Strategic Allocation

Can investors improve retirement glide paths via judicious use of smart beta funds? In their March 2017 paper entitled “Life Cycle Investing and Smart Beta Strategies”, Bill Carson, Sara Shores and Nicholas Nefouse augment a conventional equities-bonds life cycle investing glide path with smart beta strategies. They use a conventional glide path, which gradually decreases the allocation to equities with age to a constant after retirement, to determine target risk levels over the life cycle. When the investor is young, they tilt equities toward the MSCI USA Diversified Multiple-Factor (DMF) Index to boost returns via value, size momentum and quality beta exposures. As the investor approaches retirement, they shift equities to the MSCI USA Minimum Volatility Index, designed to match the market return at lower risk. For bonds, they use the Barclays Constant Weights Index, which has greater diversification and higher Sharpe ratio than a conventional market capitalization-based bond index. They incorporate the specified smart beta indexes into the glide path via a procedure that maximizes Sharpe ratio while matching the risk of the conventional glide path. Specifically, they: (1) deviate no more than 3% from conventional glide path risk; (2) constrain smart beta equities beta relative to the Russell 1000 Index and the MSCI World Index ex U.S. to within 5% of the benchmark equities beta; (3) constrain smart beta bond index duration to within 0.05 years of the benchmark bonds duration; and, (4) require at least 1% allocation to bonds for all target date portfolios. Using monthly data for conventional capitalization-weighted U.S. equity and bond indexes and for the specified smart beta indexes during 2007 through 2016, they find that: Keep Reading

We developed the Simple Asset Class ETF Momentum Strategy (SACEMS) about six years ago and the Simple Asset Class ETF Value Strategy (SACEVS) about two years ago independently, focusing on the separate logic of asset choices for each. As tested in “SACEMS-SACEVS Mutual Diversification”, these two strategies are mutually diversifying, so combining them works better in some ways than using one or the other. Beginning May 2017, we are making four changes to these strategies for ease of implementation and combination, with modest compromises in logic. Specifically, we are: Keep Reading

What are the ins and outs of crash risk measurement via Value at Risk (VaR)? In their March 2017 paper entitled “A Gentle Introduction to Value at Risk”, Laura Ballotta and Gianluca Fusai provide an introduction to VaR in financial markets, with examples mainly from commodity markets. They address problems related to VaR estimation and backtesting at single asset and portfolio levels. Based largely on mathematics and empirical considerations, they conclude that: Keep Reading

How are the asset allocations of the largest university endowments, conventionally accepted as among the best investors, evolving? In their December 2016 paper entitled “The Evolution of Asset Classes: Lessons from University Endowments”, John Mulvey and Margaret Holen summarize recent public reports from large U.S. university endowments, focusing on asset category definitions and allocations. Using public disclosures of 50 large university endowments for 2015, they find that: Keep Reading

How do widely studied anomalies relate to representative stocks-bonds portfolio returns (rather than the risk-free rate)? In his March 2017 paper entitled “Understanding Anomalies”, Filip Bekjarovski proposes an approach to asset pricing wherein a representative portfolio of stocks and bonds is the benchmark and stock anomalies are a set of investment opportunities that may enhance the benchmark. He therefore employs benchmark-adjusted returns, rather than excess returns, to determine anomaly significance. Specifically, his benchmark portfolio captures the equity, term and default premiums. He considers 10 potentially enhancing anomalies: size, value, profitability, investment, momentum, idiosyncratic volatility, quality, betting against beta, accruals and net share issuance. He estimates each anomaly premium as returns to a portfolio that is each month long (short) the value-weighted tenth, or decile, of stocks with the highest (lowest) expected returns for that anomaly. He assesses the potential of each anomaly in three ways: (1) alphas from time series regressions that control for equity, term and default premiums; (2) performances during economic recessions; and, (3) crash proneness. He measures the attractiveness of adding anomaly premiums to the benchmark portfolio by comparing Sharpe ratios, Sortino ratios and performances during recessions of five portfolios: (1) a traditional portfolio (TP) that equally weights equity, term and default premiums; (2) an equal weighting of size, value and momentum premiums (SVM) as a basic anomaly portfolio; (3) a factor portfolio (FP) that equally weights all 10 anomaly premiums; (4) a mixed portfolio (MP) that equally weights all 13 premiums; and, (5) a balanced portfolio (BP) that equally weights TP and FP. Using monthly returns for the 13 premiums specified above from a broad sample of U.S. stocks and NBER recession dates during July 1963 through December 2014, he finds that: Keep Reading

What is “under the hood” at quantitative investment firms? In their December 2016 book-length paper entitled “Factor Investing and Asset Allocation: A Business Cycle Perspective”, Vasant Naik, Mukundan Devarajan, Andrew Nowobilski, Sebastien Page and Niels Pedersen examine the process of translating macroeconomic forecasts into alpha-generating portfolios via mean-variance optimization. They address how to: (1) specify the risk factors driving returns in global financial markets; (2) estimate factor returns and volatilities; and, (3) construct an optimal portfolio of factors. They emphasize the primacy of the business cycle in estimating future returns and volatilities of risk factors across multiple asset classes. They also emphasize the importance of market valuations (to identify when price fluctuations create tactical opportunities) in investment decision making. Based on the body of financial markets research over the last 50 years and their own experiences with the investment process, they conclude that: Keep Reading

What is a safe portfolio withdrawal rate for early retirees who expect more than 30 years of retirement? In their February 2017 paper entitled “Safe Withdrawal Rates: A Guide for Early Retirees”, ERN tests effects of several variables on retirement portfolio success:

• Retirement horizons of 30, 40, 50 and 60 years.
• Annual inflation-adjusted withdrawal rates of 3% to 5% in increments of 0.25%.
• Terminal values of 0% to 100% of initial portfolio value in increments of 25%.
• Implications of different starting levels of Shiller’s Cyclically Adjusted Price-to-Earnings ratio (CAPE or P/E10).
• Implications of Social Security payments coming into play after retirement.
• Effects of reducing withdrawal rate over time (planning a gradual decline in consumption during retirement).

They assume 6.6% average real annual return for U.S. stocks with zero volatility. For 10-year U.S. Treasury notes (T-note), they assume 0% real return for the first 10 years and 2.6% thereafter (zero volatility except for one jump). They assume monthly withdrawal of one-twelfth the annual rate at the prior-month market close, with monthly portfolio rebalancing to target stocks and T-note allocations. They assume annual portfolio costs of 0.05% for low-cost mutual fund fees. Based on the stated assumptions, they find that: Keep Reading

A subscriber requested a horse race among the following four simple asset class allocation strategies:

1. Seasonal SPY-VFITX – the strategy tested in “Bonds During the Off Season?”, which switches between SPDR S&P 500 (SPY) and Vanguard Intermediate-Term Treasury (VFITX) based on the calendar. This strategy switches between U.S. equity risk and U.S. interest rate risk.
2. SPY:SMA10-VFITX – a strategy that holds SPY (VFITX) when the S&P 500 Index is above (below) its 10-month simple moving average (SMA10). This strategy also switches between U.S. equity risk and U.S. interest rate risk.
3. SACEVS Best Value – the version of the Simple Asset Class ETF Value Strategy (SACEVS), which holds SPY, a corporate bond exchange-traded fund (ETF), a mid-duration U.S. Treasuries ETF or cash according to which offers the best yield. This strategy offers three ways to escape U.S. equity risk and two ways to escape U.S. interest rate risk based on relative yields.
4. SACEMS EW Top 3 – the version of the Simple Asset Class ETF Momentum Strategy (SACEMS) that holds the equally weighted (EW) three of nine ETFs spanning multiple asset classes with the highest past returns. This strategy offers multiple ways to escape both U.S. equity risk and U.S. interest rate risk based on relative price trends.

Because of the different available sample periods, we pit 1 vs. 2 since January 1993 (limited by data for SPY), 1 vs. 2 vs. 3 since July 2002 (limited by availability of bond ETFs) and 1 vs. 2 vs. 3 vs. 4 since July 2006 (limited by availability of all ETF asset class proxies). For these tests, we ignore fund switching frictions. Using monthly data for the specified assets through January 2017, we find that: Keep Reading

Does adjusting stocks-bonds allocations according to trend following rules improve the performance of 30-year retirement portfolios? In their November 2016 paper entitled “Applying a Systematic Investment Process to Distributive Portfolios: A 150 Year Study Demonstrating Enhanced Outcomes Through Trend Following”, Jon Robinson, Brandon Langley, David Childs, Joe Crawford and Ira Ross compare retirement portfolio performances for variations of the following three strategies that may hold a broad stock market index, a 10-year government bond index or cash (3-month government bills) in the U.S., UK or Japan:

1. Buy and Hold – each month rebalance to fixed 60%-40% or 80%-20% stock-bond allocations.
2. T8 – each month set allocations among stocks, bonds and cash according to whether each of stocks and bonds are above (uptrend) or below (downtrend) respective 8-month exponential moving averages (EMA).
3. T12 – same as T8 but using a 12-month EMA.

See the first two tables below for precise T8 and T12 allocation rules. The authors consider annual portfolio distributions of 0%, 4%, 4.5% or 5% over a 30-year holding interval. They employ the S&P 500, FTSE 100 and TOPIX total return indexes for the U.S., UK and Japan, respectively. When 3-month government bill data are unavailable for the UK or Japan, they insert U.S. data. Using monthly total returns for the specified asset class proxies since 1865 for the U.S., 1935 for the UK and 1925 for Japan, all through 2015, they find that: Keep Reading

“Cross-asset Class Intrinsic Momentum” summarizes research finding that past country stock index (government bond index) returns relate positively (positively) to future country stock market index returns and negatively (positively) to future country government bond index returns. Is this finding useful for specifying a simple strategy using exchange-traded fund (ETF) proxies for the U.S. stock market and U.S. government bonds? To investigate we test the following five strategies:

1. Buy and hold.
2. TSMOM Long Only – Each month, hold the asset (cash) if its own 12-month past return is positive (negative).
3. TSMOM Long or Short – Each month, hold (short) the asset if its own 12-month past return is positive (negative).
4. XTSMOM Long Only – Each month hold stocks if 12-month past returns for stocks and government bonds are both positive, and otherwise hold cash. Each month hold bonds if 12-month past returns are negative for stocks and positive for government bonds, and otherwise hold cash. 
5. XTSMOM L-S-N (Long, Short or Neutral) – Each month hold (short) stocks if 12-month past returns for both are positive (negative), and otherwise hold cash. Each month hold (short) bonds if 12-month past returns are negative (positive) for stocks and positive (negative) for bonds, and otherwise hold cash.

We use SPDR S&P 500 (SPY) and iShares 7-10 Year Treasury Bond (IEF) as proxies for the U.S. stock market and U.S. government bonds. We use the 3-month U.S. Treasury bill (T-bill) yield as the return on cash. We apply the five strategies separately to SPY and IEF, and to an equally weighted, monthly rebalanced combination of the two for a total of 15 scenarios. Using monthly total returns for SPY and IEF and monthly T-bill yield during July 2002 (inception of IEF) through December 2016, we find that: Keep Reading