Modern Portfolio Theory (MPT), as developed my Harry Markowitz in the
1950’s, is supposed to be a theory of tradeoffs between investment risk
and potential return. MPT has served as the supposed basis for many
financial advisors to develop their investment portfolios and asset
allocation models. However, MPT as intended by Markowitz, has aspects
that have been widely overlooked, misused, misunderstood, and maybe even
twisted by the financial services industry.
In his published research entitled “Portfolio Selection” in the Journal of Finance in 1952 he led with:
“The
process of selecting a portfolio may be divided into two stages. The
first stage starts with observation and experience and ends with beliefs
about the future performances of available securities. The second stage
starts with the relevant beliefs about future performances and ends
with the choice of portfolio.”
Many “diversify and buy-and-hold”
or strategic asset allocation users cite the work of Dr. Markowitz as
the basis of their framework. But that may not have been what he
intended. Yes, stocks have more risk and therefore generally expected
higher returns than bonds over the long term, but what if your timeframe
is not seventy-five to one hundred years? What if you are starting from
a period of relatively high stock valuations and therefore an
expectation of below-average stock returns?
In looking at all of
the rolling ten year periods over the past 100 years it becomes quite
obvious that it makes a HUGE difference in realized returns depending
upon what the market valuations were at the starting point.
“Conventional wisdom” has forgotten or ignored the essential “first
stage” of portfolio management according to Markowitz. Too often, MPT is
used with the assumption that future returns will be in-line with long
term average returns without regard to the valuation of the market at
the starting point. Though future performance of the stock market cannot
be predicted with certainty, insights and observations and experience
about the cycles that exist within the market and the importance of
valuations can head us in a more correct direction with expectations of
future returns and how to plan.
Currently, valuations by several
measures that have a high degree of historical accuracy show the stock
market as very highly valued and that the expectation over the next
several years is more biased towards risk rather than return. This fact
is being ignored by most advisors and portfolio managers however. They
are still using long term average returns as their expectations and
still building portfolios in what they have been lead to believe is in
line with MPT. They diversify among asset classes and styles in the
traditional 60/40 or other mixes and feel that all is well. They ignore
the very important point of expected returns.
Ed Easterling at Crestmont Research is one of the top researchers in this area. Others, like John Hussman, Rob Arnott, and Jeremy Grantham of GMO are also thought leaders in this important area.
All
of these people are in agreement right now that the expected average
annualized return from stocks over the next ten years is somewhere
between 2% to -2% and that the expected return over any time period of
seven years or less is negative. That’s far from the regularly quoted,
long term expected return from stocks of 10%.
So, in order for
advisors to properly plan to get their clients where they want to be, it
is extremely important to know where we are currently. This is exactly
what Markowitz meant when he said:
“The first stage starts with
observation and experience and ends with beliefs about the future
performances of available securities. The second stage starts with the
relevant beliefs about future performances and ends with the choice of
portfolio.”
Now, using valuation measures alone for timing changes
to the portfolio structure is not very effective. More recent academic
research is finding that using approaches known as Adaptive Asset Allocation or Tactical Asset Allocation
is very effective and uses systems that can tactically or adaptively
adjust the portfolio allocation when needed using a repeatable,
rules-based approach. Our AlphaRotation strategies use this type of
tactical approach that can be very effective at implementing the theory
Markowitz intended.
Monday, June 16, 2014
What is Drawdown and why is it Critical to Control It?
Drawdown is an important risk measure for portfolio management.
Without explicit loss control mechanisms, traditional passive asset
allocation portfolios can experience large drawdowns that take a long
time to recover from.
Source: Newfound Financial Innovators
The “drawdown message”:
1) Even by eliminating the noise, which means ignoring drawdowns of less than 5%, the S&P 500 Index has spent 82.95% of its time (between 1927 and 2012) in a state of drawdown (defined as either in a declining state or climbing out of drawdown and not yet exceeding prior high).
2) As shown on the chart below, the gain required to recover from a loss is exponential. Drawdowns of 20% or less can be recovered from fairly quickly but letting them get much bigger requires a lot of time to recover. Keeping maximum drawdown to 20% or less for growth-oriented portfolios is a good goal for portfolio managers. More conservative portfolios for clients with lower risk tolerance should have even lower maximum drawdown tolerance.
Source: Crestmont Research
Ways to Control Drawdown:
1) Strategic allocation of non-correlated investments:
This is by far the most commonly used technique by investment advisors. If properly constructed, this type of portfolio is usually fairly low maintenance - only requiring rebalancing at designated intervals and regular monitoring of investments chosen for each asset class.
This method can be quite effective at controlling the drawdown but its effectiveness is dependent on the non-correlation of each asset class in the portfolio. There have been times that too many asset classes have become very highly correlated and therefore not as effective.
The negative to this approach is that is creates a drag on the portfolio performance when things are going well. It assures mediocre performance when stocks are doing well because it has a constant allocation to assets that are non-correlated and may not be doing well - kind of like have the brake applied all the time so you don’t get in trouble going around a curves and also keeping the brake applied on the straight-aways too.
2) Purchase Put Options:
This method can be effective at cutting off the “left tail” returns and helping reduce maximum drawdown but it comes at the cost of purchasing the options themselves, which reduces overall return and requires quite a bit of maintenance and working knowledge of options.
3) Tactical Overlay:
Using a rules-based, tactical overlay to implement an adaptive asset allocation or flexible asset allocation can significantly reduce the left tail returns and reduce maximum drawdown. It can also retain or even enhance the return structure in bullish market conditions.
AlphaRotation tactical ETF portfolios utilize a unique tactical approach to minimize drawdown and retain growth potential.
Source: Newfound Financial Innovators
The “drawdown message”:
1) Even by eliminating the noise, which means ignoring drawdowns of less than 5%, the S&P 500 Index has spent 82.95% of its time (between 1927 and 2012) in a state of drawdown (defined as either in a declining state or climbing out of drawdown and not yet exceeding prior high).
2) As shown on the chart below, the gain required to recover from a loss is exponential. Drawdowns of 20% or less can be recovered from fairly quickly but letting them get much bigger requires a lot of time to recover. Keeping maximum drawdown to 20% or less for growth-oriented portfolios is a good goal for portfolio managers. More conservative portfolios for clients with lower risk tolerance should have even lower maximum drawdown tolerance.
Source: Crestmont Research
Ways to Control Drawdown:
1) Strategic allocation of non-correlated investments:
This is by far the most commonly used technique by investment advisors. If properly constructed, this type of portfolio is usually fairly low maintenance - only requiring rebalancing at designated intervals and regular monitoring of investments chosen for each asset class.
This method can be quite effective at controlling the drawdown but its effectiveness is dependent on the non-correlation of each asset class in the portfolio. There have been times that too many asset classes have become very highly correlated and therefore not as effective.
The negative to this approach is that is creates a drag on the portfolio performance when things are going well. It assures mediocre performance when stocks are doing well because it has a constant allocation to assets that are non-correlated and may not be doing well - kind of like have the brake applied all the time so you don’t get in trouble going around a curves and also keeping the brake applied on the straight-aways too.
2) Purchase Put Options:
This method can be effective at cutting off the “left tail” returns and helping reduce maximum drawdown but it comes at the cost of purchasing the options themselves, which reduces overall return and requires quite a bit of maintenance and working knowledge of options.
3) Tactical Overlay:
Using a rules-based, tactical overlay to implement an adaptive asset allocation or flexible asset allocation can significantly reduce the left tail returns and reduce maximum drawdown. It can also retain or even enhance the return structure in bullish market conditions.
AlphaRotation tactical ETF portfolios utilize a unique tactical approach to minimize drawdown and retain growth potential.
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