Allocate Smartly

Asset Allocation Roundup

Six recent asset allocation articles (tactical or otherwise) that you might have missed:

1. Fragility Case Study: Dual Momentum GEM (Newfound) + Response from Gary Antonacci

Corey’s post kicked off quite a lively discussion. I encourage you to click through to both pieces, but here’s the argument in a nutshell. Note: Corey is using Antonacci’s Dual Momentum (GEM) to illustrate his point, but the same case could be made for a number of the asset allocation strategies that we track.

GEM uses a single lookback (12-months) to allocate the entire portfolio to a single asset at any given time (1). According to Corey, that makes it particularly susceptible to what he calls “specification risk”, or “the gap between the long-term supporting evidence of an investment style (i.e. momentum and trend) and the precise strategy we use to implement it (i.e. GEM)”.

Obviously, because of how GEM was designed (100% allocation to a single asset), it’s very susceptible to short-term specification risk. We saw that in December; GEM faltered, despite trend-following/momentum as a style performing well. In the real-world, that’s a problem. Try as we may to combat it, investors are myopic. Period. A month like GEM had in December was a hiccup in the grand scheme of things, but it scared a lot of investors away.

Corey’s approach, which is to split GEM into 7 equal parts, each using a different lookback from 6 to 12-months, is one way to reduce that short-term specification risk. An even better approach is combining multiple disparate strategies, each effective on their own, into a combined portfolio (2). That’s a challenge our site was specifically built to tackle.

The end goal is to be left with just style risk (quality TAA strategies as a whole), and not specification risk (any particular strategy). As we’re seeing in January, sometimes the entire style is out of favor, but that’s a lot easier to accept than being the only one at the party left out in the rain.

I think the real argument lies in GEM’s susceptibility to specification risk in the long-term.

Let’s say we were boarding a spaceship to a distant planet. We’ll be in hypersleep for 40 years (analogous to our life as an investor pre-retirement). We need to set a TAA portfolio now that will be automatically traded, unaltered, while we slumber (to kickstart our new career in terraforming, or…something).

What strategy should we choose? Let’s say for argument’s sake that GEM has been the very best strategy historically. Should we allocate 100% of our portfolio to GEM? I think any reasonably cautious person would say no. How might market mechanics change in the next 40 years? Even a moderate amount of specification error could have enormous consequences on terminal wealth over that length of time. We would want some level of process diversification. Maybe something more sophisticated than Corey’s illustrative example, but something.

Now let’s say that instead of sleeping for 40 years, we could wake up every year and reevaluate our portfolio (i.e. the real world). How would that change our approach? I would argue not much. One year isn’t enough time to judge the efficacy of one TAA strategy over another. Maybe 10 or 20 years is, but by then the damage has been done – the length of our space voyage (and investing lifespan) is finite. Process diversification is still king for managing both short and long-term specification risk (2).

By our scorecard, Corey’s diversified GEM has outperformed the original since the paper was first published 6+ years ago in terms of both terminal wealth and risk-adjusted performance (granted, at the cost of higher turnover and a bit less tax efficiency). Will the original GEM stage a comeback? Maybe. Who knows? And that’s the point. Diversification isn’t just about the oft stated goal of reducing risk by blending less than perfectly correlated return streams. It’s more than that. It’s an acknowledgement that we don’t know what we don’t know. And rather than throw a hero-or-zero Hail Mary to win the game, we’re going to run a balanced offense that ensures we don’t lose.

Of course, these are just one allocation nerd’s opinion and we encourage you to draw your own conclusions. To help in your quest, we’ve added Corey’s “Diversified Dual Momentum” approach to our members area. Members: go there now.

2. Exploring Smart Leverage: DAA on Steroids (TrendXplorer)

This is a follow up to a recent piece from Dr. Keller, showing the results of trading their strategy, Defensive Asset Allocation (DAA), using leveraged ETFs. DAA is one of the 40+ asset allocation strategies that we track.

We’ve received a number of requests about adding “DAA on Steroids” to our site. As a rule of thumb, we don’t track leveraged ETF strategies (or strategies employing margin). We don’t think that there’s anything inherently wrong with leverage (it’s something I apply from time to time in my own portfolios), but we also worry that some of our members may lack the sophistication to understand the risks that leverage entails, and will just be wowed by big historical returns (evidence). That’s not a judgement on leverage itself, just a recognition of our duty not to entice anyone to take on more risk than they’re prepared for.

Having said that, this strategy is essentially using its unlevered cousin to signal trades. That means that an investor could use our signal to follow the strategy, while actually executing trades on each ETF’s leveraged counterpart.

3. Jack Bogle: The Apostle of Index Investing (Mathematical Investor)

Ironically enough, it was Bogle’s work that first sent me down the path of quantitative analysis more than 20 years ago. His simple quantitative approach to debunking the sacred cows of the active management industry spoke to me.

It also inspired me to consider what other generally accepted wisdom might be wrong. I spent years testing all sorts of things from trend-following to seasonality to swing trading techniques (I’ve run more dead cat bounce studies than is sane for any one human).

The short answer is that a lot of said wisdom is garbage. The slightly longer answer is that, through history, many short-term techniques have been profitable for a time (I’ve ridden a number of them), but inevitably, most are traded out of the market. Short-term trading is a perpetual cat and mouse game, and requires constant evolution. The only techniques that have stood the test of time since essentially the dawn of markets, are of the variety that you’ll find on this site (trend-following, momentum, asset class diversification, etc.)

RIP Jack Bogle. I thank you for the inspiration sir.

4. Is Multi-Manager Diversification Worth It? (Newfound Research) + Dart-Throwing Monkeys and Process Diversification (Newfound Research)

More classic think pieces from Newfound. Both show the benefit of combining multiple managers together, even within the same “style”. In our case, that style is tactical asset allocation, and more specifically, usually some variation of asset class trend-following and/or momentum.

Our site was specifically built around this concept of combining individual TAA strategies. The reduction in portfolio risk (ex. volatility and drawdown) that Corey discusses is obvious when seeing the effect it has on historical performance. Couple this with the discussion about out-of-sample, real-world “specification vs style risk” (see above) and I think it’s a no brainer.

Other recent links that you might have missed:

Recent goodness from Allocate Smartly:

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(1) Here we’re referring to the public version of GEM described in Antonacci’s paper Risk Premia Harvesting Through Dual Momentum.

(2) A healthy dose of common sense is in order here. Just blindly combining every TAA strategy wouldn’t make sense. Some strategies are clearly better than others. Some are more or less tax efficient than others (which may or may not matter depending on the individual investor’s situation). Some are highly similar and don’t benefit much from trading together. Some investors combine strategies that share common assets to limit unnecessary turnover. The list is literally endless. We try to respond to all of these with our Meta Strategy (except for the tax efficiency issue), but that’s just one approach. Members can use our platform to forge their own unique path. Again, the point is that common sense is required here.