Wednesday, August 8, 2012

Estimating Future Stock Market Returns: August 2012 Update


"Mankind are so much the same, in all times and places, that history informs us of nothing new or strange in this particular. Its chief use is only to discover the constant and universal principles of human nature." - David Hume

Long-time readers will know that we do not make predictions in the normal sense. That is, we endorse the decisive evidence that markets and economies are complex, dynamic systems which are not reducible to normal cause-effect analysis. However, we are willing to acknowledge the likelihood that the future is likely to rhyme with the past. Thus, we apply simple statistical models to discover mean estimates of what the future may hold over meaningful investment horizons (10+ years), while acknowledging the wide range of possibilities that exist around these averages.
There are several reasons why it may be useful to have a more robust estimate of future expected returns on stocks:
  • People who are approaching retirement need to estimate probable returns in order to budget how much they need to save.
  • A retiree's level of sustainable income is largely dictated by expected returns over the early years of retirement.
  • Investors of all types must make an informed decision about how best to allocate their capital among various investment opportunities.
Many studies have attempted to quantify the relationship between Shiller PE and future stock returns. Shiller PE smoothes away the spikes and troughs in corporate earnings which occur as a result of the business cycle by averaging inflation-adjusted earnings over rolling historical 10-year windows.
This study contributes substantially to research on smoothed earnings and Shiller PE by adding three new valuation indicators: the Q-Ratio, total market capitalization to GNP, and deviations from the long-term price trends. The Q-Ratio measures how expensive stocks are relative to the replacement value of corporate assets. Market capitalization to GNP accounts for the aggregate value of U.S. publicly traded business as a porportion of the size of the economy. In 2001, Warren Buffett wrote an article in Fortunewhere he states, "The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment." Lastly, deviations from the long-term trend of the S&P inflation adjusted price series indicate how 'stretched' values are above or below their long-term averages.
These three measures take on further gravity when we consider that they are derived from four distinct facets of financial markets: Shiller PE focuses on the earnings statement; Q-ratio focuses on the balance sheet; market cap to GNP focuses on corporate value as a proportion of the size of the economy; and deviation from price trend focuses on a technical price series. Taken together, they capture a wide swath of information about markets.
We analyzed the power of each of these 'valuation' measures to explain inflation-adjusted stock returns including reinvested dividends over subsequent multi-year periods. Our analysis provides compelling evidence that future returns will be lower when starting valuations are high, and that returns will be higher in periods where starting valuations are low.
This last point may seem obvious, but I want to emphasize a critical point about traditional wealth management of which most investors are not aware:
Traditional investment planning does not account for whether markets are cheap or expensive. An investor who visited a traditional Investment Advisor at the peak of the technology bubble in early 2000 would, in practice, be advised to allocate the same proportion of his wealth to stocks as an investor who visited an Advisor near the bottom of the markets in early 2009. This despite the fact that the first investor would have had a valuation-based expected return on his stock portfolio from January 2000 of negative 2% per year, while the second investor would expect inflation-adjusted compound annual returns of 6.5%. For an investor with $1,000,000 to invest, this would represent a difference of more than $1.26 million in cumulative wealth over a decade.
Said differently, traditional wealth advice is rooted in the assumption that the best estimate of future returns is the average long-term return to stocks. No matter where markets are on the continuum from very cheap to very expensive, traditional Advisors will make recommendations on the assumption that investors should expect 6.5% inflation adjusted returns on stocks over all investment horizons.
John Hussman at Hussman funds is careful to qualify the value of this analysis: "Rich valuation is strongly associated with weak subsequent returns, but only reliably so over periods of 7-10 years. In contrast, the present syndrome of overvalued, overbought, overbullish, rising-yield conditions is typically associated with abrupt and often steep losses, but is more commonly resolved over a period of months rather than years." (Hussman, Feb 14, 2011). Thus, we are not making a forecast of market returns over the next several months; in fact, markets could go substantially higher from here. However, over the next 10 to 15 years, markets are very likely to revert to average valuations, which are much lower than current levels. This study will demonstrate that investors should expect 6.5% returns to stocks only during those very rare occasions when the stock market passes through 'fair value' on its way to becoming very cheap, or very expensive. At all other periods, there is a better estimate of future returns than the long-term average, and this study will quantify that estimate.
Investors should be aware that, relative to meaningful historical precedents, markets are currently expensive and overbought by all three measures, indicating a strong likelihood of low inflation-adjusted returns going forward over periods as long as 20 years.
This prediction is also supported by evidence from an analysis of corporate profit margins. In his recent book, Vitaly Katsenelson provided in Chart 1 of long-term profit margins to U.S. companies. Companies have clearly been benefitting from a period of extraordinary profitability.
Source: Vitaly Katsenelson (2011) The profit margin picture is critically important. Jeremy Grantham recently stated, "Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly." On this basis, we can expect profit margins to begin to revert to more normalized ratios over coming months. If so, stocks may face a future where multiples to corporate earnings are contracting at the same time that the growth in earnings is also contracting. This double feedback mechanism may partially explain why our statistical model predicts such low real returns in coming years. Caveat Emptor.

Modeling Across Many Horizons

Many studies have been published on the Shiller PE, and how well (or not) it estimates future returns. Almost all of these studies apply a rolling 10-year window to earnings as advocated by Dr. Shiller. But is there something magical about a 10-year earnings smoothing factor? Further, is there anything magical about a 10-year forecast horizon?
Kitces (2008, PDF format) demonstrated that "the safe withdrawal rate for a 30-year retirement period has shown a 0.91 correlation to the annualized real return of the portfolio over the first 15 years of the time period". So there is clearly merit in studying a 15-year forecast horizon as well. Further, the tables below will demonstrate that statistical models have the greatest explanatory power at the 15-year horizon.
This study will attempt to address the question of 'perfect forecast horizon', perfect valuation factor, and 'perfect earnings smoothing factor', by analyzing the explanatory power of earnings, the Q-Ratio, and regressed historical stock returns, over return horizons from 1 to 30 years. We will also put all of the factors together to construct an optimized model.
Table 1. below provides a snapshot of some of the results from our analysis. The table shows estimated future returns based on several factor models over some important investment horizons. The "Best Fit Multiple Regression" is by far the most accurate model, but other results are provided for context.
Table 1. Factor Based Return Forecasts Over Important Investment Horizons
Source: Shiller (2011), DShort.com (2011), Chris Turner (2011), World Exchange Forum (2011), Federal Reserve (2011), Butler|Philbrick & Associates (2011)
You can see from the table that every single valuation factor model generates results which suggest a very low future return environment for stocks. Further, the 'Best Fit Multiple Regression', which has historically provided a surprising degree of forecast accuracy, confirms this outlook with a high degree of confidence (see explanation below). Those who are not interested in our process can skip to the bottom sections, 'Putting the Predictions to the Test', and 'Conclusion'.

Process

The following matrices show the R-Squared ratio, regression slope, regression intercept, and current predicted forecast returns for each valuation factor. The matrices are heat-mapped so that larger values are reddish, and small or negative values are blue-ish. Click on each image for a large version.
Matrix 1. Explanatory power of valuation/future returns relationships
Source: Shiller (2011), DShort.com (2011), Chris Turner (2011), World Exchange Forum (2011), Federal Reserve (2011), Butler|Philbrick & Associates (2011)
Many analysts quote 'Trailing 12-Months' or TTM PE ratios for the market as a tool to assess whether markets are cheap or expensive. If you hear an analyst quoting the market's PE ratio, odds are they are referring to this TTM number. Our analysis slightly modifies this measure by averaging the PE over the prior 12 months rather than using trailing cumulative earnings through the current month, but this change does not substantially alter the results. As it turns out, TTM average earnings have very mild explanatory value over periods greater than 8 years. However, the explanatory power of TTM earnings is substantially less reliable than all other factors studied in this analysis, so investors may wish to pay little heed to this indicator of whether stocks are cheap or expensive.

Forecasting Expected Returns

The next matrices provide the slope and intercept coefficients for each regression. We have provided these in order to illustrate how we calculated the values for the final matrix below of predicted future returns to stocks.
Matrix 2. Slope of regression line for each valuation factor/time horizon pair.
Source: Shiller (2011), DShort.com (2011), Chris Turner (2011), World Exchange Forum (2011), Federal Reserve (2011), Butler|Philbrick & Associates (2011)
Matrix 3. Intercept of regression line for each valuation factor/time horizon pair.
Source: Shiller (2011), DShort.com (2011), Chris Turner (2011), World Exchange Forum (2011), Federal Reserve (2011), Butler|Philbrick & Associates (2011)
Our final matrix below shows predicted future real returns over each time horizon, as calculated from the slopes and intercepts above, by using the most recent values for each of the 13 earnings series, the Q-Ratio, and the return series as inputs. For statistical reasons which are beyond the scope of this study, we have substituted the ordinal rank for the nominal value for each factor in running our analysis. Therefore, when we solve for future returns based on current monthly data, we apply the monthly rank in the equations.
For example, the 15-year return prediction based on the current Q-Ratio can be calculated by multiplying the current ordinal rank of the Q-Ratio (969) by the slope from Matrix 2. at the intersection of 'Q-Ratio' and '15-Year Rtns' (-0.0000894), and then adding the intercept at the same intersection (0.1202323) from Matrix 3. The result is 0.0336, or 3.36%, as you can see in Matrix 4. below at the same intersection (Q-Ratio : 15-Year Rtns).
Matrix 4. Modeled forecast future returns using current valuations.
Source: Shiller (2011), DShort.com (2011), Chris Turner (2011), World Exchange Forum (2011), Federal Reserve (2011), Butler|Philbrick & Associates (2011)
Finally, at the bottom of the above matrix we show the forecast returns over each future horizon based on our best-fit multiple regression from the factors above. We began testing the multiple regression against the Q-ratio, the 15-year Shiller PE, the price regression, and the market cap to GNP as a 4 factor model. However, we discovered that the 15-year PE provided more noise than signal to the regression (that is, these factors were not statistically significant and reduced the F-score), so we narrowed the regression to include just the Q ratio, market cap/GNP, and the real price series over each forecast horizon.
We provided the R-squared for each multiple regression at the bottom of each forecast horizon column in Matrix 4.; you can see that at the 15-year forecast horizon, our regression explains 82% of total returns to stocks. Further, the regression is very highly statistically significant, with a p value of effectively zero.
Chart 2. below demonstrates how closely the model tracks actual future 15-year returns. The red line tracks the model's forecast annualized real total returns over subsequent 15-year periods using the Q ratio and deviation from price regression as inputs at each period. The blue line shows the actual annualized real total returns over the same 15-year horizon.

Chart 2. 15-Year Forecast Returns vs. 15-Year Actual Future Returns

Source: Shiller (2011), DShort.com (2011), Chris Turner (2011), World Exchange Forum (2011), Federal Reserve (2011), Butler|Philbrick & Associates (2011)
You can see that 15-year "Regression Forecast" returns are 0.69% per year and 10-year returns are forecast to be 2.49% per year using market valuations as of July 30, 2012.

Putting the Predictions to the Test

A model is not very interesting or useful unless it actually does a good job of predicting the future. To that end, we tested the model's predictive capacity at some key turning points in markets over the past century or more to see how well it predicted future inflation-adjusted returns.
Table 2. Comparing Long-term average forecasts with model forecasts
Source: Shiller (2011), DShort.com (2011), Chris Turner (2011), World Exchange Forum (2011), Federal Reserve (2011), Butler|Philbrick & Associates (2011)
You can see we tested against periods during the Great Depression, the 1970s inflationary bear market, the 1982 bottom, and the middle of the 1990s technology bubble in 1995. The table also shows expected 15-year returns given market valuations at the 2009 bottom, and current levels. These are shaded green because we do not have 15-year future returns from these periods yet. Note real total return forecasts of 5.92% annualized from the bottom of the market in February 2009. This suggests that prices just approached fair value at the market's bottom, but they were nowhere near the level of cheapness that markets achieved at bottoms in 1932 or 1982. As of the end of July 2012, annualized future returns over the next 15 years are expected to be less than 1 percent.
We compared the forecasts from our model with what would be expected from using just the long-term average real returns of 6.5% as a constant forecast, and demonstrated that estimates form long-term average returns yield over 433% more error than estimations from our model over these 15-year forecast horizons (1.28% annualized return error from our model vs 5.55% using the long-term average). Clearly the model offers substantially more insight into future return expectations than simple long-term averages, especially near valuation extremes.

Conclusions

The 'Regression Forecast' return predictions along the bottom of Matrix 4. are robust predictions for future stock returns, as they account for over 100 different cuts of the data, using 3 distinct valuation techniques, and utilize the most explanatory statistical relationships. The models explain up to 82% of future returns based on R-Squared, and are statistically significant at p~0. It is worth noting, however, that even this model has very little explanatory power over horizons less than 6 or 7 years, so almost anything is possible in the short-term.
Returns in the reddish row labeled "PE1" in Matrix 4 were forecast using just the most recent 12 months of earnings data, and correlate strongly with common "Trailing 12-Month" PE ratios cited in the media. Note that our Matrix 1. proves that this trailing 12 month measure is not worth very much as a measure for forecasting future returns over any horizon. However, the more constructive results from this metric probably helps to explain the general consensus among sell-side market strategists that markets will do just fine over coming years. Just remember that these analysts have no proven ability whatsoever in predicting market returns (see here, here, and here). Further, it can be argued that their firms have a substantial incentive to keep their clients invested in stocks.
Investors would do much better to heed the results of robust statistical analyses of actual market history, and play to the relative odds. This analysis suggests that markets are currently expensive, and asserts a very high probability of low returns to stocks (and possibly other asset classes) in the future. Remember, any returns earned above the average are necessarily earned at someone else's expense, so it will likely be necessary to do something radically different than everyone else to capture excess returns going forward.

Friday, July 27, 2012

You're Looking at the Wrong Number

In a prior post entitled 'Retirement's Volatility Bogeyman' we introduced the critical concept that volatility is the unsung villain of retirement sustainability. This article will reiterate the concepts we presented in the prior article, and demonstrate how an investor can tolerate lower returns so long as volatility is actively managed in the context of a more traditional balanced portfolio.

As a reminder, every non-pensioned person nearing or in retirement should become intimately acquainted with the following two terms:

Safe Withdrawal Rate (SWR): the percent of your retirement portfolio that you can safely withdraw each year for income, assuming the income is adjusted upward each year to account for inflation.

Retirement Sustainability Quotient (RSQ): the probability that your retirement portfolio will sustain you through death given certain assumptions about lifespan, inflation, returns, volatility and income withdrawal rate. You should target an RSQ of 85%, which means you are 85% confident that your plan will sustain you through retirement.


Portfolio Volatility Determines RSQ and SWR

The chart below shows how higher portfolio volatility results in lower SWRs, holding everything else constant:
  1. All portfolios deliver 7% average returns.
  2. Future inflation will be 2.5%.
  3. Median remaining lifespan is 20 years (about right for a 65 year old woman).
  4. We want to target an 85% Retirement Sustainability Quotient (RSQ).
Note how SWR declines as portfolio volatility rises.
Source: Butler|Philbrick|Gordillo & Associates, 2012
The green bar marks the volatility of a 50/50 stock/U.S. Treasury balanced portfolio over the long-term, while the red bar marks the long-term volatility of a diversified stock index. Note the SWR of the stock/bond portfolio is 6% versus 3.4% for the stock portfolio, highlighting the steep tax that volatility levies on retirement income.

Steady Eddy and Risky Ricky

This is actually quite intuitive when you think about it. Imagine a scenario where two retired persons, Steady Eddy and Risky Ricky by name, draw the same average annual income of $100,000 from their respective retirement portfolios. Both draw an income that is a percentage of the assets in their retirement portfolio at the end of the prior year.
Steady Eddy's portfolio is invested in a balanced strategy with a volatility of 9.5%, while Risky Ricky is entirely in stocks with a volatility of 16.5%. Both portfolios earn the same return (as they have done for the past 15, 20 and 25 years, though we will address this in greater detail below).
Due to the lower volatility of Steady Eddy's portfolio, his income is less volatile: 95% of the time his income is between $82,000 and $117,000. In contrast, Risky Ricky's portfolio swings wildly from year to year, and therefore so does his income: 95% of the time his income is between $67,000 and $133,000. Of course, both of their incomes average out to the same $100,000 per year over time.
All other things equal, which person would you expect to be more conservative in the amount of income they spend each year? Obviously, if your income were subject to a large amount of variability each year then you would tend to be more conservative in your spending; perhaps you would squirrel away some income each year in case next year's income comes in on the low end of the range.
This relates directly to the impact of volatility on SWRs in the chart above. Volatility introduces uncertainty which is amplified by the fact that money is being extracted from the portfolio each and every year regardless of portfolio growth or losses.

How Much Gain Will Neutralize the Pain?

Of course, this effect can be moderated by increasing average portfolio returns, which would then increase average available income. The question becomes, how much extra return is required to justify higher levels of portfolio volatility?
The chart below defines this relationship quantitatively by illustrating the average return that a portfolio must deliver to neutralize an increase in portfolio volatility. In this case we hold the following assumptions constant:
  1. Withdrawal rate is 5% of portfolio value, adjusted each year for inflation.
  2. Inflation is 2.5%.
  3. Retirement Sustainability Quotient target is 85%.
  4. Median remaining lifespan is 20 years.
Source: Butler|Philbrick|Gordillo & Associates, 2012
Again, the green bar represents the balanced stock/Treasury bond portfolio discussed above, and the red bar represents an all-stock portfolio. From the chart, you can see that the balanced portfolio needs to deliver 6.8% returns to achieve an 85% RSQ with a 5% withdrawal rate. The higher volatility stock portfolio, on the other hand, requires a 9.2% returns to achieve the same outcomes.
In theory, higher returns in your retirement portfolio should equate to higher sustainable retirement income. In reality, higher returns at the expense of higher volatility actually reduces your retirement sustainability.
Focus on What You Can Control
It is impossible to control the intermediate- to long-term returns to asset classes, but we can control the assets we hold in portfolios, and the allocation between them. To a large extent, we can also control the volatility of our portfolio, if not total portfolio risk.
First, let's focus on a typical 60/40 stock/bond portfolio, which is the template for many retirement accounts. Not incidentally, this is also the flagship allocation for most small and medium sized foundations and endowments.
For our study, we focus on returns to Treasuries rather than corporate bonds because we couldn't find good daily data for corporate bonds, and because Treasuries alone provide true diversification against financial shocks, which means they perform as bonds should when it really counts.
Chart. A 60/40 portfolio 1963 - 2012
Source: Ken French, FRED 
The simple 60/40 portfolio exhibited pretty good performance over the almost 50 year period from 1963, delivering 8.82% annualized returns with a volatility of 9.91%. Unfortunately, the strategy lost 31% of its value in 1973/1974, and 26% in 2008/2009, which would have been very difficult to stomach.
Next, we investigated a 60/40 strategy with two simple twists: we applied a 60/40 risk weighting instead of the typical capital weighting, and we applied a target volatility of 6% at the portfolio level to maintain a stable risk experience.
Chart. A 60/40 volatility weighted portfolio with 6% ex-ante target volatility, 1963-2012
Source: Ken French, FRED 
We observe a drop in returns from 8.8% per year to 7.8%, which is not insignificant. However, the risk character changes much more dramatically. Ex-post observed volatility drops from 9.91% to 5.33%, a reduction of 46%, and drawdowns are also much more muted, dropping by almost 50% from over 30% to 16.5%.
Let's examine the impact of this simple risk management overlay on the Safe Withdrawal Rate that each strategy will support.
Chart. Safe Withdrawal Rate for Traditional 60/40 portfolio vs. 60/40 risk weighted portfolio with 6% volatility target
Source: Ken French, FRED, QWeMA
Astute observers will notice that despite the higher average returns to the traditional 60/40 portfolio, the risk managed portfolio will support a higher SWR: 6.8% vs. 6.6%. This offers an excellent example of the impact of volatility on the SWR. An investor can tolerate lower returns so long as volatility is actively managed.
Further, from a behavioural and experiential standpoint, the risk managed portfolio provides a much more stable experience that investors are more likely to stick with. This last point is absolutely critical, as the chart below from Dalbar shows that the inability of traditional balanced investors to stick with their strategy over the long-term caused these investors to trail a 60/40 balanced index strategy by 5.94% per year over the 20 years through the end of 2011.
Chart. Realized investor returns vs. indexes
Source: Dalbar, Ken French, FRED
Balanced portfolio is rebalanced monthly

Monday, July 23, 2012

Dividend Delusions

Just a short post to highlight the frothy premiums currently being bestowed upon the 'slow and steady' blue-chip dividend stocks at the moment. As central banks have successfully reduced yields on government and high grade corporate bonds to levels that will not sustain institutional funding or retirement income goals, investors of all stripes have flocked to dividend funds in their chase for yield.

Unfortunately, in the stampede for yield, investors in dividend stocks are overlooking the single most critical fact: valuations for the 'bluest of blue chip' dividend stocks, as measured by the Dow Jones Select Dividend Index, are now higher in aggregate than valuations for the broader market.

This must represent a profound source of consternation for traditional value investors, who must be enormously frustrated that their value bias can no longer be reconciled with a dividend focus.

Chart 1. Price to Book Discount of Dow Jones Select Dividend Index vs. Russell 1000
Source: Bloomberg

Chart 2. Price to Earnings Discount of Dow Jones Select Dividend Index vs. Russell 1000
Source: Bloomberg


You can see that based on both PE ratio and PB ratio that dividend stocks are valued at or near a premium to the broader stock market. Further, looking back to 2003 (the inception of the dividend index), dividend stocks have rarely been more expensive relative to the broader market.

Readers of this blog won't be surprised to learn that we would advocate for investors to replace their thirst for yield with a thirst for low volatility. The following charts make the case.

Chart 3. Low volatility stocks outperform the market in absolute and relative terms
 Source: Deutsche Bank

Chart 4. Low volatility stocks are substantially cheaper than dividend stocks
Source: Yahoo finance

Chart 5. When yields are adjusted for risk, rational investors would be agnostic about investing in low volatility versus high dividend stocks, but would prefer either to the market index
Source: Yahoo finance

Chart 6. Last but not least, low volatility stocks in aggregate are under-owned - in stark contrast to the extremely over-owned dividend sectors.
Source: Deutsche Bank

Friday, June 15, 2012

Adaptive Asset Allocation for a Regime Agnostic 'Balanced Fund'

Risk Parity: Past its Prime
This is a follow-on to our research on Adaptive Asset Allocation

Our last article described an Adaptive Risk Parity (ARP) framework for a stock/bond balanced allocation, and discussed the advantages and risks relative to traditional 60/40 approach. While ARP makes intuitive, logical and empirical sense as an allocation framework, there are long-term risks to this approach related to asset class regimes.

Stocks, bonds and other asset classes generally move through long periods of high total return followed by long-periods of low total return. While there is more contention about where we are in the long-term stock cycle, there can be little debate about whether we are closer to the end or the beginning of the long-term interest rate cycle.

The chart below from Mebane Faber's great new(ish) series on Risk Parity demonstrates the long-term efficacy of a static version of the approach for a portfolio of stocks and bonds using long-term relative stock and bond volatility for allocations, and targeting the same long-term volatility as the 60/40 portfolio (10.44%). Notice that to achieve the same level of risk as a 60/40 portfolio, the risk parity portfolio must be levered by 160%.

Chart 1. Long-term risk parity with S&P 500 and 10-Year Treasuries, 1972 - 2012


Source: Mabane Faber, 2012


While the performance of the static risk parity approach is better over the full period, Faber points out that the relative out-performance is sensitive to the start and end dates of the observation period. If we go back in time to mid 2000 and observe the relative performance over the first 28 years, we may have drawn a different conclusion.

Chart 2. Long-term risk parity with S&P 500 and 10-Year Treasuries, 1972 - 2000
Source: Mabane Faber, 2012

So what happened during the last decade to create such a massive disparity in returns? The next chart offers a clue: it plots the progression of interest rates since 2000.

Chart 3. 10-Year Treasury yield, 2000 - 2012
 Source: FRED database

Clearly this has been an exceptional period for interest rates, as they have dropped by over 70% over the past 12 years, delivering almost 7.6% in total returns per year, compared with 0.80% per year for stocks.

The question is, with interest rates at or very near historic lows, and the relative return differential between risk parity and more traditional approaches at an all-time high, should we expect this approach to continue to dominate other approaches going forward? Or should we acknowledge that the best days for risk parity are probably behind us - and adapt?

Adaptive Asset Allocation (AAA)

In this article we will apply the integrated AAA approach described in our whitepaper to a more traditional stock and bond portfolio to create a resilient 'balanced fund' that is immune to the interest rate bias that represents the Achilles Heel of risk parity.

AAA uses estimates of returns, volatility and correlation for assets in a portfolio based on recently observed measures of these parameters, rather than long-term averages. These estimates are then integrated using a robust mean-variance optimization algorithm analogous to the equations described under the banner of Modern Portfolio Theory.

Estimates for returns and correlations are drawn from time series for each asset over a 6-month look-back horizon, while volatility is measured over a shorter 60 day horizon. Further, portfolio level volatility at each rebalance period is managed to a 10% target. Depending on the measured volatility of the assets, and the correlation between them, at each rebalance period, cash or leverage may be required to reach the volatility target. No yield on cash or cost of leverage is included for this illustration.

Chart 4. Adaptive Asset Allocation balanced portfolio, rebalanced monthly, 1995 - May 31, 2012
Max 200% exposure
Source: Data from Yahoo Finance

For those with no tolerance for leverage or margin, here is a version of the AAA approach with a maximum 100% portfolio exposure.

Chart 5. Adaptive Asset Allocation balanced portfolio, rebalanced monthly, 1995 - May 31, 2012
Max 100% exposure
Source: Data from Yahoo Finance


You can see that the Adaptive Asset Allocation framework described in our whitepaper applies quite well to a typical balanced portfolio of stocks and bonds. To illustrate the adaptive nature of the program, the diagram below illustrates how the portfolio adapts its allocations over time based on changing momentum, volatility and correlation dynamics.


You can see that the starting allocation for June would have been 53.72% in stocks and 46.28% in bonds.

Chart 6. Adaptive Asset Allocation balanced portfolio, historical allocations, Aug 31, 2011 - May 31, 1012. Max 100% exposure.
Source: Data from Yahoo Finance

Notice how during late 2011's extreme market behaviour, the AAA balanced portfolio dramatically reduced exposure to both stocks and bonds, lowering equity allocation to 11% and Treasury allocations to 39% at the end of September, with the balance in a 50% cash allocation. This was necessary to maintain the target 10% portfolio volatility during a period where the observed volatility was much too high. 

Also notice that, for the most part, the allocations do not stray too far from the Investment Policy Statement (IPS) guidelines for a typical balanced investor. Where deviations do occur, they are usually biased toward too much cash, and rarely last more than a month or two except during extreme situations like 2008.


Fortunately, many IPSs have enough flexibility in their guidelines to to allow for deviations from stated benchmarks over periods up to 3 months, and longer deviations are allowed with appropriate client consultation.

As a result, while portfolio flexibility is an important and central element of the AAA framework, the examples above demonstrate that it is constrained enough to make it a compelling and comprehensive alternative for traditional balanced clients.

Conclusion

The November article 'Rebalancing Resurrected' introduced the concept of weighting portfolio allocations based on relative volatility rather than as a set portion of capital. It was shown that relative volatility sizing delivered a substantial improvement to risk-adjusted returns without sacrificing absolute returns.

The prior article on Adaptive Risk Parity was a natural extension to a volatility sizing approach because it applies the same math to allocate between the assets based on volatility, but then overlays a risk budget at the portfolio level. The ARP approach further improved risk adjusted performance with consistent absolute performance.

Further, by allowing the portfolio to take on a limited amount of leverage at times of low asset level volatility and/or very low asset correlations in order to achieve the target risk budget, the ARP portfolio delivered a 27% improvement in absolute returns with the same level of portfolio volatility as the traditional balanced portfolio.

Finally, in acknowledgment of the primary flaw in the usual risk parity approach - the structural overweight to fixed income - we applied an Adaptive Asset Allocation framework that applied better estimates of return, volatility and correlation to create rolling optimal portfolios. This framework delivered performance consistent with the ARP approach, but because it is guided by asset class momentum as well as relative volatility and correlations, it is robust to structural shifts in interest rate regimes.

Investors are looking for robust, adaptive investment solutions to manage indelible liabilities like funding objectives or retirements. Traditional SAA and endowment model 60/40 portfolios are vulnerable to long-term shifts in return, volatility and correlation regimes across asset classes. This risk is especially acute with interest rates at historic lows.

The Adaptive Asset Allocation framework offers a working solution for investors that provides strong returns with managed risk, a combination that substantially and positively skews the probability of success for investors, regardless of market outcomes.

Wednesday, June 6, 2012

Adaptive Risk Parity for a Better 'Balanced Fund'

Rebalancing Revisited

Back in November of 2011 we published our first article introducing the concept of volatility sizing for asset allocation within a stock and bond portfolio as an alternative to traditional static capital weightings, such as 60/40. The volatility sizing technique produced an 18% improvement in risk-adjusted performance, including a 30% reduction in peak-to-trough drawdown.

More recently, we integrated volatility related ideas from the original article along with concepts related to momentum, correlation, and the architecture of Modern Portfolio Theory, to introduce a novel Adaptive Asset Allocation framework (expanded whitepaper here) for a broad basket of global asset classes.

In this article we revert our focus back to stocks and bonds. Specifically, we will demonstrate how to create a more optimal 'balanced fund' using ETFs tracking the S&P 500 and long-term Treasuries by applying a strategy we call Active Risk Parity (ARP). This approach borrows heavily from the literature related to standard risk parity, but overlays active volatility management both at the individual asset class level, and the portfolio level, to achieve a 27% improvement in absolute returns, and a 29% improvement in risk-adjusted performance, relative to a traditional balanced portfolio.

Recall that the difference between the previously described volatility weighted approach and a typical balanced approach, is that rather than allocating equal portions of capital to assets in a portfolio, the volatility weighted portfolio allocates equal portions of risk, as measured by recently observed volatility.

To illustrate this concept consider the following chart, which captures the relative contribution of portfolio volatility from stocks versus bonds in a typical 60/40 balanced portfolio.

Chart 1. Marginal risk contribution: 60/40 portfolio of U.S. stocks vs. Treasuries, 1995 - 2012
Source: Data from Yahoo Finance

The blue area reflects the proportion of portfolio volatility attributable to the 60% stock allocation, while the red area indicates the proportion contributed by the 40% Treasury allocation. Note that while the capital is allocated 60/40 to stocks and bonds respectively, the risk is actually allocated about 80/20. This reality is lost on most investors, including most investment managers, despite the hard lessons learned during recent bear market periods.

The volatility weighting framework allocates capital to assets at each rebalance period such that each asset class contributes an equal amount of risk to the portfolio rather than a set proportion of capital. In our November article we compared the performance of a traditional 50/50 capital allocated approach to the performance of a volatility weighted approach using data for stocks and Treasuries going back to 1995. The following charts update the performance of these two mandates through the close of trading on May 31, 2012.

Chart 2. Equal weight portfolio of stocks and bonds, rebalanced quarterly, Jan 1995 - May 2012
Source: Data from Yahoo Finance

Chart 3. Equal volatility weighted portfolio of stocks and bonds, rebalanced quarterly, Jan 1995 - May 2012
Source: Data from Yahoo Finance

The relative volatility weighted portfolio delivers better risk adjusted, and absolute, performance than the traditional 50/50 portfolio. Further, in two other prior articles we demonstrated that this approach to asset allocation is equally robust for Canadian and Japanese balanced portfolios as well.

Given that asset allocation is improved by focusing on proportional risk rather than proportional capital, we are ready to explore a more robust application of this concept.

Active Risk Parity

The volatility weighting approach described above ensures that the volatility contributions of stocks and bonds are equal in a fully invested portfolio. While this approach promises a much more stable return distribution than the traditional 50/50 capital allocation framework, it is still vulnerable to short- and intermediate-term changes in asset correlations which impacts total risk at the portfolio level.

Recall that portfolio volatility is impacted by the volatilities of the individual assets AND the correlation between those assets. For example, if we assume two assets have the same volatility, then the following chart quantifies the change in portfolio level volatility as a function of the change in correlation between the assets based on Markowitz' famous equation.


In contrast, in a Risk Parity framework once the assets have been risk-weighted within the portfolio, the portfolio itself is then levered or de-levered to achieve a desired target for portfolio volatility. The math for volatility targeting is simply:  

target volatility
observed volatility

For example, a Risk Parity investor targeting a 10% risk budget for a portfolio with observed volatility of 8% would allocate 10% / 8% = 125% to the portfolio, which would require 25% leverage. 

Typically, Risk Parity suffers from the same issues as Strategic Asset Allocation related to the fact that the guiding assumptions for the volatility and correlation inputs to the portfolio optimization are derived from long-term average values. We have published several research pieces (here) discussing the dangers of using long-term average values for portfolio inputs, so we will avoid that error here. Rather, we will use 60 day rolling measures of volatility and correlation for allocation decisions at each rebalance period. 

For the purpose of this article we have coined a new term, Active Risk Parity (ARP), which captures the risk parity concept but applies better portfolio optimization estimates based on near-term observed values.  The following ARP performance chart uses a 60 day trailing observation period to allocate  at each rebalance period, and to also target a 10% portfolio volatility, rebalanced quarterly. In an effort to keep leverage to manageable levels, maximum portfolio exposure has been limited to 200%, which is practical for typical margin accounts. Note that we have assumed no yield on cash nor costs associated with the use of leverage for this illustration.

Chart 4. Active Risk Parity balanced portfolio, rebalanced quarterly, 1995 - May 31, 2012
Max 200% exposure
Source: Data from Yahoo Finance

For investors with no tolerance for margin or leverage, the following chart updates the ARP portfolio   assuming a maximum of 100% exposure.

Chart 5. Active Risk Parity balanced portfolio, rebalanced quarterly, 1995 - May 31, 2012
Max 100% exposure
Source: Data from Yahoo Finance

Risk Parity, and ARP in particular have significant advantages over a typical asset allocation framework. Obviously, risk adjusted performance is improved substantially in terms of both average portfolio volatility and drawdowns. In addition, absolute performance is consistent with no leverage, and about 27% higher with leverage, at a similar average level of volatility.


Some Challenges


However, Risk Parity skeptics have long complained that the success of the approach can largely be attributed to the much higher relative allocation to fixed income over a testing period where interest rates have steadily declined. Bonds are structurally much less volatile than stocks, and so command a much higher allocation in a Risk Parity framework on average relative to a typical balanced approach. Obviously during a period of steadily declining rates a risk parity portfolio will have an advantage.


But what happens to a risk parity approach when, inevitably, rates start to rise again. Should bonds continue to maintain such a perpetually overweighted position in portfolios when long-term Treasuries promise yields of less than 3% for the next 30 years?

We feel this is a valid point. Obviously, return estimates need to be factored into the portfolio optimization somehow. However, we don't accept that this argument suggests that investors should move away from risk parity back toward the traditional Strategic Asset Allocation approach.

The next article will apply our Adaptive Asset Allocation framework to improve on the ARP approach by introducing a return estimate. This will short-circuit the fixed income conundrum so that balanced investors have a chance to capture a larger proportion of returns to stocks as rates normalize.