A policy portfolio is a poor reflection of investor preferences, argued Peter Bernstein. This philosophical question has now been empirically tested by MIT’s Mark Kritzman, who shows the inter-temporal disparity of a policy portfolio’s risk profile. He suggests a simple framework for addressing this deficiency.
Kritzman encourages investors to replace rigid policy portfolios with flexible investment policies.
It’s not unlike a dynamic asset allocation idea, except he uses different information or signals as the conduit for any change.
Kritzman, who is a senior lecturer in finance at the MIT Sloan School of Management and the president and chief executive officer of Windham Capital Management, presents empirical evidence, and a potential framework, to the philosophical argument put forward by finance historian Peter Bernstein.
Bernstein argued that a policy portfolio is a poor reflection of an investor’s preferences; instead, it may simply be a benchmark for determining the success or failure of active management.
Selecting a portfolio of asset classes that best meets an investor’s objectives, given the outlook for expected returns, risk and correlations at a point in time, is not desirable because it changes over time.
“The return distribution implied by a particular portfolio at one point in time may be quite different at another point in time – and investors want the distribution, not the portfolio. The portfolio is simply a means to an end. The solution to the problem, therefore, is to revise the portfolio as needed to preserve the desired return distribution or at least to give the next best distribution,” Kritzman argues in his latest paper, Risk Disparity. “Or in other words, to replace a rigid policy portfolio with a flexible investment policy.”
He says that investors have two conflicting goals of growing their assets and limiting their exposures to significant drawdowns.
“The policy portfolio is supposed to be a way of balancing those. There is an implicit assumption that a policy portfolio will deliver consistent risk profile, but they are actually highly changeable,” he says, adding that the standard deviation of a broadly diversified portfolio can range from 3 to 25 per cent.
“It is not a valid argument that a reference portfolio is giving you stability,” he says. “I argue that you should replace a rigid portfolio with fluid allocation to get stability.”
Kritzman says that investment strategy defined as a set of fixed weights doesn’t do a good job at all of seeing an investor’s risk preference.
“Fixed asset weights don’t do the job they’re supposed to,” he says. “Further, our two measures of risk, beyond standard deviation and correlation, give a more reliable measure of when markets are dangerous and a portfolio is susceptible to that.”
“Investors can get a more stable risk profile by opportunistically changing their exposure to risky assets,” he says.
While typically dynamic asset allocation is driven by metrics of valuation such as stocks versus bonds, Kritzman suggests a change in allocations by drivers of risk, and he looks in particular at two different types of risk.
Predicting portfolio volatility is a tricky science.
Implied volatility and historical volatility are both of limited value according to Kritzman, who instead argues investors use the absorption ratio to anticipate shifts in portfolio volatility.
He says this measure captures the extent to which a set of assets is unified or tightly coupled, which means they will exhibit a unified response to bad news.
Over the years Kritzman and various co-authors have used this measure to predict broad market fragility and among other uses the US Treasury Department’s Office of Financial Research used it in the analysis of early warning signals of financial crises.
Kritzman says it can be applied to measuring the fragility of any set of assets, including the components of an individual portfolio.
“It’s a measure of the fragility in external markets. For example, if US stock markets are tightly coupled then they are more susceptible to shocks. We have taken the same methodology and applied it to a portfolio. We end up having a measure of risk that gives external danger measures.”
He also looks at the intrinsic fragility of a portfolio, which is dependent on the assets in that particular portfolio.
What this means in practical sense, he says, is investors can start with a policy portfolio and if there is no external or intrinsic fragility, then stay with the status quo.
“In the paper I show that if there is a measure of one of these, then there is heightened fragility and the equities portfolio should be cut in half. If both show fragility, then cut back virtually all equities. This is a pretty extreme move and in reality it would probably mean cutting equities by 25 to 50 per cent,” he says.
Such a dynamic approach is possible because of the use of exchange traded funds or futures exposures and, as such, avoiding implementation costs.