Adaptive Asset Allocation

Vitaliy Katsenelson in Institutional Investor doesn’t mince words when it comes to Modern Portfolio Theory (MPT):

Teachers will teach what is teachable; they’ll default to solving a mathematical equations (while stuffing it with arbitrary numbers for the most part), because that is what they know how to do.  They can learn MPT by reading their predecessors’ textbooks, and therefore that is what they’ll teach, too.  The beauty of MPT, at least from a teaching perspective, is that it turns investing into a math problem, with elegant equations that always spit out precise, albeit random numbers.

But please don’t tell anyone I said this, because as an investor I’d love for MPT to be taught starting in kindergarten.  It would make my job easier: I’d be competing against imbeciles who still believe the world is flat.  However, as a well-wishing person dispensing advice, I’d say, spend as little time as you can studying MPT.

Among the more dubious assumption in MPT are that correlations between assets are fixed and constant forever and that the volatility of an asset is known in advance and is also constant.  Yea, about that…  See below for a chart that is a couple years old, but the point should be pretty clear—correlations change!

rex2

Source: Rex Macey, Investments & Wealth Monitor

The five-year correlation between domestic large stocks (Russell 1000) and the MSCI EAFE index varied but never exceeded 0.6 from the start of the dataset until the late 1990s.  Consultants used this data to argue for international diversification.  Who would have expected based on historical data that the correlation would rise to the 0.9 level matching the correlation of large U.S. stocks with small U.S. stocks?  I suspect those relying on international diversification were quite disappointed.

It has been estimated that there is some $7 trillion invested in accordance with the tenets of MPT, so this is far from being just an academic exercise.

So, what’s the alternative?  How about Tactical Asset Allocation for one.  Rather than relying on an approach to asset allocation that makes assumptions about how the future should look, why not embrace a tactical approach to asset allocation that is designed to adapt?  Correlations can change, variances can change, and returns can change and tactical asset allocation still has the potential to produce favorable returns over time.

Click here to read an FAQ on our Global Macro strategy, which provides a truly tactical alternative to MPT.

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