Stephane Deo and Ramin Nakisa, strategists at UBS, believe that choosing an asset allocation to maximize risk adjusted returns is of paramount importance. They mentioned two separate studies: one by Gary Brinson and another by Ibbotson and Kaplan. Both studies sought to segment return sources. Both Brinson and Ibbotson found that asset allocation policy comprised over 90% of portfolio returns. The rest could be explained by tactical asset allocation and security selection.
Deo and Nakisa postulate that allocating assets solely based on risk (measured by standard deviation) and diversification value works but generates larger drawdowns. This risk parity approach helps manage portfolio volatility but does not consider risk adjusted returns. The portfolio manager may increase funding to a falling asset with a low standard deviation and not fund an asset that is increasing in value and has a higher standard deviation. Also, risk parity tends to over allocate to U.S. and Japanese government bonds and spread products including corporate and high yield bonds. As an alternative, Deo and Nakisa proposed using Sharpe ratios to weight assets.
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Maximize risk adjusted returns using Sharpe ratio based weights
A Sharpe ratio weighted allocation considers both returns and volatility. According to UBS, the manager assigns risk premiums based on returns. For example, if asset A has a Sharpe ratio of 1 and asset B has a Sharpe ratio of 2, the weight for asset B will be double the weight for asset A. This strategy does not weigh assets based on exposing portfolio to different asset classes. Also, the Sharpe ratio weighted strategy depends on momentum as it depends on recent asset performance history.
Deo and Nakisa noted that even though the Sharpe ratio weighted strategy does not specifically focus on diversification it can switch swiftly among a broad range of asset classes. There is no constraint as to which asset class can be used to generate high Sharpe ratios. In UBS’ view, the Sharpe ratio weighted strategy has lower risk relative to risk parity due to its broader asset class exposure. On absolute performance terms, the Sharpe ratio weighted strategy outperforms other strategies including risk parity. It generates a 14.8% annualized return from 2003 to present.
Importantly, the Sharpe ratio weighted strategy also limits the scale of drawdown and the time taken to recover. From 2003 to present, the Sharpe ratio weighted strategy’s maximum drawdown was 20% and it took 352 days to recover losses. The recovery time was the shortest compared to other strategies.