Asset Allocation Composite
Asset Allocation Composite (AAC) strategy is a hybrid of Strategic Asset Allocation and Tactical Asset Allocation. Its portfolio allocation is based strategic (or long term) asset allocation among major assets. On the other hand, it incorporates a market indicator to decide whether it warrants to tactically reduce or increase risk asset (stocks) allocations.
As always, we believe in diversification among major assets that include US stocks, international developed market stocks, emerging market stocks, Real Estate (REITs), commodities and bonds. Among the major risk assets (i.e. the assets other than bonds mentioned in the above), we adopt a long term strategic view that’s similar to our Strategic Asset Allocation (SAA). The following is a synopsis on SAA:
Strategic Asset Allocation (SAA) is based on the main stream Modern Portfolio Theory: an investor decides asset allocation among major asset classes, based on personal long term risk and asset return expectations. Such an allocation is called strategic as it is meant to be long term oriented and should be only adjusted when some major events such as job change, getting closer to retirement etc. happen. As any asset allocation strategy, two critical factors should be considered:
- Risk tolerance: Being too aggressive could have damaging psychological and financial effects when markets perform poorly: often, investors are too late to realize that the portfolio is severely damaged and cannot bear with the risk anymore. Changing the portfolio allocation mix during market bottoms can have long term damage. On the other hand, being too conservative may not achieve the long term investment goal. Investors should pay careful attention to deciding the risk tolerance.
- Diversification: It is critical to diversify a portfolio into various uncorrelated assets. Different assets behave differently during different economic and market cycles. As long as these assets have reasonable long term expected returns, the diversification smoothes out the volatility of a portfolio and helps the portfolio to achieve better risk-adjusted return.
We further recognize that US companies, especially large companies, have oversized exposure in oversea or international markets. Thus, US stock allocation actually includes some non-insignificant exposure that needs to be taken into account. Our AAC allocation now incorporates this viewpoint.
We also adopt a more conservative view on commodities asset class. We believe other than gold, other commodities subclasses are not efficiently investable as currently, their exposure has to be through derivatives or so called futures. Technical issues make funds representing these assets not cost effective. We thus don’t recommend commodities allocation for average investors.
Funds in assets
We have long advocated the following in terms of selecting candidate funds for various asset classes (see our article here):
We advocate using ultra low cost index funds for these asset classes. We have discussed the rationale behind this. A simple reason for this (among other factors) is that actively managed stock funds are usually much less predictable as they greatly depend on managers’ subjective investment viewpoints, making them not really suitable for long term investments. Furthermore, more and more efficient stock markets are making actively managed stock funds much harder to outperform index funds. In fact, majority of actively managed stock funds underperform index funds, based on many academic studies on long running data.
Recently, (smart) factor ETFs have become more mature and have shown great potential (see November 4, 2019: Factor ETF Rotation, for example). Though some of these index based funds are not really passive per se, they nevertheless are based on a well defined set of rules (or quantitative), free of subjective human opinions. These factor ETFs are utilized in some of our advanced portfolios.
Bonds (fixed income):
On the other hand, for fixed income (bonds), we believe the outperformance persistence by some good bond managers is much more consistent and greater, especially for intermediate term bond funds. It’s also possible to use a momentum based strategy to periodically rotate/select a fund to achieve even better returns with lower risk. Our long running total return bond fund portfolios on Brokerage Investors page have consistently outperformed index bond funds and the excellent total return bond funds used as candidate funds. We have written extensively on these types of portfolios (for example, see August 28, 2017: Total Return Bond Fund Portfolios: Where Do They Fit?).
ETFs or mutual funds
For stock assets, we generally prefer index ETFs over index mutual funds, though mutual funds are also workable. The reasons are as follows:
- Stock index ETFs now possess lower expense ratios than their mutual fund counterparts. This is evident in Vanguard’s index ETFs and its index mutual funds.
- Stock index ETFs have no minimum holding period restriction, unlike mutual funds. Many brokerages impose a minimum 3 month holding period for mutual funds (TD Ameritrade is even more extreme, having 3 month minimum holding requirement). This can sometimes hinder our risk exposure adjustment in a fast changing market.
- ETFs can now be traded commission free in many major brokerages.
- Major stock index ETFs now have large liquidity, thus much lower premium/discount over their net asset values.
Of course, for some investors, unlike mutual funds whose prices are set after market close, it’s still a hassle to have to pay attention to ETFs’ intraday prices when making a trade. This can become a source of distraction and/frustration. For this, mutual funds can be still useful.
Our AAC based portfolios will look once a month to decide whether to rebalance. Notice that not every month a portfolio needs to rebalance. This depends on the candidate funds in a portfolio. Our general purpose MPIQ Core ETFs AAC portfolios (see below), for example, average only 4 trades a year.
At a rebalance time, the strategy will decide whether to perform risk asset exposure change (decrease or increase) as well as individual fund selection. The risk asset (stock) exposure decision is based on our market indicator.
Our AAC always makes rebalance decision at the end of a month and investors will perform rebalance orders on the first trading day of the next month.
Risk asset exposure and fund selection
Our AAC based portfolios can dynamically reduce or increase risk asset exposure based on our our market indicator. As stated in the previous newsletter November 11, 2019: Market Indicator And Momentum, our market indicator makes infrequent such change: for example, since 1996, it only decided to change exposure five times. The main purpose of such risk asset exposure change is to reduce or avoid large portfolio loss during a severe market downturn. As we stated many times, holding a diversified stock index fund for a very long period of time can in general result in an inflation beating return (of course, we want to emphasize again here the term ‘a very long period of time’, usually means 20 years or longer). We thus make a conscious decision not to be too active and aggressive to reduce stock exposure in a normal market correction. Our market indicator will only become more aggressive when stock trend and other factors such as credit and interest rate risk, market valuation and market internals together confirm a severity of a downtrend.
Once asset allocations are decided, our strategy selects funds within each asset class. The method is still momentum based. Momentum based fund rotation/selection can result in further return improvement.
- Martin Gruber, Stephen Brown, William Goetzman, “Modern Portfolio Theory and Investment Analysis”. Willey, 7th Edition, 2006.
- Roger Gibson. “Asset Allocation: Balancing Financial Risks”. McGraw-Hill. 2007.
- William Bernstein, “The Four Pillars of Investing: Lessons for Building a Winning Portfolio”.McGraw-Hill. 2002.
- Gary Gorton, Geert Rouwenhorst. “Facts and Fantasies about Commodity Futures“.Yale University Research Paper. 2004.
- David Swesen, “Unconventional Success: A Fundamental Approach to Personal Investment”. Free Press, Aug 2, 2005.
- Paul Farrell, “Marketwatch.com Lazy Portfolios”. marketwatch.com. It maintains a list of lazy portfolios including the one called “Yale U’s Unconventional” and “Aronson Family Taxable”.
- William Bernstein, The July 1997 Coward’s Portfolio. www.efficientfrontier.com, 1997.
- Carhart, Mark, M. “On Persistence in Mutual Fund Performance“, Journal of Finance, Vol. 52 No. 1, March 1997.
- Blitz, David and Van Vliet, Pim, “Global Tactical Cross-Asset Allocation: Applying Value and Momentum Across Asset Classes“. Journal of Portfolio Management, May 2008.
- Asness, Clifford S., Moskowitz, Tobias J. and Pedersen, Lasse Heje, Value and MomentumEverywhere (March 6, 2009). AFA 2010 Atlanta Meetings Paper.
- Asness, Clifford, “The Power of Past Stock Returns to Explain Future Stock Returns”, Goldman Sachs Asset Management, 1995.
- Narasimhan Jegadeesh & Sheridan Titman, “Momentum“, SSRN Working Paper, 2001
- Doron Avramov, Russ Wermers, “Investing in mutual funds when returns are predictable”. Journal of Financial Economics 81 (2006) 339–377. For asset and industry rotation and fund selection.