A Better Robo Advisory

Building a Better Robo Advisor

The more we learned about the current crop of robo advisory firms, the more we realized we could do better. This brief blog post hits the high points of that thinking.

Not Just the Same Robo Advisory Technology

It appears that all major robo advisory companies use 50+ year-old MPT (modern portfolio theory). At Sigma1 we use so-called post-modern portfolio theory (PMPT) that is much more current. At the heart of PMPT is optimizing return versus semivariance. The details are not important to most people, but the takeaway is the PMPT, in theory, allows greater downside risk mitigation and does not penalize portfolios that have sharp upward jumps.

Robo advisors, we infer, must use some sort of Monte Carlo analysis to estimate “poor market condition” returns. We believe we have superior technology in this area too.

Finally, while most robo advisory firms offer tax loss harvesting, we believe we can 1) set up portfolios that do it better, 2) go beyond just tax loss harvesting to achieve greater portfolio tax efficiency.

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Semivariance Excel Example

The most in-demand topic on this blog is for an Excel semivariance example. I have posted mathematical semivariance formulas before, but now I am providing a description of exactly how to compute semivariance in “vanilla” Excel… no VBA required.

The starting point is row D. Cell D$2 contains average returns of over the past 36 months. The range D31:D66 contains those returns.  Thus the contents of D$2 are simply:

=AVERAGE(D31:D66)

This leads us to the semivariance formula:

{=SQRT(12)*(SQRT(SUM(IF((D31:D66-D$2)<0,(D31:D66-D$2)^2,0))/(COUNT(D31:D66-1))))}

We will now examine each building block of this formula starting with

IF((D31:D66-D$2)<0,(D31:D66-D$2)^2,0)

We only want to measure “dips” below the mean return. For all the observations that “dip” below the mean we take the square of the dip, otherwise we return zero. Obviously this is a vector operation, the IF function returns a vector of values.

Next we divide the resulting vector by the number of observations (months) minus 1. We can simply COUNT the number of observations with COUNT(D31:D66-1).  [NOTE 1: The minus 1 means we are taking the semivariance of a sample, not a population. NOTE 2: We could just as easily taken the division “outside” the SUM — the result is the same either way.]

Next is the SUM. The following formula is the monthly semivariance of our returns in row D:

{=SUM(IF((D31:D66-D$2)<0,(D31:D66-D$2)^2,0))/(COUNT(D31:D66-1))}

You’ll notice the added curly braces around this formula. This specifies that this formula should be treated as a vector (matrix) operation.  The curly braces allow this formula to stand alone.  The way the curly braces are applied to a vector (or matrix) formula is to hit <CTRL><SHIFT><ENTER> rather than just <ENTER>. Hitting <CTRL><SHIFT><ENTER> is required after every edit.

We now have monthly semivariance. If we wanted annual semivariance we could simply multiply by 12.

Often, however, we ultimately want annual semi-deviation (also called semi-standard deviation) for computing things like Sortino ratios, etc. Going up one more layer in the call stack brings us to the SQRT operation, specifically:

{=SQRT(SUM(IF((D31:D66-D$2)<0,(D31:D66-D$2)^2,0))/(COUNT(D31:D66-1)))}

This is monthly (downside) semi-deviation. We are just one step away from computing annual semi-deviation. That step is multiplying by SQRT(12), which brings us back to the big full formula.

There it is in a nutshell. You now have the formulas to compute semivariance and semi-deviation in Excel.

 

 

Clover Patterns Show How Portfolios Manage Risk

Illustration of Classic Covariance.

The red and green “clover” pattern illustrates how traditional risk can be modeled.  The red “leaves” are triggered when both the portfolio and the “other asset” move together in concert.  The green leaves are triggered when the portfolio and asset move in opposite directions.

Each event represents a moment in time, say the closing price for each asset (the portfolio or the new asset).  A common time period is 3-years of total-return data [37 months of price and dividend data reduced to 36 monthly returns.]

Plain English

When a portfolio manager considers adding a new asset to an existing portfolio, she may wish to see how that asset’s returns would have interacted with the rest of the portfolio.  Would this new asset have made the portfolio more or less volatile?  Risk can be measured by looking at the time-series return data.  Each time the asset and the portfolio are in the red, risk is added. Each time they are in the green, risk is subtracted.  When all the reds and greens are summed up there is a “mathy” term for this sum: covariance.  “Variance” as in change, and “co” as in together. Covariance means the degree to which two items move together.

If there are mostly red events, the two assets move together most of the time.  Another way of saying this is that the assets are highly correlated. Again, that is “co” as in together and “related” as in relationship between their movements. If, however, the portfolio and asset move in opposite directions most of the time, the green areas, then the covariance is lower, and can even be negative.

Covariance Details

It is not only the whether the two assets move together or apart; it is also the degree to which they move.  Larger movements in the red region result in larger covariance than smaller movements.  Similarly, larger movements in the green region reduce covariance.  In fact it is the product of movements that affects how much the sum of covariance is moved up and down.  Notice how the clover-leaf leaves move to the center, (0,0) if either the asset or the portfolio doesn’t move at all.  This is because the product of zero times anything must be zero.

Getting Technical: The clover-leaf pattern relates to the angle between each pair of asset movements.  It does not show the affect of the magnitude of their positions.

If the incremental covariance of the asset to the portfolio is less than the variance of the portfolio, a portfolio that adds the asset would have had lower overall variance (historically).  Since there is a tenancy (but no guarantee!) for asset’s correlations to remain somewhat similar over time, the portfolio manager might use the covariance analysis to decide whether or not to add the new asset to the portfolio.

Semi-Variance: Another Way to Measure Risk

 

Semi-variance Visualization

After staring at the covariance visualization, something may strike you as odd — The fact that when the portfolio and the asset move UP together this increases the variance. Since variance is used as a measure of risk, that’s like saying the risk of positive returns.

Most ordinary investors would not consider the two assets going up together to be a bad thing.  In general they would consider this to be a good thing.

So why do many (most?) risk measures use a risk model that resembles the red and green cloverleaf?  Two reasons: 1) It makes the math easier, 2) history and inertia. Many (most?) textbooks today still define risk in terms of variance, or its related cousin standard deviation.

There is an alternative risk measure: semi-variance. The multi-colored cloverleaf, which I will call the yellow-grey cloverleaf, is a visualization of how semi-variance is computed. The grey leaf indicates that events that occur in that quadrant are ignored (multiplied by zero).  So far this is where most academics agree on how to measure semi-variance.

Variants on the Semi-Variance Theme

However differences exist on how to weight the other three clover leaves.  It is well-known that for measuring covariance each leaf is weighted equally, with a weight of 1. When it comes to quantifying semi-covariance, methods and opinions differ. Some favor a (0, 0.5, 0.5, 1) weighting scheme where the order is weights for quadrants 1, 2, 3, and 4 respectively. [As a decoder ring Q1 = grey leaf, Q2 = green leaf, Q3 = red leaf, Q4 = yellow leaf].

Personally, I favor weights (0, 3, 2, -1) for the asset versus portfolio semi-covariance calculation.  For asset vs asset semi-covariance matrices, I favor a (0, 1, 2, 1) weighting.  Notice that in both cases my weighting scheme results in an average weight per quadrant of 1.0, just like for regular covariance calculations.

 

Financial Industry Moving toward Semi-Variance (Gradually)

Semi-variance more closely resembles how ordinary investors view risk. Moreover it also mirrors a concept economists call “utility.” In general, losing $10,000 is more painful than gaining $10,000 is pleasurable. Additionally, losing $10,000 is more likely to adversely affect a person’s lifestyle than gaining $10,000 is to help improve it.  This is the concept of utility in a nutshell: losses and gains have an asymmetrical impact on investors. Losses have a bigger impact than gains of the same size.

Semi-variance optimization software is generally much more expensive than variance-based (MVO mean-variance optimization) software.  This creates an environment where larger investment companies are better equipped to afford and use semi-variance optimization for their investment portfolios.  This too is gradually changing as more competition enters the semi-variance optimization space.  My guestimate is that currently about 20% of professionally-managed U.S. portfolios (as measured by total assets under management, AUM) are using some form of semi-variance in their risk management process.  I predict that that percentage will exceed 50% by 2018.

 

Semi-variance: Choosing the Best Formula

Unlike variance, there a several different formulas for semivariance (SV).  If you are a college student looking to get the “right” answer on test or quiz, the formula you are looking for is most likely:

Classic Semi-Variance Formula

The question-mark-colon syntax simply means if the expression before the “?” is true then the term before the “:” is used, otherwise the term after the “:” is used.  So a?b:c simply means chose b if a is true, else chose c.  This syntax is widely used in computer science, but less often in the math department.  However, I find it more concise than other formulations.

Another common semivariance formula involves comparing returns to a required minimum threshold r_t.  This is simply:

Min Return Threshold SV

Classic mean-return semivariance should not be directly compared to mean-return variance.  However a slight modification makes direct comparison more meaningful.  In general approximately half of mean-adjusted returns are positive and half are negative (exactly zero is a relatively rare event and has no impact to either formula).  While mean-variance always has n terms, semi-variance only uses a subset which is typically of size n/2.  Thus including a factor of 2 in the formula makes intuitive sense:

Modified Semi-Variance

Finally, another useful formulation is one I call “Modified Drawdown Only” (MDO) semivariance.  The name is self-explanatory… only drawdown events are counted.  SV_mdo does not require r_avg (r bar) nor r_t.  It produces nearly identical values to SV_mod for rapid sampling (say for anything more frequent than daily data).  For high-speed trading it also has the advantage of not requiring all of the return data a priori, meaning it can be computed as each return data point becomes available, rather than retrospectively.

Modified Drawdown-Only Semi-variance

Why might  SV_mdo be useful in high-speed trading?  One use may be in put/call option pricing arbitrage strategies.  Black–Scholes, to my knowledge, makes no distinction between “up-side” and “down-side” variance, and simply uses plain variance. [Please shout a comment at me if I am mistaken!]    However if put and call options are “correctly” priced according to Black–Scholes, but the data shows a pattern of, say, greater downside variance than normal variance on the underlying security, put options may be undervalued.  This is just an off-the-cuff example, but it illustrates a potential situation for which SV_mdo is best suited.

Pick Your Favorite Risk Measure

Personally, I slightly favor SV_mdo over SV_mod for computational reasons. They are often quite similar in practice, especially when used to rank risk profiles of a set of candidate portfolios. (The fact that both are anagrams of each other is deliberate.)

I realize that the inclusion of the factor 2 is really just a semantic choice.  Since V and (classic) SV, amortized over many data sets, are expected to differ by a factor of 2, standard deviation, σ,  and semideviation, σ_d, can be expected to differ by the square root of 2.  I consider this mathematically untidy.  Conversely, I consider SV_mod to be the most elegant formulation.

The Future of Investing is Automation

A significant and growing portion of today’s individual investors have never placed a trade using a human stock broker.

Developing an Automation Mindset for Investing

In 2010, I bought the domain name Sigma1.com with the idea of creating an hedge fund that I would manage.  In order to measure and manage my investment strategies objectively, I began thinking about benchmarks and financial analysis software.  And as I ran scenarios through Excel and some light-weight analysis software I created, I began to realize that analysis, by itself was very limited.  I could only back-test one portfolio at a time, and I had to construct each portfolio’s asset weights manually.  It soon became obvious that I needed portfolio optimization software.

I learned that portfolio optimization software with the capabilities I wanted was extremely expensive. Further, I realized that even if, say, I negotiated a deal with MSCI where they provided Sigma1 Financial with their Barra Portfolio Manager for free, it would not differentiate a Sigma1 hedge fund from other hedge funds using the same software.

I was beginning to interact with several technology entrepreneurs and angel investors.  I quickly learned that legal costs and barriers to entry for a new hedge were intractable.  If Sigma1 attracted $10M in assets from accredited investors in 12 months, and charged 2 and 20, it would be a money loosing enterprise.  Cursory research revealed that critical mass for a profitable (for the hedge fund managers) hedge fund could be as high as $500M.  Luckily, I had learned about the concept of the “entrepreneurial pivot“.

The specific pivots Sigma1 used were a market segment pivot followed by a technology pivot. I realized that while the high cost of good portfolio optimization software is bad for a hedge fund startup, it was great for a financial software startup.  Suddenly, the Sigma1 Financial target market switched from accredited investors to financial professionals (investment managers, fund managers, proprietary traders, etc).  This was a key market segment pivot.

Just creating a cheaper portfolio optimizer seemed unlikely to provide sufficient incentive to displace entrenched portfolio optimizers. Sigma1 needed a technology pivot — finding a solution using a completely different technology.  Most prior portfolio optimizers use some variant of linear programming (LP) [or QP or NLP] to help find optimal portfolios. Moreover they also create an asset covariance matrix as a starting point for the optimization.

One stormy day, I realized that some algorithms I created to solve statistical electrical engineering problems in grad school could be adapted to optimize investment portfolios. The method I devised not only avoided LP, QP, or NLP methods; it also dispensed with the need for a covariance matrix.  Over then next several days I realized that by eliminating dependence on a covariance matrix, the algorithm I later named HALO, could use both traditional and alternate risk measures ranging from variance-based (eg. standard-deviation of return) to covariance-based ones (e.g. beta) to semivariance to max draw down.  By developing a vastly different technology, HALO could optimize for risks such as semivariance and Sortino ratios, or max drawdown, or even custom risk measures devised by the client.

Algorithms Everywhere

Long before Sigma1 began developing HALO, the financial industry has been increasingly reliant on digital systems and various financial algorithms. As digital communication networks and electronic stock exchanges gained trading volume, various forms of program trading began to flourish.  This includes the often maligned high-frequency trading variant of automated trading.

Concurrently, more and more trading volume has gone online.  A significant portion of today’s individual investors have never placed a trade using a human stock broker.

Automated Investment Advice, Analysis, and Trading

There are now numerous automated investment analysis tools, many of which come free with a brokerage account, while others are free or low-cost stand-alone online tools.  Examples of the former include the Fidelity’s nascent GPS (Guided Portfolio Summary) to more seasoned offerings such as Financial Engines.  Online portfolio analysis offering range from Morningstar’s Instant X-Ray, to sites like ETFreplay.

However these software offerings are just the beginning. A company call FutureAdvisor has partnered with Fidelity and TD Ameritrade to allow its automate portfolio software to make trades on its users behalf. Companies like Future Advisor have the potential to help small investors benefit from custom-tailored investment advice utilizing proven academic research (e.g. Fama French) at a very low cost — costs so low that they would not be profitable for human investment advisers to provide.

If successful (and I believe some automated investment companies will be), why should they stop at small-time investors, with less than $500,000 in investable assets?  Why not $1,000,000 or more?  Nothing should stop them!

I could easily imagine Mark Zuckerberg, Sergey Brin, or Larry Page utilizing an automated investment company’s software to manage a large part of their portfolios.  If we, as a society, are considering allowing automated systems to drive our cars for us, surely they can also manage our investment portfolios.

The Future Roll of the Human Financial Adviser

There will always be some percentage of investors who want a personal relationship with a financial adviser. Human investment advisers can excel at explaining investment concepts and putting investors at ease during market corrections.  In some ways human investment advisers even function as personal financial counselors, listening to their clients emotional financial stories.  And, of course, there are some people who want to be able to pick up the phone and yell at a real person for letting them suffer market losses.  Finally, there are people with Luddite tenancies who want as little to do with technology as possible.  For all these reasons human investment advisers will have a place in the future world of finance.

Investment Automation will Accelerate

There are some clear trends in the investing world.  Index investing will continue to grow, as will total ETF assets under management (AUM). Alternative investments from rental property to master limited partnerships (MLPs) to private equity are also likely to become part of the portfolios of more sophisticated and affluent investors.

With the exception of high-frequency trading, which has probably saturated arbitrage and front-running opportunities, I expect algorithmic (algo) management to increase as an overall percentage of US and global AUM. Some algorithmic trading and investing will be of the “hardwired” variety where the algo directly connects to the exchanges and makes trades, while the rest of the algo umbrella will comprise trading and investing decisions made by financial software and entered manually by humans with minimal revision.  There will also be hybrid methods where investment decisions are a synthesis of “automated” and “manual” processes.  I expect the scope of these “flavors” of automated investing to not only increase, but to accelerate in the near term.

It is important to note, however, that for the foreseeable future, the ultimate arbiters of algorithmic investing and portfolio optimization will be human.  The software architects and developers will exercise significant influence on the methodology behind the fund and portfolio optimization software.  Furthermore, the users of the software will have supreme control over what parameters go into the optimization process such as including or excluding or bounding certain assets and asset classes (amongst many other factors under their direct control).

That being said, the future of investing will be increasingly the domain of financial engineers, software developers and testers, and people with skills in financial mathematics, statistics, algorithms, data structures, GUIs, web interfaces and usability. Additionally, the financial software automation revolution will have profound impacts on legal professionals and marketers in the financial domain, as well as more modest impacts on accountants and IT professionals.

Some financial professionals will take the initiative and find a place on the leading edge of the financial automation revolution. It is likely to be a wild but lucrative ride. Others will seek the short-term comfort of tradition. They may be able to retain many of their current clients through sheer charisma and inertia, but may find it increasingly difficult the appeal to younger affluent clients steeped in a culture of technology.

Pursuing Alpha with Antivariance

A simple and marginally-effective strategy to reduce portfolio variance is by constructing an asset correlation matrix, selecting assets with low (preferably negative) correlations, and building a portfolio of low-correlation assets.  This basic strategy involves creating a set of assets whose cross-correlations (covariances) are minimized.

One reason this basic  strategy is only somewhat effective is that a correlation matrix (or covariance matrix) only provides a partial picture of the chosen investment landscape.  Some fundamental limitations include non-normal distributions, skewness, and kurtosis to name a few.  To most readers these are fancy words with varying degrees of meaning.

Personally, I often find the mathematics of the work I do seductive like a Siren’s song.  I endeavor to strike a balance between exploring tangential mathematical constructs, and keeping most of my math applied. One mental antidote to the Siren’s song of pure mathematics is to think more conceptually than mathematically by asking questions like:

What are the goals of portfolio optimization?  What elements of the investing landscape allow these goals to be achieved?

I then attempt to answer these questions with explanations that a person with a college degree but without a mathematically background beyond algebra could understand.  This approach lets me define the concept first, and develop the math later.  In essence I can temporarily free my mind of the slow, system 2 thinking generally required for math.

Recently, I came up with the concept of antivariance.  I’m sure others have had similar ideas and a cursory web search reveals that as profession poker player’s nickname.  I will layout my concept of antivariance as it relates to porfolio theory in particular and the broader concept in general.

By convention, one of the key objective of modern portfolio theory is the reduction of portfolio return variance.  The mathematical concept is the idea that by combining assets with correlations of less than 1.0, the return variance is less than the weighted sums of each asset’s individual variance.

Antivariance assumes that there are underlying patterns explain why two or more assets should be somewhat less correlated (independent), but at times negatively correlated.  Consider the affects of major hurricanes like Andrew or Katrina.  Their effects were negative for insurance companies with large exposures, but were arguably positive for companies that manufactured and supplied building materials used in the subsequent rebuilds.  I mention Andrew because there was much more and more rapid rebuilding following Andrew than Katrina.  The disparate groups of stocks of (regional) insurance versus construction companies can be considered to exhibit paired antivariance to devastating weather events.

Nicholas Nassim Taleb coined the the term antifragile, because terms such as robust simply don’t convey the exact mental connections.  I am beginning to use the term antivariance because it conveys concepts not well captured by terms like “negatively correlated”, “less correlated”, “semi-independent”, etc.   In many respects antifragile systems should exhibit antivariance characteristics, and vice versa.

The concept of antivariance can be extended to related concepts such as anticovariance and anticorrelation.

 

 

Principles of Portfolio Optimization Software

Explaining technical investment concepts in a non-technical way is critical to having a meaningful dialog with individual investors.  Most individual investors (also called “retail investors”, or “small investors”) do not have the time nor the desire to learn the jargon and concepts behind building a solid investment portfolio.  This is generally true for most individual investors regardless of the size of their investment portfolios.  Individual investors expect investment professionals (also called “institutional investors”) to help manage their portfolios and explain the major investment decisions behind the management of their individual portfolios.

In the same way that a good doctor helps her patient make informed medical decisions, a good investment adviser helps her clients make informed investment decisions.

I get routinely asked how the HALO Portfolio Optimizer works.  Every time I answer that question, I face two risks: 1) that I don’t provide enough information to convince the investment profession or their clients that HALO optimization provides significant value and risk-mitigation capability and 2) I risk sharing key intellectual property (IP) unique to the Sigma1 Financial HALO optimizer.

This post is my best effort to provide both investment advisers and their clients with enough information to evaluate and understand HALO optimization, while avoiding sharing key Sigma1 trade secrets and intelectual property.  I would very much appreciate feedback, both positive and negative, as to whether I have achieved these goals.

First Principle of Portfolio Optimization Software

Once when J.P. Morgan was asked what the market would do, he answered “It will fluctuate.”  While some might find this answer rather flippant, I find it extremely insightful.  It turns out that so-called modern portfolio theory (MPT) is based understanding (or quantifying) market fluctuations. MPT labels these fluctuations as “risk” and identifies “return” as the reward that a rational investor is willing to accept for a given amount of risk.  MPT assumes that a rational investor, or his/her investment adviser will diversify away most or all “diversifiable risk” by creating a suitable investment portfolio tailored to the investor’s current “risk tolerance.”

In other words, the primary job of the investment adviser (in a “fiduciary” role), is to maximize investment portfolio return for a client’s acceptable risk.  Said yet another way, the job is to maximize the risk/reward ratio for the client, without incurring excess risk.

Now for the first principle: past asset “risk” tends to indicate future asset “risk”.  In general an asset that has been previously more volatile will tend to remain more volatile, and and asset that has been less volatile will tend to remain less volatile.  Commonly, both academia and professional investors have equated volatility with risk.

Second Principle of Portfolio Optimization Software

The Second Principle is closely related to the first.  The idea is that the past portfolio volatility tends to indicate future portfolio volatility. This thesis is so prevalent that it is almost inherently assumed.  This is evidenced by search results that reaches beyond volatility and looks at the hysteresis of return-versus-volatility ratios, papers such at this.

Past Performance is Not Necessarily Indicative of Future Results.

Third Principle of Portfolio Optimization Software

The benefits of diversification are manifest in risk mitigation.  If two assets are imperfectly correlated, then their combined volatility (risk) will be less than the weighted averages of their individual volatilities.  An in-depth mathematical description two-asset portfolio volatilities can be found on William Sharpe’s web page.  Two-asset mean-variance optimization is relatively simple, and can be performed with relatively few floating-point operations on a computer.  This process creates the two-asset efficient frontier*.  As more assets are added to the mix, the computational demand to find the optimal efficient frontier grows geometrically, if you don’t immediately see why look at page 8 of this paper.

A much simpler explanation of the the third principle is as follows.  If asset A has annual standard deviation of 10%, and asset B an annual standard deviation of 20%, and A and B are not perfectly correlated, then the portfolio of one half invested in A and the other half invested in B will have a annual standard deviation of less than 15%.  (Non-perfectly correlated means a correlation of less than 1.0).  Some example correlations of assets can be found here.

In so-called plain English, the Third Principle of Portfolio Optimization can be stated: “For a given level of expected return, portfolio optimization software can reduce portfolio risk by utilizing the fact that different assets move somewhat independently from each other.”

Forth Principle of Portfolio Optimization Software

The Forth Principle of Portfolio Optimization establishes a relationship between risk and return.  The classic assumption of modern portfolio theory (MPT) is that so-called systematic risk is rewarded (over a long-enough time horizon) with increased returns.  Portfolio-optimization software seeks to reduce or eliminate unsystematic risk when creating an optimized set of portfolios.  The portfolio manager can thus select one of these optimized portfolios from the “best-in-breed” list created by the optimization software that is best suited to his/her client’s needs.

Fifth Principle of Portfolio Optimization Software

The 5th Principle is that the portfolio manager and his team adds value to the portfolio composition process by 1) selecting a robust mix of assets, 2) applying constraints to the weights of said assets and asset-groups, and 3) assigning expected returns to each asset.  The 5th Principle focuses on the assignment of expected returns.  This  process can be grouped under the category of investment analysis or investment research.  Investment firms pay good money for either in-house or contracted investment analysis of selected securities.

Applying the Portfolio Optimization Principles Together

Sigma1 Financial HALO Software applies these five principles together to help portfolio managers improve or fine-tune their proprietary-trading and/or client investment portfolios.  HALO Portfolio Optimization software utilizes the assets, constraints, and expected returns from the 5th Principal as a starting point.  It then uses the 4th Principal by optimizing away systematic risk from a set of portfolios by taking maximum advantage of varying degrees of non-correlation of the portfolio assets.  The 3rd Principle alludes to the computational difficulty of solving the multi-asset optimization problem.  Principles 1 and 2 form the bedrock of the concepts behind the use of historical correlation data to predict and estimate future correlations.

The Fine Print

Past asset volatility of most assets and most portfolios is historically well correlated with future volatility. However, not only are assets increasingly correlated, there is some evidence that asset correlations tend to increase during times of financial crisis. Even if assets are more correlated, there remains significant value in exploiting partial-discorrelation.
(*) The two-asset model can be represented as two parametric functions of a single variable, “t”, ER(t), and var(t).  t simply represents the investment proportion invested in asset 0 (aka asset A).  For three variables, expected return becomes ER(t0,t1) as does var(t0,t1).  And so on for increasing numbers of assets.  The computational effort required to compute ER(t0…tn) scales linearly with number of assets, but var(t0…tn) scales geometrically.
Optimizing efficiently within this complex space benefits from creative algorithms and heuristics.

Inverted Risk/Return Curves

Over 50 years of academic financial thinking is based on a kind of financial gravity:  the notion that for a relatively diverse investment portfolio, higher risk translates into higher return given a sufficiently long time horizon.  Stated simply: “Risk equals reward.”  Stated less tersely, “Return for an optimized portfolio is proportional to portfolio risk.”

As I assimilated the CAPM doctrine in grad school, part of my brain rejected some CAPM concepts even as it embraced others.  I remember seeing a graph of asset diversification that showed that randomly selected portfolios exhibited better risk/reward profiles up to 30 assets, at which point further improvement was minuscule and only asymptotically approached an “optimal” risk/reward asymptote.  That resonated.

Conversely, strict CAPM thinking implied that a well-diversified portfolio of high-beta stocks will outperform a marketed-weighted portfolio of stocks over the long-term, albeit in a zero-alpha fashion.  That concept met with cognitive dissonance.

Now, dear reader, as a reward for staying with this post this far, I will reward you with some hard-won insights.  After much risk/reward curve fitting on compute-intensive analyses, I found that the best-fit expected-return metric for assets was proportional to the square root of beta.  In my analyses I defined an asset’s beta as 36-month, monthly returns relative to the benchmark index.  Mostly, for US assets, my benchmark “index” was VTI total-return data.

Little did I know, at the time, that a brilliant financial maverick had been doing the heavy academic lifting around similar financial ideas.  His name is Bob Haugen. I only learned of the work of this kindred spirit upon his passing.

My academic number crunching on data since 1980 suggested a positive, but decreasing incremental total return vs. increasing volatility (or for increasing beta).  Bob Haugen suggested a negative incremental total return for high-volatility assets above an inflection-point of volatility.

Mr. Haugen’s lifetime of  published research dwarfs my to-date analyses. There is some consolation in the fact that I followed the data to conclusions that had more in common with Mr. Haugen’s than with the Academic Consensus.

An objective analysis of the investment approach of three investing greats will show that they have more in common with Mr. Haugen than Mr. E.M. Hypothesis (aka Mr. Efficient Markets, [Hypothesis] , not to be confused with “Mr. Market”).  Those great investors are 1) Benjamin Graham, 2) Warren Buffet, 3) Peter Lynch.

CAPM suggests that, with either optimal “risk-free”or leveraged investments a capital asset line exists — tantamount to a linear risk-reward relationship. This line is set according to an unique tangent point to the efficient frontier curve of expected volatility to expected return.

My research at Sigma1 suggests a modified curve with a tangent point portfolio comprised, generally, of a greater proportion of low volatility assets than CAPM would indicate.  In other words, my back-testing at Sigma1 Financial suggests that a different mix, favoring lower-volatility assets is optimal.  The Sigma1 CAL (capital allocation line) is different and based on a different asset mix.  Nonetheless, the slope (first derivative) of the Sigma1 efficient frontier is always upward sloping.

Mr. Haugen’s research indicates that, in theory, the efficient frontier curve past a critical point begins sloping downward with as portfolio volatility increases. (Arguably the curve past the critical point ceases to be “efficient”, but from a parametric point it can be calculated for academic or theoretical purposes.)  An inverted risk/return curve can exist, just as an inverted Treasury yield curve can exist.

Academia routinely deletes the dominated bottom of the the parabola-like portion of the the complete “efficient frontier” curve (resembling a parabola of the form x = A + B*y^2) for allocation of two assets (commonly stocks (e.g. SPY) and bonds (e.g. AGG)).

Maybe a more thorough explanation is called for.   In the two-asset model the complete “parabola” is a parametric equation where x = Vol(t*A, (1-t)*B) and y = ER( t*A, (1-t)*B.  [Vol == Volatility or standard-deviation, ER = Expected Return)].   The bottom part of the “parabola” is excluded because it has no potential utility to any rational investor.  In the multi-weight model, x=minVol (W), y=maxER(W), and W is subject to the condition that the sum of weights in vector W = 1.  In the multi-weight, multi-asset model the underside is automatically excluded.  However there is no guarantee that there is no point where dy/dx is negative.  In fact, Bob Haugen’s research suggests that negative slopes (dy/dx) are possible, even likely, for many collections of assets.

Time prevents me from following this financial rabbit hole to its end.  However I will point out the increasing popularity and short-run success of low-volatility ETFs such as SPLV, USMV, and EEMV.  I am invested in them, and so far am pleased with their high returns AND lower volatilities.

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NOTE: The part about W is oversimplified for flow of reading.  The bulkier explanation is y is stepped from y = ER(W) for minVol(W) to max expected-return of all the assets (Wmax_ER_asset = 1, y = max_ER_asset_return), and each x = minVol(W) s.t. y = ER(W) and sum_of_weights(W) = 1.   Clear as mud, right?  That’s why I wrote it the other way first.

 

Portfolio Management Advice. What is it worth?

The best way to manage a personal investment portfolio starts with a complete picture of assets and liabilities.  The greater the net worth, the more potential worth good portfolio-management advice offers.

For a given net worth, investment advice is most useful to investors who exhibit any of the following:

• disinterested in investing
• lack knowledge about certain types of investments
• lack knowledge about the tax-implication of investment choices
• are undisciplined in their investment approach
• overestimate returns, or underestimate risk or risk tolerance

Here are a few examples of experiences of the above-type investors.  Keep in mind that most exhibit more than one of the above traits.

Disinterested Investor

• Has not changed their 401K from its default 3% contribution to 100% money-markets.
• Has a broker who trades for them, yet has no idea how their investments have compared to the S&P 500 Index  
• $100,000 in their bank account because they are too lazy/indifferent to invest it
• Doesn’t rebalance

Ignorant Investor

• Only owns cash and CD’s because they don’t understand stocks, ETFs, or mutual funds
• Trades individual stocks but doesn’t know what a P/E ratio is 

Tax-Ignorant Investor

• Holds tax-exempt muni-bond funds in a 401K or IRA
• Holds annuities in a 401K or IRA (for no good reason)
• Doesn’t know about qualified dividends
• Doesn’t consider tax consequences of unrealized gains in ETFs and mutual funds

Undisciplined “Investor”

• Chases trends like the tech bubble.  Extremely undiversified. Often losing big money 
• Day traders. Eventually get burned.  Then out of the stock market all together.  Then finally back in only to buy into a market top.
• Doesn’t even know how much they’ve made or lost

Irrational Investor

• Expects 12%+ market returns. Surprised when markets fall.
• Thinks they can tolerate a 40% correction, then sells in panic near the market bottom when such a correction occurs

The unfortunate truth is that the vast majority of investors I’ve encountered harbor at least one of the above investing flaws.  Many of these people make 6-figure salaries.  It appears that being a complete investor is a rather rare trait.  For these reasons good investment advice can be very valuable to the majority of people who are “incomplete investors”.  In many cases %1 of net investment assets or $495 for a two-hour consultation can be quite worthwhile.

Show Me 3D

I was having a dinner conversation and showing some Sigma1 Financial images from this site on an Android phone to a UI developer.  I kept looking for a 3-D perspective plot, and soon realized that I hadn’t posted one yet!  How easily remedied:

 

This plot shows the objective space and the trade offs between return, variance, and semivariance. It contains the same information present in other example plots, but presented from a different perspective.

3-D Frontier of Optimized Investment Portfolios