drawdown
is cut in half from 44% to under 20%.

This is a dramatic reduction in risk without sacrificing any returns. Aside from the reduced
emotional burden this approach provides, it also very substantially boosts safe withdrawal rates
for retirement or endowment portfolios, but that's a tale for another post.

Now let's re-introduce momentum as a better return estimate. We demonstrated how assets that
have risen the most over the prior 6 to 12 months tend to continue to outperform over subsequent
weeks. Momentum is therefore just a better way of estimating performance over the near-term
future. So let's consider a new portfolio assembled monthly from the top 5 assets out of the 10
asset basket above, based on their performance over the past 6 months. This will be our pure
Momentum Portfolio [Example 3].

Example 3: 10 Assets, Top 5 Equal Weight By 6-Month Momentum, Rebalanced Monthly

Source: Yahoo finance, DarwinFunds.ca

You can see that by holding the top 5 assets each month based exclusively on their 6-month
momentum, we again nearly double the Sharpe ratio, but we also substantially increase
annualized returns - from 8.36% for the equal weight to 14.30% for our Momentum Portfolio.
The average volatility for the momentum portfolio is slightly lower than the equal weight
portfolio at 11.6% versus 12.7% annualized, and the drawdown is 40% smaller.

Our next step is to combine estimates of return based on momentum with estimates of volatility
based on recent observed volatility. The following chart shows the performance of an approach
that assembles the top 5 assets by 6-month momentum, and then applies the same volatility
sizing overlay as we used in Example 2, so that each of the top 5 assets contributes the same 1%
of daily risk to the portfolio, again to a maximum of 100% exposure [Example 4].

Example 4: 10 Assets, Top 5 By 6-Month Momentum, Volatility Weighted, Rebalanced

Monthly
Source: Yahoo finance, DarwinFunds.ca

This technique lowers returns slightly from 14.3% to 13.7%, but the Sharpe ratio increases from
1.23 to 1.51, and the maximum drawdown drops to 16% from 26%.

The next and final step is to integrate momentum, volatility and correlation using our improved
return (momentum), volatility and correlation estimates to achieve true Adaptive Asset
Allocation (AAA).

A novel approach to this might be to create portfolios at each monthly rebalance based on the
Top 5 assets by 6-month momentum, but allocate among the assets according to a minimum
variance algorithm rather than by volatility sizing each asset individually

The minimum variance algorithm takes into account the volatility and correlations between the
Top 5 assets to create the momentum portfolio with the lowest expected portfolio level volatility.
If we rebalance the portfolio monthly with this approach we achieve the following performance
[Example 5.].

Example 5: 10 Assets, Top 5 By 6-Month Momentum, Minimum Variance, Rebalanced

Monthly
Source: Yahoo Finance, DarwinFunds.ca

You can see that by integrating our last factor, correlation, we are able to achieve higher returns
of 15.4% versus 13.7%, and with a substantially higher Sharpe ratio of 1.71 versus 1.51, while
preserving the maximum drawdown profile under 16%.

The Next Generation of Portfolio Management

While there are much better algorithms to integrate momentum, volatility and correlation, the
examples above show a clear evolution of techniques that demonstrate how to integrate the three
primary variables used for portfolio construction under a true Adaptive Asset Allocation
framework.

Portfolios assembled using classic Strategic Asset Allocation are vulnerable to the 'flaw of
averages' where long-term average values hide enormous variability over time. Quantitative
Tactical Asset Allocation suffers from considerably lower returns over time, and is vulnerable to
changing market character. For example, QTAA has suffered recently because the dispersion of
returns around monthly moving averages has increased by multiples over the past few years.

In contrast, Adaptive Asset Allocation (AAA) is robust to changes in market character because
proper application uses a variety of standard parameter lookbacks for estimation. Further,
volatility and correlation management, as well as more regular rebalance frequency, provides
substantial tailwinds for portfolios. Lastly, AAA portfolios are always optimally diversified,
which makes them robust to market shocks which wreak havoc on more concentrated tactical
portfolios.

The portfolio management industry is undergoing a revolution analogous to the shift that
occurred after Markowitz introduced his Modern Portfolio Theory in 1967. Managers who
embrace the new methods will increasingly dominate traditional managers; those who fail to
adapt will, inevitably, face extinction.

*[Geek note: Technically, the Sharpe ratio is calculated using returns in excess of the cash yield,
though we use a simple return/risk ratio in this article.]

Articles in this series:

How to Beat the Market, and Why Most Investors Don't

Volatility Management for Better Absolute and Risk-Adjusted Performance
Diversification: Still the Only Free Lunch
Adaptive Asset Allocation: A True Revolution in Portfolio Management (this
article)

Adam Butler and Mike Philbrick are Portfolio Managers with

Butler|Philbrick|Gordillo & Associates at Macquarie Private Wealth in Toronto, Canada.

(c) Butler|Philbrick|Gordillo & Associates, 2011

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