Research Review | 11.23.2011 | Managing Asset Allocation

Testing Rebalancing Strategies for Stock-Bond Portfolios: Where is the Value Added of a Rebalancing Strategy?
Hubert Dichtl (Alpha Portfolio Advisors), et al. | September 15, 2011
This study addresses the question why institutional investors prefer rebalancing even though these strategies require the selling of a fraction of the better-performing assets and investing the proceeds in the less-performing assets. Analyzing the value added of rebalancing strategies for investors, we document that the return effect is negligible, and hence it is primarily a risk management argument which justifies the widespread use of these strategies. Minimizing risk (defined as return volatility) with respect to a given asset allocation seems to be the primary objective of any rebalancing strategy.

Recessions and balanced portfolio returns
Joseph Davis and Daniel Piquet (Vanguard) | October 2011
Given the rising risk of a renewed U.S. recession, investors may wonder about the merits of a more “defensive” posture for their broad portfolio. To provide perspective, we calculated the historical returns of a balanced 50% equity/50% bond portfolio under two distinct U.S. business cycle regimes: recessions and expansions. We show that the average real returns of such a portfolio since 1926 have been statistically equivalent regardless of whether the U.S. economy was in or out of recession. Although it may seem counterintuitive, this similarity in average real returns has occurred because of two typical market patterns: first, the tendency for bonds to outperform stocks during the initial period of economic weakness (a “flight-to-safety” effect), and second, the tendency for stock prices to decline before a recession officially occurs and to rise before it officially ends (a “leading indicator” effect). While a recession is always unwelcome, our results support the utility of an investment program focused on a diversified, long-term strategic asset allocation, and should give considerable pause to those who recommend a more tactical or reactive approach to investing.
Investing for the Long Run
Andrew Ang (Columbia Business School) and Knut Kjaer | November 11, 2011
Long‐horizon investors have an edge. They can ride out short‐term fluctuations in risk premiums, profit from periods of elevated risk aversions and short‐term mispricing, and they can pursue illiquid investment opportunities. The turmoil we have seen in the capital markets over the last decade has increased the competitive advantage of a long investment horizon. Unfortunately, the two biggest mistakes of long‐horizon investors – procyclical investments and misalignments between asset owners and managers – negate the long‐horizon advantage. Long‐horizon investors should harvest many sources of factor risk premiums, be actively contrarian, and align all stakeholders so that long‐horizon strategies can be successfully implemented. Illiquid assets can, but do not necessarily, play a role for long-horizon investors, but investors should demand high premiums to compensate for bearing illiquidity risk and agency issues… To take advantage of the long‐run advantage, investors should first institutionalize contrarian behavior by adopting a rebalancing rule. Avoiding procyclicality also requires redefining the concept of risk away from just volatility. Low volatility often coincides with low expected risk premiums, which are a more relevant concept of risk for the long‐run investor who can withstand short‐term fluctuations. Investors should practice factor investing and build robust factor portfolios. Long‐term investors can harvest many sources of factor risk premiums. They should go beyond asset classes and use the underlying factor risk premium drivers as the basis for portfolio construction.
Paired-Switching for Tactical Portfolio Allocation
Akhilesh Maewal and Joel Bock (Scalaton) | August 22, 2011
Paired-switching refers to investing in one of a pair of negatively correlated equities/ETFs/Funds and periodic switching of the position on the basis of either the relative performance of the two equities/ETFs/Funds over a period immediately prior to the switching or some other criterion… It is based upon the idea that if the returns of two equities are negatively correlated, overlapping of the periods during which the equities individually yield returns greater than their respective mean values will be infrequent. Consequently, if the criterion for switching is even minimally accurate in its ability to identify the boundaries of such periods, there is a possibility of improving the performance of the portfolio consisting of the two equities over the portfolio wherein the two equities are statically weighted on the basis of traditional methods such as, for example, variance minimization. Trading based on paired-switching is fundamentally distinct from paired-trading, which seeks enhanced returns by attempting to exploit the departure of the behavior of the time series of the actual returns from the prediction of a model based upon historical data and implements a market neutral strategy on the assumption that the prices will ultimately move to conform with the model. In contrast, paired switching embraces the model – which is just the fact that the returns are negatively correlated – and tries to ride it out. When applied to each equity in a portfolio, paired-switching provides an alternative means of dynamic or tactical portfolio allocation. Some results of back testing shown below suggest that some very simple criteria for paired-switching can lead to lower volatility without any significant penalty in terms of lower returns.
On the Equity and Interest Rate Predictability for Balanced Portfolios and Coverage Ratios for Pension Plans
Foort Hamelink (Lombard Odier & Cie and University Amsterdam) | October 17, 2011
The purpose of this study is twofold. On one hand we derive an optimal allocation framework between stocks and bonds, with and without a momentum factor, taking into account a regime-switching model based on monthly equity and interest rate data since 1870. On the other, we investigate the optimal portfolio construction for the manager of a pension plan, where the pension’s liabilities are valued in present value terms. Assuming such a pension plan is exposed to two risk factors only, an equity factor and an interest rate factor, the manager needs to decide on the exposure to equities (the beta to equities measured at the level of the total portfolio), and the level of exposure to interest rates, relative to the benchmark defined by the liabilities. Using over 140 years of monthly data pertaining to US equities and 10-year yields, I show that combining a momentum factor with a Markov regime switching approach provides a very robust framework with optimal allocations to stocks and bonds in each regime for the traditional manager, and a well defined equities (beta) exposure and interest rate hedge policy for the manager of the pension plan.
Tactical Commodity Allocation and the Theory of Storage
Pierre Six (Rouen Business School) | September 15, 2011
This article examines the benefit of adding commodity futures and/or spot commodity to a portfolio of bonds and equity. We find that an investor, who optimally considers the information conveyed by the whole term structure of commodity futures, greatly improves the wealth certainty equivalent of his/her strategy. However, this strategy results in extreme positions on the term structure of commodity futures. We show nevertheless that a suboptimal strategy that consists of the spot commodity only, also significantly improves the bond-stock mix performance. Our two key results justify the investment on commodity markets through single commodity indexes as regularly released by the Commodity Futures Trading Commission (CFTC).