visit: adaptiveassetallocation.com

Adaptive Asset Allocation Policies by William F. Sharpe

NOTE: We post papers in the Resource Center as a stable link to research we will source in a blog post or another paper. We do not necessarily agree with the content of the paper. For example, the Adaptive Asset Allocation disscussed in this paper does not match how we define and execute Adaptive Asset Allocation. However, the paper is still interesting whether we agree with all of it or not.

ABSTRACT

Many institutional and individual investors have an asset allocation policy that calls for investing a specified percentage of the total value of a portfolio in each of several asset classes. To conform with such a policy as market values change requires selling assets that performed relatively well and buying those that performed relatively poorly. Such a strategy is clearly contrarian and can only be followed by a minority of investors. In practice, many investors seldom rebalance completely to conform with their policy. On the other hand, many multi-asset mutual funds, increasingly used in defined contribution plans, do so frequently, resulting in contrarian behavior. This paper presents an alternative approach, in which an asset allocation policy adapts as markets move, taking into account changes in the outstanding market values of major asset classes. Such policies can take important information into account, reduce or avoid contrarian behavior
and could be followed by a majority of investors.

OVERVIEW

The Third Edition of the CFA Institute’s book on Managing Investment Portfolios states
that:

“… strategic asset allocation can be viewed as a process with certain well-defined
steps. Performing those steps produces a set of portfolio weights for asset classes;
we call this set of weights the strategic asset allocation (or the policy portfolio).”

This is a paper about such asset allocation policies.

I begin by describing traditional policies and provide three examples of mutual funds that
have such policies and appear to conform closely to them. I then show that these actions
are inherently contrarian in nature and that it is impossible for a majority of investors to
follow such policies. This may seem surprising, given the ubiquity of such asset allocation policies. The apparent paradox is resolved by noting that many organizations and individuals fail to adhere to their policies when markets change.

Next, I argue that for many investors, it may be undesirable to follow a traditional asset
allocation policy by frequently rebalancing portfolio holdings to regain the specified asset
weights. While this may comfort those who rarely rebalance their portfolios, it raises
concerns about those who make frequent trades to maintain an allocation that conforms
with stated policy, as do many multi-asset retail mutual funds.
To show the likely magnitude of the problems with traditional asset allocation policies, I
analyze the relative market values of bonds and stocks in the United States over the last
thirty years. The variation has been substantial. This implies, for example, that a
purportedly medium-risk asset allocation policy would have varied from having the same
risk as the portfolio of the average investor to being more aggressive than such a portfolio
at some times and more conservative at others.

Next, I consider two non-traditional ways to set asset allocation policy. Key to both
methods is the use of the current market values of the outstanding securities in each asset
class -- information which I argue should be incorporated whenever an asset allocation is
chosen. The first method relies on both optimization and reverse optimization procedures.
It is more sophisticated but requires significant analyses from period to period. The
second approach, which I term an Adaptive Asset Allocation Policy, is simple, easy to
execute and can be readily adopted by organizations with pre-existing traditional asset
allocation policies.

To illustrate, I show how institutional investors, investment advisors, balanced mutual
funds and target-date funds can adopt and follow adaptive asset allocation policies. In
most cases this will provide guidelines that are more consistent with their stated goals and
objectives. For simplicity I employ examples involving only two asset classes but the
procedures can be utilized with as many asset classes as desired.

Finally, I briefly describe several desirable products and services not currently offered by
index providers and investment companies – products that would explicitly take current
asset market values into account. If the arguments in this paper have merit, investors
would be well served if the industry responded by providing such services and
investment products.

Click here for complete paper: Adaptive Asset Allocation Polices by William Sharpe.pdf

Source: Sharpe, William F., Adaptive Asset Allocation Policies (May 25, 2010). Financial Analysts Journal, Vol. 66, No. 3, 2010. Available at SSRN: http://ssrn.com/abstract=1615459