July 18th 2011: Equal Weight or Not Equal Weight in Strategic Asset Allocation?

07/18/2011 Share 0 comments

In our previous newsletters, we outlined intuitions and the fund selection method for the strategic asset allocation. By default, the strategic asset allocation adopts a simple equal weight allocation among risk assets (the allocations of risk assets and fixed income are first determined by the risk profile). Within an asset class, allocations of funds are further equal weighted, again by default.

A natural question arises from this is how well the equal weight strategic asset allocation does. The answer: pretty well. This might surprise some of you.

The most systematic academic study on this subject is a research done by DeMiguel, Garlappi and Uppal at London Business School and University of Texas. In a paper titled as How inefficient are simple asset-allocation strategies?, they compared the simple equal weight asset allocation with various sophisticated methods such as mean variance optimization (MVO) and some dynamic asset allocation strategies. They reached the following conclusions:

We find that the simple asset-allocation rule of 1/N (with or without rebalancing at each trading date) is not very inefficient. In fact, it performs quite well out-of-sample: it often has a higher Sharpe ratio and a lower turnover than the policies from the static and the dynamic models of optimal asset allocation.

In practice, the most interesting equal weight allocation example is the Rydex S&P Equal Weight fund (RSP). From 5/2/2003 (the inception date of RSP) to 7/15/2011, the annualized return of RSP is 9.4% (annualized standard deviation 23%), compared with SPY's 6.3% (20% annualized standard deviation). For more detailed comparison, refer here.

Though equal weight allocation is very competitive, it is still desirable to have allocations based on some plausible weights. We are soon releasing a feature that allows users to customize their portfolios based on Guru allocation templates (such as those lazy portfolios proposed by Gurus like Yale's David Swensen and Harry Browne, to name a few). But investors can rest assured that equal weight allocation does have some research and practical backings.

Interested readers are encouraged to compare an SAA model portfolio (such as six core asset ETFs SAA risk profile 0) with some other portfolios with different weights. We will have more on this once our new feature is released.

Market Overview

The most noticeable developments last week include the following:

• Commodities continued their come back. Gold made historical high. 
• Stocks all went lower
• US Treasury bonds were strong.

We are still in a very unstable period. Any substantial development can be a tipping point, especially in the downside.

For more information on how these assets are ranked, please see here. 

MyPlanIQ's top Smart Money Managers' equity allocation swung back to 77% on last Friday. This is a meaningful indication as US stock market (VTI) lost over 2%. On the other hand, we can see the allocations are having wide swings. That again says how unstable the markets are at the moment. For more information, please refer to MyPlanIQ SmartMoney Indicators page (click on larger chart link such as this for better reading).

Benchmark Portfolios

Our TD Ameritrade Commission Free ETFs model portfolios have not done well recently. The following shows the performance of the two model portfolios

Portfolio Performance Comparison

Though 5 year or longer term performance is still quite favorable, year to date, our strategies have had some difficulty dealing with volatile commodity sector funds and country stock funds. Unlike other plans, TD Ameritrade plan consists of over 101 ETfs some of them are very sector concentrated and many others are country stock funds. We are improving our strategies and expect in the future, we will have a much more effective way to better handle these funds.

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