Our Robust Asset Allocation (RAA) Solution by Wesley R. Gray, Ph.D., Alpha Architect

Robustness: Strong and effective in all or most situations and conditions.

Executive Summary:

Many investors are faced with a fundamental problem: What should I do with my money?

People usually pursue one of four broad solutions to this problem–each has costs and benefits:

  1. Hire an expensive investment advisor that offers a limited value proposition. (generally a bad idea, although quite common)
  2. Hire an affordable advisor that delivers a strong value proposition.  (reasonable idea)
  3. Hire a cheap robo-advisor that will deliver a generic, but reasonable value proposition.  (reasonable idea)
  4. Do-it-yourself. (reasonable idea)

We think educated investors can successfully move down the “do-it-yourself” path when equipped with the tools and knowledge to move forward. There are a few critical areas to get familiar with, but once that’s complete, DIY is perfectly viable for many. For those who are not comfortable with the DIY approach, we recommend approach 2 or 3, depending on personal preferences and circumstances.

I want to be a DIY investor, so what do I do next?

Easiest solution: 50% BND; 50% VTI (or your own special weights depending on your risk tolerance, individual circumstances).

  • Insanely cheap; insanely easy; throw away the key. Not an unreasonable approach.

More complex solution:

Meb Faber and Eric Richardson in their book, “The Ivy Portfolio,” hint at a do-it-yourself model that utilizes a simple 10-month trend-following rule  to run a risk-managed portfolio allocated across US equity, developed equity, REITs, commodities, and US Treasury bonds. These 5 asset classes are commonly referred to as the “IVY 5,” since they form the basic building blocks for the endowments of the ivy league schools and others. This is a reasonable solution for a DIY investor, but the live performance of a related strategy has been underwhelming the past few years.

However, not all is lost–simple still is the key to success, we just need a few tweaks…

We explore a more robust asset allocation solution that improves upon the IVY 5 model in three ways:

  1. We introduce security selection (value and momentum).
  2. We improve upon the IVY 5 risk-management system.
  3. We focus on fee and tax-management.

The outcome of our solution highlights what we call Robust Asset Allocation (RAA).

RAA Mission: A low-cost, low-complexity, high-liquidity, diversified, tax-efficient, risk-managed retirement portfolio.

RAA Goal: A One-Stop Retirement Solution.

Let’s get started…

1. What is Your Portfolio’s Mission?

1.1 The Purpose-Driven Portfolio

Wealth is often built by concentrated holdings, but wealth is protected by diversification. Most people accumulate wealth by working, which is a concentrated position, as this usually requires time and effort.

Having a clear purpose is the premise of portfolio investment.

Example:

  • Purpose of the portfolio: Preserve and compound wealth to assure financial security.
  • Return objective: RF (10Yr) + 400bps, AFTER TAX.
  • Risk appetite: As low as practical to achieve objective.
  • Taxes:  Can be huge drag on returns for private individuals –> minimize damage.
  • Human capital: Don’t confuse frenetic human activity, or a large staff, with higher risk-adjusted return potential.

1.2 Strategy Assessment: Stick to FACTS

“Get your facts first, then you can distort ‘em as you please.”
— Attributed to Mark Twain

While there is no “one-size fits all” strategy assessment and allocation model, a systematic framework for decision-making can help simplify the process and maximize returns. For every allocation contemplated, and each strategy that needs to be critically assessed, the FACTS framework (consisting of Fees, Access, Complexity, Taxes and Search) can be employed to clarify important considerations for the prospective investor.

Robust Asset Allocation

Click to read our white paper: Stick to the FACTSA in-depth look at the FACTS framework is here.

The high level summary is as follows: Create a portfolio that minimizes fees, increases access to your own capital (e.g., liquid investments), is easy to understand (low complexity), minimizes taxes, and minimizes manager search costs. Our goal is to propose a portfolio that optimizes across all 5 key points.

2. Does Complexity Enhance Asset Allocation?

2.1 Do Fancy Models Work? Not Exactly…

“Of the 14 models we evaluate across seven empirical datasets, none is consistently better than the 1/N rule…”
— DeMiguel, Garlappi and Uppal.

Victor Demiguel and his colleagues have explored many sophisticated methodologies to optimize asset allocation. They have solutions that can possibly beat an equal-weight allocation, but these alternative solutions add a high degree of complexity. Prof. DeMiguel has an outstanding outline of asset allocation research here if you’d like to explore further. We’ve discussed the empirical rational for following a simple asset allocation model in the past, here, and here. An equal-weight portfolio–also promoted by DeMiguel et al.–would seem to fly in the face of modern portfolio management, which in general has suggested that investors rely on mean-variance type allocation, or other highly engineered schemes. However, while mean-variance-analysis has reverse engineered the best historical Sharpe ratio (i.e. the tangency portfolio), this solution relies on a correlation matrix input, which is highly unstable and difficult to estimate. Indeed other approaches have this same weakness. The results below, taken from the DeMiguel et al. paper on asset allocation, highlight the incredible robustness associated with an equal-weight, or 1/N, type of asset allocation regime.

Robust Asset Allocation

Source: DeMiguel, V., L. Garlappi, and R. Uppal, 2009, Optimal Versus Naïve Diversification: How Inefficient is the 1/N Portfolio Strategy? Review of Financial Studies 5, 1915-1953.DeMiguel et al. are not the only researchers pointing towards the 1/n solution. Even the great Harry Morkowitz, a Nobel Prize winner and the founder of portfolio management, is quoted as saying:

“I should have computed the historical covariance of the asset classes and drawn an efficient frontier…I split my contributions 50/50 between bonds and equities.”

A few quotes attributed to Einstein sum up the key lessons learned from piles of disinterested research compiled on the subject of asset allocation.

  1. Keep it simple.
  2. Complexity does not imply value.

A Robust Asset Allocation (RAA) Solution [ANALYSIS]

2.2 Simplify the Allocation Problem: Simplify; Simplify; Simplify

“Don’t try anything fancy. Stick to a simple diversified portfolio, keep your costs down and rebalance periodically to keep your asset allocations in line with your long-term goals.”
–David Swensen, Yale Endowment CIO.

The “IVY 5” portfolio, described by Faber (2007) and then further elaborated by Faber and Richardson (2009), includes 5 asset classes:

  • SP500 = SP500 Total Return Index
  • EAFE = MSCI EAFE Total Return Index
  • REIT = FTSE NAREIT All Equity REITS Total Return Index
  • GSCI = GSCI Index
  • LTR = Merrill Lynch 7-10 year Government Bond Index

Robust Asset Allocation

Click to enlarge.At a high level, one can think of the IVY 5 portfolio as a 40% equity, 40% real asset, and 20% fixed income portfolio. I consider it a goldilocks portfolio: Not too simple; not too complex; just right.

2.3 Simplify Risk-Management

In general, while efforts to time the market should be viewed with skepticism, certain systematic timing strategies that have been explored in academia appear to reduce risk, without significantly impacting long-run returns. In particular, the application of simple moving average rules has been demonstrated to protect investors from large market drawdowns, which is defined as the peak-to-trough decline experienced by an investor. Jeremy Siegel, in his book, “Stocks for the Long Run,” explores the effect on performance on the Dow Jones Industrial Average from 1886 to 2006, when applying a 200-day moving average rule. Applying the rule is straightforward. If the market

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