By Kevin L. Coppola

Article source:
http://www.advisorperspectives.com/commentaries/bp_51412.php

In the article by Adam Butler and Mike Philbrick, entitled “
Adaptive Asset Allocation: A True Revolution In Portfolio Management,” published this week in Advisor Perspectives (as well as several other industry publications) the authors go through extensive financial calisthenics to justify their conclusion that financial managers who embrace Adaptive Asset Allocation “will increasingly dominate traditional managers; those who fail to adapt will, inevitably, face extinction.”

Understanding and sensing this potential extinction of my own personal portfolio 20 years ago is what started me on the path toward identifying an alternative to Modern Portfolio Theory (MPT)—aka, “pie-chart” investing—which would prove to yield substantially better results for the amount of risk taken.


Back in 2002, the
Compass Institute defined Adaptive Asset Allocation as having of TWO major distinctions from MPT. First, it reviews and modifies an investment mix more frequently, and second, it determines how to adjust a portfolio based on current market realities rather than on an arbitrary ratio of stocks to bonds determined by an investor’s answers to a “risk tolerance” profile. 

The article elegantly identifies the impact of these same two distinctions on portfolio value and risk as well as highlights the significant “flaw” of traditional investing strategies that the Institute also identified more than a decade ago.


Rebalance Frequency. The authors’ studies were based on a monthly rebalancing. The
Horizon™ Adaptive Asset Allocation approach employs a 5 week rebalance cycle, having concluded after a 5-year extensive research study conducted by the Compass Institute that a 4-6 week rebalancing frequency was optimal.

Rebalance Input. The authors offer a simple, yet effective, formula of investing in the top 50% of their balanced portfolio of stock and bond alternatives based on metrics gathered during the 6 months leading up to each rebalance date. The Horizon™ approach uses a more complicated formula that weights multiple prior time periods and has a different algorithm for deciding how many and how much of each alternative to invest in. Regardless, the point being highlighted here is that “the best estimate of
tomorrow's value is today's value” and therefore making reallocation decisions based on recent market conditions is a far more effective way versus going with a fixed or static allocation.

The authors present their “flaw of averages” concept which asserts that any investment strategy that is based on long-term averages—which is at the core of MPT’s efficient frontier theory—exposes the strategy’s results to the enormous short-term variability that can devastate a portfolio. At Compass Investors, we refer to this “flaw” as the “Time of Retirement” risk and it can be best understood by observing the behaviors of life cycle, or Target Date Funds (TDF) over time.


If you are keeping up, you know that TDFs are all the rage. These one-stop shopping investments utilize an entirely different 2-step process: First, choose your retirement year, and then second, go away for 10, 20, 30 (or more) years. So much emphasis is put on selecting the “right” retirement year when, in fact, the year in which you retire matters little. However, what does matter is how the market is performing in the year you decide to  retire.

To see this clearly, look at this chart that compares the performance of the “best” and “worst” performing Fidelity Freedom funds over the last 15 years  to the performance of a balanced portfolio of Fidelity funds managed with the Horizon Adaptive Asset Allocation strategy. Notice that the “best” and  the “worst” TDFs are in a horse race; the best becomes the worst and vice versa as the markets ebb and flow. Also notice that the gap between the best and the worst is never very large, nor would you ever expect to be given the natural market cycles that take turns inhibiting the growth of static asset allocation portfolios.


The marketplace continues to realize that traditional investing strategies—formulaic asset allocation investing, buy-and-hold, TDFs—simply do not nor cannot generate the results that people need to have to achieve Retirement Income Security in their lifetime. And as always, there is bad news and good news. The bad news is investors have piddled around for the last decade in a haze of confusion, generating results that have barely kept up with inflation. The good news is investors have places to go to put Adaptive Asset Allocation to work for them NOW. There are several models available—including the ones proposed in the article—for the do-it-yourselfers, and there is the Compass Investors Adaptive Asset Allocation service called Horizon™ that will do the heavy lifting for you.

Kevin


Kevin L. Coppola, President, Compass Investors, LLC

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