Adaptive Asset Allocation
May 10, 2016
by Adam Butler
David Einhorn's Greenlight Capital funds were up 11.9% for 2021, compared to the S&P 500's 28.7% return. Since its inception in May 1996, Greenlight has returned 1,882.6% cumulatively and 12.3% net on an annualized basis. Q4 2021 hedge fund letters, conferences and more The fund was up 18.6% for the fourth quarter, with almost all Read More
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We recently published our first book, Adaptive Asset Allocation: Dynamic Global Portfolios to Profit in Good Times – and Bad. It spent roughly six weeks as Amazon’s #1 Hot New Release in Investments, and we’re pretty psyched about that.
In our book, we spend a great deal of time extending the research and concepts we explore on our blog, GestaltU. We did this in order to distill the most salient points, and also to tie seemingly disparate topics together into a cohesive narrative. We cover topics like behavioral economics, market valuations and expected returns, factor investing, retirement income planning, and a spectrum of asset allocation strategies. The book was meant to stand as a comprehensive but accessible reference for what ought to matter to modern investors.
Today, we’re proud to share a few sample chapters with the community at Advisor Perspectives. Specifically, below you will find:
- Chapter 25, which discusses the differences between strategic, tactical and dynamic asset allocation.
- Chapter 26, which addresses the “optimization machine,” our term for the connection between philosophical beliefs about markets, and how they are expressed in portfolios.
- Chapter 27, which covers the flaws – and salvation – of mean-variance optimization.
- Chapter 34, which provides a concise taxonomy of portfolio optimization methods.
Not included in this post are Chapters 28-33, which discuss in detail the spectrum of portfolio optimization methods from buy-and-hold traditional balanced; through strategic portfolios that embrace structural diversification like the Permanent Portfolio; evolving to inverse volatility weighting, robust risk parity, and minimum variance; and finishing with our flagship strategy, Adaptive Asset Allocation.
We cover the entire spectrum from passive to active asset allocation because investors are far more likely to stay committed if their investment methodology aligns with how they believe markets work. But that’s a topic for another day.
For the moment, we hope you enjoy the sample chapters below.
Part IV: An Investment Framework for Stability, Growth, and Maximum Income
This is where the rubber hits the road, so to speak.
Given current difficult market conditions, the traditional means of portfolio management simply won’t help investors achieve their financial objectives. Static stock and bond portfolios, strategic asset allocation, and buy-and-hold might work during certain market regimes, but if they didn’t get the job done over the last 13 years, and we’re expecting 20 more years of the same, something’s got to change.
This situation calls for flexibility, responsiveness and adaptability. The Adaptive Asset Allocation (AAA) framework embraces all of these qualities, and was largely developed in response to the issues we’ve posed thus far.
As Darwin said, “It is not the strongest of the species that survives, nor the most intelligent. It is the one that is the most adaptable to change.”
Chapter 25: A Word about Asset Allocation
Before beginning, we need to deal with some issues of nomenclature. For the remainder of this book, we will use the terms ‘policy portfolio’ and ‘strategic asset allocation’ somewhat interchangeably. However, it’s important to understand what they are and how they are similar and different.
A policy portfolio is a long-term prescribed asset allocation. For example, the ubiquitous 60% equity / 40% fixed income (balanced portfolio) is a common policy portfolio for private investors and many institutions. A manager that holds the policy portfolio in appropriate weights at all times without active deviation, and rebalances back to the prescribed weights on a regular basis, practices Strategic Asset Allocation (SAA). So SAA is simply a passively rebalanced manifestation of a policy portfolio.
In contrast, a manager that actively deviates from the policy portfolio is said to practice some tactical asset allocation (TAA). Traditionally, TAA is a practice that applies even when a policy portfolio has been declared. Though the manager is free to deviate from the stated guidelines, often the manager won’t deviate too far.
Further out on the asset allocation continuum is dynamic asset allocation (DAA), which is unconstrained allocation among all of the eligible assets in the investment universe. The universe is probably specified in advance—hopefully it is robust and coherent as we will discuss below—but no policy weights are assigned to the assets. A manager who practices DAA can hold all assets, none of the assets, or anything in between at his or her discretion.
You can see that asset allocation runs along a continuum from strategic at one end, with no active portfolio bets, to dynamic at the other end, with exclusively active portfolio bets. The question is: What would motivate an investor to choose a strategic, tactical, or dynamic approach? The answer lies in what the investor thinks he knows about the way assets behave. Let’s explore that.
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Adaptive Asset Allocation: Dynamic Global Portfolios to Profit in Good Times – and Bad by Adam Butler