Saturday, December 24, 2011

Rebalancing Canada


Prologue: 


This is a 'Canadian-ized' version of an article we published on Monday, December 19, 2011, which featured a study of US equity and fixed-income markets. As we are located in Canada, we were motivated to see how well the same techniques work in our home market using the S&P/TSX Composite.

As expected, it turns out that they work quite well.


The investment community is in the midst of an identity crisis, though admittedly many in the industry don't know it yet. At the heart of the matter is the following misconception:

Investors perceive that investment professionals add value via security selection and market timing. What's worse, most investment professionals believe that they add value via security selection and market timing. This perception is dangerously misguided.

Repeat after me: Investment professionals add value via asset allocation, not security selection. Again: Investment professionals add value via asset allocation, not security selection.

The following chart is from Pawley (2004) who sourced Brinson, Hood and Beebower (1986) and Simon (1998). The chart contrasts perceived sources of investment value from a large survey of investors with the empirical sources of investment value from the Brinson study. The average investor thinks that their Advisor adds value by picking stocks and bonds; my sense is that the average Advisor thinks that too. The reality however is that a good Advisor adds value by having a system to emphasize stocks versus bonds or cash, and vice versa. That is, a good Advisor adds value through intelligent asset allocation.
Click for a larger image

The Brinson study is controversial, mostly because it is improperly cited as validation for pseudo (read false) asset class diversification, such as small-cap versus large-cap, or value versus growth. It is also used to justify Strategic Asset Allocation (SAA) whereby very long-term averages (returns, volatility and correlation) are used to model an 'optimal' allocation to stocks, bonds and cash for each individual based on their risk tolerance. While this justification for SAA makes intuitive sense, we will demonstrate how traditional SAA is a suboptimal diversification approach by every metric except perhaps 'simplicity'. But then, why do you pay your Advisor those big fees?

The Magic of Simple Rebalancing

Strategic Asset Allocation requires one further step beyond the initial asset allocation decision: periodic rebalancing. This is the process whereby each asset is bought or sold on a fixed schedule to bring the stock/bond allocation ratio back into alignment. The assets frequently move out of alignment when one asset class outperforms the other in any period.

While adherents to a Strategic Asset Allocation approach are explicitly expected to perform rebalancing on a pre-established schedule, for example annually or bi-annually (defined in your Investment Policy Statement), in my experience many Advisors do not revisit the rebalancing decision on a regular basis, and so many clients miss out on the value of this simple exercise over time.

Let's conceive of a real life example, say a retired couple with just enough money to sustain a reasonable lifestyle assuming that they are able to receive average returns in retirement. These Canadian domestic investors may have been advised to adopt a 50/50 stock/bond Strategic Asset Allocation with quarterly rebalancing. If they had started with this approach in Canada in 1993 (our earliest data), and stuck with the strategy through to the present, their returns would look something like this:

Case 1: 50/50 stock/bond portfolio with quarterly rebalancing

Source: Butler|Philbrick & Associates, Click for a larger image

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 9.89% 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 1.11.
  • 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 -25.05%.
  • % Winning Months (top right): This is the percentage of months in which the strategy delivered positive absolute returns. This strategy delivered positive returns in 69% of months.
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/TSX Composite 'Buy and Hold'
Source: Butler|Philbrick & Associates, Click for a larger image

Canadian investors have enjoyed two decades of very strong returns, benefitting from the strong U.S. economic expansion of the 1990s and then again from China's decade- long infrastructure boom during the 'aughts' which drove prices for Canada's commodities to record levels.

Over the past 18 years Canadian stocks delivered a remarkable 9.41% per year including reinvested dividends. To compare, Canadian stocks delivered 1.83 percentage points per year more than US stocks, and 12% per year more than Japanese stocks. Of course, investors still had to endure two near 50% drops, and a 6-year period of zero returns (from 1998 through 2003), which would have wreaked havoc on retirement plans. Further, despite the strong overall performance, stocks only delivered positive returns in 74% of 12-month periods — not a very consistent experience.

While a traditional SAA approach definitely improved results over a pure Canadian equity portfolio, we can improve the performance even more by reconsidering how we think about risk.

True Risk Optimization

While a simple, traditional SAA portfolio with periodic rebalancing delivered much stronger, and more efficient returns over the period tested than did stocks on their own, the simple SAA framework as described still has some very serious drawbacks.

Let's revisit the true objective of the SAA process: to ensure that an investor achieves the maximum return available at a specified level of risk that is a function of the investor's risk tolerance. Unfortunately, we know from experience, and a mountain of research, that in real life market risk is constantly changing. When markets are rising in a nice orderly uptrend, market risk (volatility) is generally very low. When markets are falling, or even going sideways, uncertainty and risk (volatility) are generally elevated. (See our article Jekyll or Hyde Markets for more on the market's multiple personalities.)

If the objective of SAA is to maintain a fixed level of portfolio risk that is commensurate with each investor's risk tolerance, then shouldn't we reduce our allocation to each asset class dynamically when we start to experience amplified levels of risk (volatility), and increase our allocation when volatility declines? In this way we can preserve a much more consistent level of risk within the portfolio. Such expansion and contraction in portfolio allocations might be considered at each rebalance period.

If we simply alter the traditional SAA strategy so that at each rebalance date we reduce relative allocations to stocks or bonds when they exhibit relatively risky behaviour (geek note: based on 60 day trailing volatility), and increase allocations when they exhibit low relative risk, we can achieve a much more efficient portfolio, again just with stocks and bonds:

Case 3: SAA with Dynamic Volatility Weighted Rebalancing, 50/50 stocks/bonds

Source: Butler|Philbrick & Associates, Click for a larger image

Note that the objective of this portfolio is to keep the risk stable 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 risk allocation.

It will come as no surprise by now that the volatility weighted rebalancing framework performs much better than the traditional 50/50 approach. Indeed, the relative volatility approach delivered 10.28% annualized returns, maximum drawdown of just 15.3%, and 90% positive rolling 12-month periods. In fact, this simple approach produced a Sharpe ratio over 1.5!

Not bad for a simple and intuitive twist on an old idea. The following chart draws on US data to illustrate how this approach also exposes an investor to a much more consistent portfolio experience as the grey line in the chart below (relative volatility weighted portfolio) tracks well below the black line (SAA 50/50) for most of the past 18 years, indicating much lower and more consistent volatility for the investor. The blue line is beyond the scope of this article, but suffice to say that by explicitly holding risk constant by systematically adding cash, portfolio risk and return characteristics can be improved even more dramatically.



Source: Butler|Philbrick & Associates, Click for a larger image

Opportunities for Action

We have demonstrated that over several market cycles a diversified portfolio substantially outperforms an all-equity portfolio, both in absolute terms and on a risk-adjusted basis. The period studied, from 1993 through 2011 is especially interesting because it includes two record-setting equity bull markets during the 1990s and 2000s, interspersed with two intense bear markets in 2001-2003, and 2008.

While the success of the diversified and rebalanced stock and bond portfolio relative to stocks on their own is not a revelation, many investors might be surprised at just how well this portfolio has done over the past 18 years on both an absolute and risk adjusted basis. Further, while we would in no way espouse this model as an optimal framework, not least of which because the stock / bond diversification framework ignores the myriad opportunities available from other markets and asset classes, this simple portfolio outperformed the average retail investor by 8% per year over the same period (See Dalbar, 2011).

We also demonstrated the conceptual and empirical validity of implementing portfolio allocations based on a true risk target that is commensurate with each individual's risk tolerance, rather than on static Strategic Asset Allocation percentages. In a traditional SAA approach, a stock/bond allocation is chosen at the inception of the investment process, and the portfolio is altered at each rebalance date to move it back toward its long-term target allocation. In a risk-optimized framework however, the allocation to both equities and bonds depends on the relative risk associated with each asset class based on their relative volatilities at each rebalance date. In this way, portfolio allocations to stocks and bonds will ebb and flow according to their respective risk, holding aggregate portfolio risk near the initial target over time.

Empirically, this simple technique measurably improved absolute returns, but dramatically improved portfolio efficiency: Sharpe ratio improved by 36% and Maximum Daily Drawdown was reduced by 65%.

In closing, we would assert that Advisors and investors should consider an approach to Strategic Asset Allocation that incorporates explicit 'buffers' which expand and contract allocations to assets when they are volatile so as to keep aggregate portfolio volatility constant. This approach has merit conceptually, mathematically, and empirically as seen in the associated tests. This type of framework should be robust to asset classes, market regimes, and exogenous shocks, and provide a much more stable return experience for investors.

Rebalancing Japan

Prologue:
This is a 'Japan-amized' version of an article we published on Monday, December 19, 2011, which featured a study of US equity and fixed-income markets. The Japanese experience since 1993 was dramatically different than the U.S. experience. While U.S. stocks climbed 267% over the past 18 years, Japanese stocks dropped 48% over the same period, which annualizes to losses of 3.43% per year.


Of course, Japanese investors endured a seemingly endless series of intermediate term extremes of hope and despair as markets oscillated wildly above and below their long-term negative trend. Japan's multi-decade crash and stagnation is unique among modern market economies (so far), so we wanted to see how well our volatility adjusted rebalancing framework worked in this difficult environment.


The results are even better than we had any right to expect, which gives us some hope for investors over what we forecast to be a very difficult decade for equities going forward.



The investment community is in the midst of an identity crisis, though admittedly many in the industry don't know it yet. At the heart of the matter is the following misconception:


Investors perceive that investment professionals add value via security selection and market timing. What's worse, most investment professionals believe that they add value via security selection and market timing. This perception is dangerously misguided.


Repeat after me: Investment professionals add value via asset allocation, not security selection. Again: Investment professionals add value via asset allocation, not security selection.



The following chart is from Pawley (2004) who sourced Brinson, Hood and Beebower (1986) and Simon (1998). The chart contrasts perceived sources of investment value from a large survey of investors with the empirical sources of investment value from the Brinson study. The average investor thinks that their Advisor adds value by picking stocks and bonds; my sense is that the average Advisor thinks that too. The reality however is that a good Advisor adds value by having a system to emphasize stocks versus bonds or cash, and vice versa. That is, a good Advisor adds value through intelligent asset allocation.




Click for a larger image


The Brinson study is controversial, mostly because it is improperly cited as validation for pseudo (read false) asset class diversification, such as small-cap versus large-cap, or value versus growth. It is also used to justify Strategic Asset Allocation (SAA) whereby very long-term averages (returns, volatility and correlation) are used to model an 'optimal' allocation to stocks, bonds and cash for each individual based on their risk tolerance. While this justification for SAA makes intuitive sense, we will demonstrate how traditional SAA is a suboptimal diversification approach by every metric except perhaps 'simplicity'. But then, why do you pay your Advisor those big fees?


The Magic of Simple Rebalancing


Strategic Asset Allocation requires one further step beyond the initial asset allocation decision: periodic rebalancing. This is the process whereby each asset is bought or sold on a fixed schedule to bring the stock/bond allocation ratio back into alignment. The assets frequently move out of alignment when one asset class outperforms the other in any period.

While adherents to a Strategic Asset Allocation approach are explicitly expected to perform rebalancing on a pre-established schedule, for example annually or bi-annually (defined in your Investment Policy Statement), in my experience many Advisors do not revisit the rebalancing decision on a regular basis, and so many clients miss out on the value of this simple exercise over time.


Let's conceive of a real life example, say a retired couple with just enough money to sustain a reasonable lifestyle assuming that they are able to receive average returns in retirement. These Japanese domestic investors may have been advised to adopt a 50/50 stock/bond Strategic Asset Allocation with quarterly rebalancing. If they had started with this approach in Japan in 1993 (our earliest data), and stuck with the strategy through to the present, their returns would look something like this:


Case 1: 50/50 Japanese stock/bond portfolio with quarterly rebalancing

Source: Butler|Philbrick & Associates, Click for a larger image


With such a long-term downtrend, even traditional SAA with quarterly rebalancing couldn't salvage a Japanese investor's portfolio from near-zero returns, as illustrated in the following equity-only example.

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 1.84% 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 0.16.
  • 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 -33.6%.
  • % Winning Months (top right): This is the percentage of months in which the strategy delivered positive absolute returns. This strategy delivered positive returns in 55% of months.
Of course, the 50/50 portfolio did much better than stocks on their own. Let's contrast the performance of the traditional 50/50 SAA portfolio with the return to a 100% stock portfolio over the same time frame:

Case 2. Nikkei 'Buy and Hold'

Source: Butler|Philbrick & Associates, Click for a larger image


Over the past 18 years Japanese stocks delivered a truly dismal -3.43% per year including reinvested dividends for a total aggregate loss to investors of 48% top date. To compare, US stocks delivered 11 percentage points per year more than Japanese stocks.


While a traditional SAA approach definitely improved results over a pure Japanese equity portfolio, it probably didn't serve as much comfort to Japanese investors.

True Risk Optimization



While a simple, traditional SAA portfolio with periodic rebalancing delivered much stronger, and more efficient returns over the period tested than did stocks on their own, the simple SAA framework as described still has some very serious drawbacks.

Let's revisit the true objective of the SAA process: to ensure that an investor achieves the maximum return available at a specified level of risk that is a function of the investor's risk tolerance. Unfortunately, we know from experience, and a mountain of research, that in real life market risk is constantly changing. When markets are rising in a nice orderly uptrend, market risk (volatility) is generally very low. When markets are falling, or even going sideways, uncertainty and risk (volatility) are generally elevated. (See our article Jekyll or Hyde Markets for more on the market's multiple personalities.)


If the objective of SAA is to mainta
in a fixed level of portfolio risk that is commensurate with each investor's risk tolerance, then shouldn't we reduce our allocation to each asset class dynamically when we start to experience amplified levels of risk (volatility), and increase our allocation when volatility declines? In this way we can preserve a much more consistent level of risk within the portfolio. Such expansion and contraction in portfolio allocations might be considered at each rebalance period.



If we simply alter the traditional SAA strategy so that at each rebalance date we reduce relative allocations to stocks or bonds when they exhibit relatively risky behaviour (geek note: based on 60 day trailing volatility), and increase allocations when they exhibit low relative risk, we can achieve a much more efficient portfolio, again just with stocks and bonds:

Case 3: SAA with Dynamic Volatility Weighted Rebalancing, 50/50 stocks/bonds

Source: Butler|Philbrick & Associates, Click for a larger image


Note that the objective of this portfolio is to keep the risk stable 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 risk allocation.

While a traditional 50/50 allocation with rebalancing struggled to deliver returns (but delivered an abundance of hope and despair), relative volatility weighting between stocks and bonds provided investors with tolerable, if not robust, results of 4.71% annualized over the period, with a very respectable Sharpe ratio of 0.78. Further, the portfolio never experienced a loss greater than 14% from peak to trough, less than half the drawdown experienced by a traditional balanced portfolio.


Not bad for a simple and intuitive twist on an old idea. The following chart uses US data to illustrate how a volatility based approach also exposes investors to a much more consistent portfolio experience as the grey line in the chart below (relative volatility weighted portfolio) tracks well below the black line (SAA 50/50) for most of the past 18 years, indicating much lower and more consistent volatility for the investor. The blue line is beyond the scope of this article, but suffice to say that by explicitly holding risk constant by systematically adding cash, portfolio risk and return characteristics can be improved even more dramatically, even in Japan!



Source: Butler|Philbrick & Associates, Click for a larger image


Opportunities for Action

We have demonstrated that over several market cycles a diversified portfolio substantially outperforms an all-equity portfolio, both in absolute terms and on a risk-adjusted basis. The period studied, from 1993 through 2011 is especially interesting because it includes a long-term secular bear market with several bull-market episodes.


While the success of the diversified and rebalanced stock and bond portfolio relative to stocks on their own is not a revelation, many investors might be surprised at just how well this portfolio has done over the past 18 years on both an absolute and risk adjusted basis. Further, while we would in no way espouse this model as an optimal framework, not least of which because the stock / bond diversification framework ignores the myriad opportunities available from other markets and asset classes, it is much better than typical 'Aggressive' all-equity allocations.




We also demonstrated the conceptual and empirical validity of implementing portfolio allocations based on a true risk target that is commensurate with each individual's risk tolerance, rather than on static Strategic Asset Allocation percentages. In a traditional SAA approach, a stock/bond allocation is chosen at the inception of the investment process, and the portfolio is altered at each rebalance date to move it back toward its long-term target allocation. 


In a risk-optimized framework however, the allocation to both equities and bonds depends on the relative risk associated with each asset class based on their relative volatilities at each rebalance date. In this way, portfolio allocations to stocks and bonds will ebb and flow according to their respective risk, holding aggregate portfolio risk near the initial target over time.

Empirically, this simple technique substantially improved absolute returns, but also dramatically improved portfolio efficiency: in the Japanese study above, the Sharpe ratio improved by 700% and Maximum Daily Drawdown was reduced by 240% over traditional SAA.


In closing, we would assert that Advisors and investors should consider an approach to Strategic Asset Allocation that incorporates explicit 'buffers' which expand and contract allocations to assets when they are volatile so as to keep aggregate portfolio volatility constant. This approach has merit conceptually, mathematically, and empirically as seen in the associated tests. 



This type of framework should be robust to asset classes, market regimes, and exogenous shocks, and provide a much more stable return experience for investors.

Thursday, November 10, 2011

Rebalancing Resurrected

The investment community is in the midst of an identity crisis, though admittedly many in the industry don’t know it yet. At the heart of the matter is the following misconception:

Investors perceive that investment professionals add value via security selection and market timing. What’s worse, most investment professionals believe that they add value via security selection and market timing. This perception is dangerously misguided.


Repeat after me: Investment professionals add value via asset allocation, not security selection. Again: Investment professionals add value via asset allocation, not security selection.
The following chart is from Pawley (2004) who sourced Brinson, Hood and Beebower (1986) and Simon (1998). The chart contrasts perceived sources of investment value from a large survey of investors with the empirical sources of investment value from the Brinson study. The average investor thinks that their Advisor adds value by picking stocks and bonds; my sense is that the average Advisor thinks that too. The reality however is that a good Advisor adds value by having a system to emphasize stocks versus bonds or cash, and vice versa.
S&P / Brinson
Click chart for a bigger version.
The Brinson study is controversial, mostly because it is improperly cited as validation for pseudo (read false) asset class diversification, such as small-cap versus large-cap, or value versus growth. It is also used to justify Strategic Asset Allocation (SAA) whereby very long-term averages (returns, volatility and correlation) are used to model an ‘optimal’ allocation to stocks, bonds and cash for each individual based on their risk tolerance. While this justification for SAA makes intuitive sense, we will demonstrate how traditional SAA is a suboptimal diversification approach by every metric except perhaps 'simplicity'. But then, why do you pay your Advisor those big fees?
The Magic of Simple Rebalancing

Strategic Asset Allocation requires one further step beyond the initial asset allocation decision: periodic rebalancing. This is the process whereby each asset is bought or sold on a fixed schedule to bring the stock/bond allocation ratio back into alignment. The assets frequently move out of alignment when one asset class outperforms the other in any period.

While adherents to a Strategic Asset Allocation approach are explicitly expected to perform rebalancing on a pre-established schedule, for example annually or bi-annually (defined in your Investment Policy Statement), in my experience many Advisors do not revisit the rebalancing decision on a regular basis, and so many clients miss out on the value of this simple exercise over time.
 

Let’s conceive of a real life example, say a retired couple with just enough money to sustain a reasonably lifestyle assuming that they are able to receive average returns in retirement. This investor may be advised to adopt a 50/50 stock/bond Strategic Asset Allocation with quarterly rebalancing. If they had started with this approach in mid-1994 (our earliest data), and stuck with the strategy through to the present, their returns would look something like this:
Case 1: 50/50 stock/bond portfolio with quarterly rebalancing
S&P / Treasuries Equal Weight Rebalanced Quarterly
Click chart for a bigger version. Source: Butler|Philbrick & Associates.

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 8.54% 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 0.84.
  • 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 -24.33%.
  • % 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.
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’
S&P / S&P 500 ‘Buy and Hold’
Click chart for a bigger version. Source: Butler|Philbrick & Associates.

Note that stocks alone over this period delivered 7.58% annualized returns, with a Sharpe ratio of 0.37, a Max Daily Drawdown of 55% (!!), and delivered positive returns in 61% of months.
This means a simple SAA portfolio with 50/50 stocks/bonds delivered 24% more total growth (330% vs. 267%), with twice the efficiency (Sharpe ratio of 0.73 vs. 0.37), half the investor anxiety (Max Daily Drawdown -24% vs. -55%), and more winning months (66% vs. 61%).
These are actually pretty good stats, but SAA only scratches the surface of what is possible with more thoughtful asset allocation techniques.
True Risk Optimization

While a simple, traditional SAA portfolio with periodic rebalancing delivered much stronger, and more efficient returns over the period tested than did stocks on their own, the simple SAA framework as described still has some very serious drawbacks.

Let's revisit the true objective of the SAA process: to ensure that an investor achieves the maximum return available at a specified level of risk that is a function of the investor's risk tolerance. Unfortunately, we know from experience, and a mountain of research, that in real life market risk is constantly changing. When markets are rising in a nice orderly uptrend, market risk (volatility) is generally very low. When markets are falling, or even going sideways, uncertainty and risk (volatility) are generally elevated. (See our article
Jekyll or Hyde Markets for more on the market's multiple personalities.)

If the objective of SAA is to maintain a fixed level of portfolio risk that is commensurate with each investor's risk tolerance, then shouldn't we reduce our allocation to each asset class dynamically when we start to experience amplified levels of risk (volatility), and increase our allocation when volatility declines?

In this way we can preserve a much more consistent level of risk within the portfolio. Such expansion and contraction in portfolio allocations might be considered at each rebalance period.

If we simply alter the traditional SAA strategy so that at each rebalance date we reduce relative allocations to stocks or bonds when they exhibit relatively risky behaviour (geek note: based on 60 day trailing volatility), and increase allocations when they exhibit low relative risk, we can achieve a much more efficient portfolio, again just with stocks and bonds:
Case 3: SAA with Dynamic Volatility Weighted Rebalancing, 50/50 stocks/bonds
S&P / SAA with Dynamic Volatility Weighted Rebalancing, 50/50 stocks/bonds
Click chart for a bigger version. Source: Butler|Philbrick & Associates.

Note that the objective of this portfolio is to keep the risk stable 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 risk allocation.
This approach delivers much more efficient performance than the traditional SAA approach. While the annualized returns to this strategy improve by just 0.15% per year, the real benefit is clear from the risk metrics.
The Sharpe ratio for this approach is 0.99, which represents 18% greater efficiency than traditional SAA, and 300% more efficiency than a pure stock portfolio. Of even greater interest for most investors, the Maximum Daily Drawdown drops to 17% from 24% for traditional SAA and 55% for stocks, an improvement of 40% and 300% respectively.
Not bad for a simple and intuitive twist on an old idea. The following chart shows how this approach also exposes an investor to a much more consistent portfolio experience as the grey line in the chart below (relative volatility weighted portfolio) tracks well below the black line (SAA 50/50) for most of the past 18 years, indicating much lower and more consistent volatility for the investor. The blue line is beyond the scope of this article, but suffice to say that by explicitly holding risk constant by systematically adding cash, portfolio risk and return characteristics can be improved even more dramatically.
S&P / Rolling 60 day Volatility
Click chart for a bigger version. Source: Butler|Philbrick & Associates. 

Opportunities for Action

We have demonstrated that over several market cycles a diversified portfolio substantially outperforms an all-equity portfolio, both in absolute terms and on a risk-adjusted basis. The period studied, from 1994 through 2011 is especially interesting because it includes a record setting equity bull market during the 1990s and a volatile sideways market through the 2000s.

While the success of the diversified and rebalanced stock and bond portfolio relative to stocks on their own is not a revelation, many investors might be surprised at just how well this portfolio has done over the past 18 years on both an absolute and risk adjusted basis. Further, while we would in no way espouse this model as an optimal framework, not least of which because the stock / bond diversification framework ignores the myriad opportunities available from other markets and asset classes, this simple portfolio outperformed the average retail investor by 8% per year over the same period (See Dalbar, 2011).
We also demonstrated the conceptual and empirical validity of implementing portfolio allocations based on a true risk target that is commensurate with each individual’s risk tolerance, rather than on static Strategic Asset Allocation percentages. In a traditional SAA approach, a stock/bond allocation is chosen at the inception of the investment process, and the portfolio is altered at each rebalance date to move it back toward its long-term target allocation. In a risk-optimized framework however, the allocation to both equities and bonds depends on the relative risk associated with each asset class based on their relative volatilities at each rebalance date. In this way, portfolio allocations to stocks and bonds will ebb and flow according to their respective risk, holding aggregate portfolio risk near the initial target over time.
Empirically, this simple technique measurably improved absolute returns, but dramatically improved portfolio efficiency: Sharpe ratio improved by 18% and Maximum Daily Drawdown was reduced by 40%.

In closing, we would assert that Advisors and investors should consider an approach to Strategic Asset Allocation that incorporates explicit ‘buffers’ which expand and contract allocations to assets when they are volatile so as to keep aggregate portfolio volatility constant. This approach has merit conceptually, mathematically, and empirically as seen in the associated tests. This type of framework should be robust to asset classes, market regimes, and exogenous shocks, and provide a much more stable return experience for investors.

Adam Butler and Mike Philbrick are Portfolio Managers with Butler|Philbrick & Associates at Macquarie Private Wealth in Toronto, Canada.

Tuesday, August 23, 2011

Demographic Blues

The Federal Reserve Bank of San Francisco published a fascinating piece of research on Monday relating U.S. stock market performance to demographic trends. The results are not encouraging for long-term 'Buy and Hold' type investors.

By Zheng Liu and Mark M. Spiegel

Historical data indicate a strong relationship between the age distribution of the U.S. population and stock market performance. A key demographic trend is the aging of the baby boom generation. As they reach retirement age, they are likely to shift from buying stocks to selling their equity holdings to finance retirement. Statistical models suggest that this shift could be a factor holding down equity valuations over the next two decades.


Historical data suggests a strong relationship exists between the age distribution of the U.S. population and stock market performance. A key demographic trend is the aging of the baby boom generation. As they reach retirement age, Boomers are likely to shift from a bias toward saving and buying stocks, to selling their equity holdings to finance retirement. Statistical models suggest that this shift could substantially depress equity valuations over the next 15 years or more.

Without belaboring the mechanics of the study, the researchers analyzed trends in the proportion of middle-aged workers in the U.S. economy relative to the proportion of retired workers to forecast future stock market valuations. This research follows other studies which found that the booming markets of the 1980s and 1990s were largely attributable to the bulge bracket of baby boomers who were entering their prime saving and investing years during those decades.

In contrast, the current Federal Reserve study finds that, as the ratio of middle aged workers to retired persons is forecast to fall persistently through 2025 as the bulk of baby boomers retire, these same boomers will be withdrawing savings from stock and bond markets, thereby exerting slow but steady downward pressure on prices of financial assets, including stocks, for the foreseeable future.

The specific demographic ratio analyzed in the study is the M/O ratio, which is the population ratio of those aged 40 - 49 to those aged 60 - 69. This ratio broadly captures the number of people in prime saving and investing years relative to the number of people who are beginning to withdraw from savings to fund retirement. From 1981 to 2000 this ratio increased from 0.18 to 0.74 at the same time stock valuations rose from roughly 8 times earnings to almost 30, and the main U.S. stock market index exploded from 150 to almost 1500.


Source: Stockcharts.com

Sadly, the U.S. Census Bureau is forecasting exactly the opposite dynamic to play out over the next 15 years as boomers retire. As this demographic scenario unfolds, the Federal Reserve Bank's model suggests that stock prices will enter a persistent decline until 2021. Further, stocks are not expected to exceed their 2010 levels until 2027, after adjusting for inflation.

Key findings:

  • The M/O ratio explains about 61% of the movements in the P/E ratio during the sample period. In other words, the M/O ratio predicts long-run trends in the P/E ratio well.
  • Given the projected path for P/E* and the estimated convergence process, we find that the actual P/E ratio should decline from about 15 in 2010 to about 8.3 in 2025 before recovering to about 9 in 2030.
  • The model-generated path for real stock prices implied by demographic trends is quite bearish. Real stock prices follow a downward trend until 2021, cumulatively declining about 13% relative to 2010. 
  • Inflation adjusted stock prices are not expected to return to their 2010 level until 2027.
  • On the brighter side, as the M/O ratio rebounds in 2025, we should expect a strong stock price recovery. By 2030, our calculations suggest that the real value of equities will be about 20% higher than in 2010.
Source: Federal Reserve Bank of San Francisco

Interestingly, the conclusions from the Federal Reserve paper mirror the conclusions from our own proprietary 'Estimating Future Returns' models, which suggest investors should expect near zero returns after inflation for at least the next 15 years.


Source: Shiller (2011), DShort.com (2011), Chris Turner (2011), World Exchange Forum (2011), Federal Reserve (2011), Butler|Philbrick & Associates (2011)

While this outcome may appear inconceivable to many, I would urge you to examine the path of Japanese stocks from their peak in 1989 at almost 40,000 to their current price under 10,000. Japan suffered from too much debt and an unhealthy property sector, but these headwinds were amplified by another challenge which we in the West share (though not quite as badly): a declining share of working persons relative to retired persons.

Source: Stockcharts.com

Perhaps not surprisingly, U.S. stock markets have been tracking the performance of Japanese stocks since U.S. stocks peaked in 2000. When we overlay the two stock market indices and align their respective peaks, the resemblance is uncanny (and not a little bit shocking for 'Buy and Hold' investors). If we continue to track the Japanese experience, we may be setting up for another major drop, perhaps to new lows.
Source: Bloomberg, Ritholtz.com

You probably aren't hearing this message from pundits on TV or in the papers, or economists at the major banks or investment firms. However, I urge you to keep three thoughts in mind when you hear these experts speak:

1. If a person's job depends on them not knowing something, then they won't know it.

2. Investment firms make much higher margins from clients who hold or trade stocks or stock mutual funds than from clients who hold bonds or cash instruments like GICs or money market funds. As such, they have a strong incentive to keep clients invested in stocks and stock mutual funds at all times, per the 'Buy and Hold' approach.

So what is a person to do when long-term Canadian bonds are yielding 0.64% after inflation, and developed market stocks are likely to yield no returns (but probably typically high volatility) for the next 15 years or more?

At Butler|Philbrick & Associates, we have a plan. At its core, our approach embraces two major areas of differentiation:

  1. Broaden the investment opportunity set for portfolios to include international and emerging market stocks, real estate, commodities,etc. Cash is an asset class!
  2. Apply a proven process to decide which asset classes to own (including cash when markets are risky), and when to own them.
As a proof of the effectiveness of our approach in difficult markets, we published a study on how to profitably trade the Japanese bear market back in February (see here for full study). We have suspected for some time that the Japanese template was the most likely trajectory for developed stock markets over the next several years.

In the study, we applied our trend following approach to the Japanese stock market to see how it would have performed over its 21 year downhill roller coaster ride.

 
Source: Butler|Philbrick & Associates 

You can see in the chart that by taking advantage of both positive and negative trends using a simple timing system over this period, our technique delivered over 16% annualized investment performance, while never dropping more than 22.9% from any peak to trough (see "CAGR%" and "Max Total Equity DD" respectively in the table above the chart).

Pretty good results generally, but especially when they're compared with the 75% cumulative loss that most Japanese investors experienced by holding stocks over the past 20 years.

We are following a proven trend following model like the one above to deliver prospective returns for clients no matter what happens in markets. What are you (or your Advisor) doing to prepare for this potential investment outcome?

Friday, July 29, 2011

Adapt or Fail

The previous article in this series discussed the ebb and flow of stock markets as they move through long periods of strong and weak returns, often lasting 15 years or more at a time. As such, there are periods when investors can set their sails and ride the prevailing winds to a sunny investment horizon. Alternatively, there are long periods where markets go sideways or down, and where any growth in investment portfolios must necessarily come at the expense of someone else.
Unfortunately, our analysis suggests that we are in the early, or perhaps middle stages of a multi-year period of low market returns, where investors will need to ‘row’ their way to positive investment performance. During such ‘rowing’ periods it is important to consider active strategies that have the potential to provide substantial risk-adjusted returns in any type of market.
Heave Ho

One such rowing strategy was recently outlined in a paper entitled Optimal Momentum by Gary Antonacci. This paper has practical relevance because it closely mirrors the general principles we apply in our proprietary investment models for clients. In the study, Antonacci constructs an investment universe that broadly captures the set of global opportunities available to investors. We simplified the strategy presented in the paper slightly, and altered the investable universe in our study to accommodate the options available to Canadian investors by investing in Exchange Traded Funds (ETFs).
At any given time, our model was able to invest in any two of the asset classes below (in bold) via a corresponding ETF (in italics).
·      US Real Estate iShares Cohen & Steer Realty REIT
·      Gold Bullion - SPDR Gold Shares
·      Japanese Stocks iShares MSCI Japan Index Fund
·      European Stocks iShares S&P Europe 350 Index Fund
·      Cash - Barclays Low Duration Treasury
·      Asian Stocks (ex-Japan) iShares Pacific ex-Japan
·      US Treasury Bonds iShares Barclay 7-10 Yr. Treasury - 7-8 Yr.
·      US Stocks - Vanguard MSCI Total U.S. Stock Market

ETFs trade on the major stock exchanges just like regular stocks, but they behave largely like very low-cost index mutual funds. That’s because each Exchange Traded Fund, or ETF, is constructed to deliver the same performance as a very broad index of underlying securities. For example, investors can purchase a single ETF to experience the exact returns of the entire S&P/TSX Index, the S&P 500, theNasdaq, gold, European stocks, or a wide variety of other asset classes or indices.
In his paper, Antonacci presents a strategy that ranks the investment opportunities above based on how each investment has performed over the prior six months. The concept is based on the well-documented phenomenon in markets called ‘Momentum’, whereby securities that have done well over the recent past have a high probability of continuing their positive performance over the subsequent 1 to 3 month period.
Accordingly, in our study we ranked the above basket of investments at the end of each month according to their relative price performance over the previous six months. At the end of each month, we altered the holdings of the portfolio so that the portfolio always held the two most highly ranked investments. In other words, the portfolio adapted at the end of each month to hold the most prospective investments over the following month based on our ranking criteria.
Table 1.

SYMBOL
EXCHANGE TRADED FUND (ETF)/ INVESTMENT MODEL
ICF
US Real Estate - iShares Cohen & Steer Realty REIT
GLD
Gold Bullion - SPDR Gold Shares
EWJ
Japanese Stocks - iShares MSCI Japan Index Fund
IEV
European Stocks - iShares S&P Europe 350 Index Fund
SHY
Cash - Barclays Low Duration Treasury
EPP
Asian Stocks (ex-Japan) - iShares Pacific ex-Japan
IEF
US Treasury Bonds - iShares Barclay 7-10 Yr. Treasury - 7-8 Yr.
VTI
US Stocks - Vanguard MSCI Total U.S. Stock Market
To illustrate the effect of this ranking and rotation into the most prospective markets each month, in the diagram below, we tracked our model’s holdings for each month of the year 2008 in Figure 1. to demonstrate how the ETF holdings of our model change over time. The numbers represent the monthly total returns for each investment, and coloured squares identify the months where our model actually held the investment.
You can see that our model rotated into gold (GLD) and U.S. bonds (IEF) for the first 7 months of 2008, and then moved out of gold and into cash (SHY) for the remainder of the year.
Figure 1: Highlighted Monthly Model Holdings in 2008

January
February
March
April
May
June
July
August
September
October
November
December
VTI
-6.17%
-2.50%
-0.90%
4.89%
2.02%
-8.12%
-0.62%
1.46%
-9.24%
-17.48%
-8.01%
1.78%
IEV
-8.80%
-0.47%
1.18%
4.43%
0.41%
-9.34%
-2.57%
-3.97%
-12.36%
-21.25%
-6.72%
7.70%
EWJ
-4.29%
-1.49%
-1.28%
7.36%
1.96%
-7.47%
-3.77%
-4.92%
-6.57%
-15.57%
-3.78%
11.56%
EPP
-7.88%
-2.57%
-2.09%
7.76%
2.86%
-9.16%
-4.66%
-4.95%
-12.67%
-26.52%
-6.90%
9.45%
SHY
1.65%
1.03%
0.25%
-0.84%
-0.35%
0.24%
0.43%
0.47%
0.78%
1.10%
1.10%
0.56%
IEF
3.36%
1.24%
1.34%
-2.41%
-1.78%
1.14%
0.72%
1.53%
-0.14%
-0.87%
7.75%
5.15%
GLD
10.84%
5.23%
-6.00%
-4.16%
0.92%
4.52%
-1.44%
-9.29%
4.11%
-16.14%
12.57%
7.73%
   Source: Antonacci (2011), Butler|Philbrick & Associates (2011)

It Pays to Row


In terms of performance, our modified Antonacci Model achieved a 407% total return between 2003 and July 2011. In the same period, the S&P 500 index of the largest U.S. stocks returned 68% including dividends. This works out to an average annual return of 21.8% for our simple strategy versus 6.6% annualized for U.S. stocks. Further, while U.S. stocks were dropping over 50% in 2008 our Antonacci study portfolio delivered a positive return of 16.1% (see Figure 2 below). Figure 2. demonstrates the relative performance of our model in each calendar year relative to all of the available investments. Notice that from 2003 to 2011 our modified Antonacci Model never dropped out of the top half in terms of annual calendar-year performance, and never experienced a losing year.
Figure 2:
Source: Antonacci (2011), Butler|Philbrick & Associates (2011)
SYMBOL
EXCHANGE TRADED FUND (ETF)/ INVESTMENT MODEL
ICF
US Real Estate - iShares Cohen & Steer Realty REIT
EWC
Canadian Stocks - iShares MSCI Canada Index Fund
GLD
Gold Bullion - SPDR Gold Shares
EWJ
Japanese Stocks - iShares MSCI Japan Index Fund
IEV
European Stocks - iShares S&P Europe 350 Index Fund
SHY
Cash - Barclays Low Duration Treasury
SPY
US Large-cap Stocks - SPDR S&P 500 Index
ANT
Modified Antonnacci Model
EPP
Asian Stocks (ex-Japan) - iShares Pacific ex-Japan
IEF
US Treasury Bonds - iShares Barclay 7-10 Yr. Treasury - 7-8 Yr.
VTI
US Stocks - Vanguard MSCI Total U.S. Stock Market

Even more impressive, the modified Antonacci model’s worst full calendar year return was positive 10%, versus minus 35% or more for the major stock markets. In fact, the Antonacci model never dropped more than 10% from any peak to trough on its ride to the top, while markets dropped 50% or more!
The Long and Short

The take away from this study is that, if left alone, and especially during low-return periods, financial markets do not deliver returns in a consistent fashion.  As such, it is of paramount importance that any investment strategy be able to adapt over time as markets change - moving to bonds, cash or perhaps gold when markets are falling, or into the most prospective markets when markets are rising – rather than sticking with a constant allocation to one market or another over time, per the traditional approach.
After studying the performance of Antonacci’s momentum based strategy over the past decade and considering the returns that buy and hold investing delivered during the same period, it should be clear that a systematic adaptive investment strategy has the potential to add tremendous value in all types of market environments, and especially during highly uncertain and volatile times like today.
For more information about how adaptive, systematic strategies may work well for you, or to read our Estimating Future Returns piece, please visit us on the Web at  http://www.macquarieprivatewealth.ca/specialist/butlerphilbrick/case-studies .