Asset Allocation

ln their seminal 1986 paper "Determinants of Portfolio Performance", Brinson, CFA, Hood, and Beebower  (BHB) asserted that asset allocation is the primary determinant of a portfolio’s return variability, with security selection and market timing playing minor roles. BHB's study examined the quarterly returns of 91 large U.S. pension funds over the 1974 to 1983 period and concluded that asset allocation explained 93.6% of the variation in a portfolio’s quarterly returns. The conclusion of their report asserted that a simple asset allocation program with few assets classes is just as effective as active investment strategies employed by pension managers. 


In 1997 William Jahnke published a critique of the original BHB study and argued "the fundamental problem with BHB's study is their focus on return volatility rather than portfolio returns" and pointed out that BHB's use of quarterly returns dampens the effect of  compounding slight differences in portfolio weightings relative to a benchmark. Jahnke went on to assert that fixed allocations are inferior in comparison to combining forward looking strategic asset allocation solutions with changes in investor’s circumstances and market opportunities. 


In his 2009 paper "Adaptive Asset Allocation Policies" William F. Sharpe discussed asset allocation policies and asserted that they are difficult if not impossible to follow in practice. Fixed allocation (rebalancing) requires the sale of assets that have performed relatively well and buying those that have performed relatively poorly. This process is clearly contrarian which according to Sharpe can be only followed by a minority of investors. Sharpe further asserted that in practice investors seldom rebalance completely to conform with their policy.   Sharpe also acknowledges work by Arnott who argued "at it's heart, rebalancing is a simple contrarian strategy. In ebullient times, it causes us to take money away from our biggest winners. In the worst of times the process forces us to invest money into the assets that have caused us the most pain. Most investors acknowledge it as a critical part of a successful investors toolkit. Yet recognition and action are two different things. Surrounded by bad news it is difficult to pull the trigger on securities that are down 50%, 75% or even 90% is difficult even for the most staunchest of rebalancers. Many lose their nerve and blink, letting a healthy portion of excess returns slip from their grasp". Sharpe also found that most pension funds, endowments and foundations have traditional asset allocation policies. However considerable discrepancies may be allowed to develop between policy and actual proportions. allocation percentage yet rather allow for ranges of exposure within each asset class..  Sharpe went on to say that rebalancing to a constant or fixed percentage will outperform buy and hold when market reversals (trendless markets) are more common than trending markets. Conversely in periods where trends are move prevalent than reversals, a fixed percentage asset allocation policy will underperform. Success of either is highly period dependent. Sharpe suggested that it is ultimately necessary to make assumptions about the nature of future markets. So it seems that investors recognize the potential value of rebalancing yet there are various reasons why asset allocation fails to work. Essentially Sharpe's paper outlined a variety of reasons why traditional asset allocation is difficult to follow in practice and consequently Sharpe proposed an alternative approach where asset allocation adapts to changes in the market value of major asset classes.This approach could be widely adopted according to Sharpe if the market value data of major asset classes was more widely available. It appears to us at Prospero however that investors would still be faced with the challenge of buying out of favor assets which would require them to somehow learn to become emotionally detached from the same securities that have caused them pain in the past. 


Behavioral Finance 

This opens up the entire behavioral finance area which broadly argues that investors are not as rational as traditional finance theory makes them out to be. Essentially behavioral finance espouses the view that psychology drives market prices. The herd instinct explains why investors imitate others. If a security or the market is going up investors fear that others know more or have better information than they do. Consequently investors may feel a strong impulse to do what others are doing. Behavioral finance has also found that investors tend to place too much faith on small data sets. i.e. if an analyst correctly predicted the movement on a stock investors are quick to attribute skill rather than luck to an analyst who picks a winning stock. Additionally behavioral finance has found that investors are slow to change their beliefs which are largely a result of past experiences (anchoring). Examples include the late 1990s when investors were convinced that a dip in the stock market was a good time to buy. Essentially behavioral finance does a better job at explaining how investors behave than traditional finance. Yet this field has provided little in the way of coherent and practical investment models. 


Technical Analysis

Technical Analysis differs from fundamental analysis in that rather than attempting to measure a securities intrinsic value this discipline is a method of analyzing a security or the market by analyzing statistics generated by the market itself. Tools include price, trend, relative strength and volume. Many technical analysts believe that the market itself is the best analyst of all in that the collective opinion of every investor is reflected in a security or market price. Essentially millions of buyers and sellers with varying opinions eventually agree on price. Their collective actions represent the energy or force behind market movements as their actions represent changing supply and demand for securities in the financial markets. If buyers are more committed than sellers prices will rise. If sellers are more anxious than buyers prices will decline. Basically technical analysis offers the opportunity to measure whether buyers or sellers are in control of market prices. Just as any method of analysis is subject to criticism. Some argue that analysis of charts tell us where a stock or market has been and does not offer any indication of future performance. Certainly traditional chart analysis is subject to interpretation and the value of the analysis will vary based on the skill and experience level of the technical analyst. Nevertheless technical analysis is widely adopted in the U.S. and continues to grow around the world. At a minimum technical analysis tends to be used as risk management tool as it offers the opportunity to minimize investment and/or portfolio losses when actual

performance deviates from expected outcomes.     


Quantitative Technical Analysis    

Quantitative technical analysis in a basic sense represents a rigorous approach to investing where tools such as trend, trend momentum, and relative price strength are back tested. This is a process of applying a set of trading rules or trading system to various historical market periods in order to simulate the results of the system over time. Back testing is conducted to evaluate the merits of the trading system based on probabilities of future outcomes in performance. Strategy developers often utilize the back testing process as a way to gain insights into indicator and financial market relationships as they test the progress of the strategy being created. In and out of sample tests along with walk forward analysis are recommended to avoid data mining, curve fitting and over optimization. 


Trend Following

Commodity traders have utilized back tested technical trading systems for at least 4 decades and from this group stems the term "trend following". While it is likely that equity traders and investors have utilized various forms of technical back tested strategies for a similar length of time the popularity and acceptance of technically based investment strategies has grown dramatically over the past 2 decades. While some may believe that technical equity trading is confined to the at home day trader managing a 6 figure portfolio the reality today is that many technical trading or rules based investment strategies are responsible for the management of billions of retail and institutional investment dollars.


Relative Price Strength

Relative price strength refers to the performance of a security, ETF or mutual fund relative to a benchmark. This is one of the most persistent price factors researched by academics. This market anomaly states that market leaders or outperformers tend to persist in their winning ways. This effect, also known as momentum is persistent in U.S. stocks both small and large, as well as developed countries and emerging markets around the world. The main reasons cited by academics include behavioral biases which include herding, investor over and under reaction and confirmation bias. In the 1960's Robert Levy published what was likely the first tests of relative strength as a stock selection strategy. In his 1968 book "The Relative Strength of Common Stock Forecasting" Levy found persistent momentum by dividing the price of a security by it's 26 week moving average. Fama and French found that last years winners show positive momentum returns in all size groups yet the persistence in returns is strongest in small and particularly micro caps. Jagadeesh and Titman found relative strength persistence at 6 month intervals with respect to international stocks. John Lewis of Dorsey Wright wrote an excellent paper on relative strengths role in portfolio management.  


Research I conducted in writing a paper for the CMT designation confirmed that high relative strength sectors tend to outperform both the average and lowest relative strength sectors. Additionally buying the weakest sectors tended to under perform the top ranked and average relative strength sectors.. Meanwhile the results of the alternative asset class study revealed that mid ranking asset classes tended to outperform top ranks. This is possibly do to the mean reverting tendencies of alternative asset classes such as commodity indices and treasury bonds.


To the extent that care has been taken has been taken from a diversification standpoint relative strength facilitates dynamic asset allocation and can be utilized as a primary factor in portfolio construction.

 

"We have 2 types of forecasters.... those who don't know and those who don't know they don't know". John Kenneth Galbreath 

 Whether you employ  traditional, tactical or  dynamic asset  allocation strategies  Prospero's research  and portfolio strategies  are  designed to help  you save time, money  and improve risk  adjusted returns.