Monday, August 26, 2013

Modern Portfolio Theory Works Just As Well as it Did in the 90's, Which is Not At All

One of the criticisms that I often hear about Modern Portfolio Theory (MPT) is that it doesn't work as well as it did in the 90's.  That is not true, MPT works just as well as it did at any time in history, which is not at all.  

The main idea behind MPT is that there is an optimum portfolio where the combination of non correlated assets creates an overall mix that can have a better risk/reward profile than the individual asset classes on their own.    From an academic standpoint MPT is very interesting because the optimum portfolio mix does exist.  The problem is that I can tell you what it was yesterday but I have no idea what it will be tomorrow, and that is where MPT becomes useless in real life.

In order to decide how much to allocate to each asset class you need to predict:

1. The future returns of each asset class
2. The future volatility of each asset class
3. The future correlation of each asset class

If you could accurately predict all three of those things then MPT would work great.  You would have predicted the crash in stocks in 2008 and the rise in bonds, along with the lack of correlation.  An MPT portfolio would then have 100% bonds and investors would have been protected.  Unfortunately, you can't predict any of these variables, making MPT interesting to study but of no practical use.

So why did MPT appear to work in the 90's?  Because anything that told an investor to buy stocks would have worked, I could have had a monkey throwing darts at an asset allocation chart and I would have made money.  That doesn't make it a valid strategy.

Thursday, August 15, 2013

The Glaring Flaw in Risk Parity

Was forwarded an interesting article from Bloomberg the other day about some of the struggles in risk parity strategies, particularly Bridgewater's All Weather.

This highlights the one glaring flaw in this approach---you are using past returns, correlations, and volatility to set allocations.  Interestingly, this is the same reason why Modern Portfolio Theory does not work.

To us risk parity can be improved in three ways:

1. Use maximum drawdown instead of standard deviation as a risk measure.  Nothing is perfect but clients tend to view risk more as drawdowns from a high water mark than day to day and month to month volatility.

2. Use methodologies instead of asset classes.  You can get a better idea of what to expect from a methodology, say momentum or counter trend, than you can from an asset class.

3. Using the above two methods can avoid having large fixed income exposure reducing or eliminating the need for leverage.

Friday, August 9, 2013

Conservative and Aggressive is Not An Asset it is a Methodology

I recently reviewed an investment portfolio for an 82 year old and his daughter.  It was the usual asset allocation mutual fund portfolio with the usual funds I normally see.  When we go the an emerging market bond fund his daughter was aghast because she thought there was no way an 82 year old should own this risky an investment.  She was partially correct.  At the time emerging market bond funds had moved from being in an uptrend to being in a downtrend.  Over the past three months they had been down somewhere in the neighborhood of 11%.  There is no way and 82 year old, a 65 year old, or a 25 year old should own emerging market bond funds, or anything else, that is in a downtrend like that.  On the other hand, prior to that, emerging market bonds had been in a steep uptrend.  I have no problem with anyone at any age owning emerging market bond funds when they are in an uptrend.

The point is that asset classes in and of themselves are not risky, it is how you use them that is risky.  In the hands of a buy and hold asset allocator emerging market bond funds are risky as they can go through periods where they lose a lot of money.  In the hands of a tactical investor then they are just another tool to shift money to when they are in favor.