The value and momentum factors have earned high praise in recent years as complementary sources of risk premia for designing and managing equity portfolios. AQR’s widely cited paper “Value and Momentum Everywhere” a few years back helped popularize the idea, pointing to applications in

Understanding Modern Portfolio Construction Cullen O. Roche (Orcam Financial Group) February 22, 2016 Over the last 75 years there have been great strides in modern finance, portfolio theory and asset allocation strategies. Despite this progress the process of portfolio construction remains grounded

Failure isn’t an option, but it happens. Modeling the possibility that a portfolio strategy will stumble isn’t exactly cheery work, but it’s a productive and necessary exercise for stress testing what the future can do to the best-laid plans for investing. The good news is that there’s a

Managing risk via tactical asset allocation (TAA) offers a number of encouraging paths for limiting the hefty drawdowns that take a toll on buy-and-hold strategies. But what looks good on paper can get ugly in the real world. There's a relatively easy fix, of course: consider the total number

Analyzing history as a guide to the future is riddled with caveats, but if you’re mindful of the limitations there’s a mother lode of perspective waiting to be mined in the cause of modeling relationships in macro and markets. One of the more useful techniques in this corner: impulse-response

Do you know where the risk in your portfolio is coming from? Well, of course, you do. After all, you designed the portfolio and so the asset weights reflect the risk contribution. A 50% weighting in stocks translates into a 50% contribution to risk for the portfolio overall, right? That’s a

In the previous installment in this series of analyzing a globally diversified portfolio we reviewed the results after adding a momentum-based risk-management system. The test suggested that a tactical overlay can be productive… maybe, depending on the details. Let’s continue to investigate our

The search for objective analysis in the cause of making informed investment decisions is the Holy Grail of finance. Unfortunately, narrative risk continually threatens to derail us on our crucial quest for perspective. Everyone loves a good story, and it’s no different when it comes to finance

Buffett’s Asset Allocation Advice: Take it … With a Twist Javier Estrada October 26, 2015 One of the most important decisions retirees need to make is the asset allocation of their portfolios. They can have a static or a dynamic allocation, and simplicity usually favors the former. Warren

Momentum has received a lot of attention in the asset-pricing literature over the past several decades, and for good reason. Trending behavior is a staple in markets. In contrast with other pricing “anomalies”, short-term return persistence—positive and negative—is a robust factor across

In a new article from Institutional Investor—“Market Timing Is Back In The Hunt For Investors”–AQR Capital Management reviews the case for market timing and finds an encouraging track record. Citing the historical record from 1900, AQR’s Cliff Asness and two colleagues outline what is

Backtests have become the weapon of choice for rationalizing various forms of tactical asset allocation, which has become increasingly popular as a risk-management tool since the 2008 crash. The hazards of backtesting—studying how a strategy performed in the past–are well known, which leads some

How Do Investors Measure Risk? Jonathan Berk and Jules H. Van Binsbergen October 1, 2015 We infer which risk model investors use by looking at their capital allocation decisions. We find that investors adjust for risk using the beta of the Capital Asset Pricing Model (CAPM). Extensions to the CAPM

Last month I tested random rebalancing strategies based on dates and found that searching for optimal points through time to reset asset allocation may not be terribly productive after all. Let’s continue to probe this line of analysis by reviewing the results of randomly changing asset weights

How much influence do investors have over their portfolios? Perhaps it's less than commonly assumed. The notion that randomness plays a role in money management has been widely studied in finance-Nassim Taleb's popular treatment in Fooled by Randomness: The Hidden Role of Chance in Life

Research Review | 13 Aug 2015 | Portfolio Management Momentum and Markowitz: A Golden Combination Wouter J. Keller, Adam Butler, and Ilya Kipnis May 16, 2015 Mean-Variance Optimization (MVO) as introduced by Markowitz (1952) is often presented as an elegant but impractical theory. MVO is “an

In theory, small-cap and value stocks offer solid premiums over their large-cap and growth counterparts. In the short term, however, turning theory into real-world profits can get messy. As an example, let's review how the small-cap and value premia stack up at the moment via representative

It’s hard to overestimate the importance of modeling tail risk when it comes to the care and feeding of investment portfolios. But where to begin? The topic of studying, estimating and otherwise dissecting rare but extreme market events can be a black hole of analytical possibilities and

The concept of building “optimal” portfolios—maximizing return and minimizing risk–is a foundational concept in quantitative finance. Unfortunately, it’s not terribly practical. The problem, as many researchers have demonstrated over the years, is the elusive aspect of developing reliable

We’re all backtesters in some degree, but not all backtested strategies are created equal. One of the more common (and dangerous) mistakes is 1) backtesting a strategy based on the historical record; 2) documenting an encouraging performance record; and 3) assuming that you’re done. Rigorous

History shows rather clearly that the stock market is prone to extreme events, aka crashes. The challenge is deciding when the risk for a repeat performance is unusually high. The literature offers endless possibilities, which is a reminder that the market can crumble for any number of reasons. The

Deaccumulation is the new new thing in finance for an obvious reason: the US population is aging, which means that retirement becomes an increasingly pressing issue for financial planning. Perhaps the leading challenge for this critical task (other than accumulating a sufficient pot of money) is

Every time someone comes up with a “new and improved” way to invest or predict which active managers will shine, it seems that subsequent research finds that it’s really just about focusing on different betas. The latest example is a new study (“Deactivating Active Share”) from AQR, a

Most of the glowing analysis of so-called smart beta ETFs focuses on individual funds and how they offer advantages over their conventionally designed counterparts that weight securities by market capitalization—classic beta, as we’ll call them here. But what happens when we design portfolios

How Often Should You Take Tactical Asset Allocation Decisions? Byeong-Je An, et al. March 5, 2015 About once a quarter. We compute optimal tactical asset allocation (TAA) policies over equities and bonds when both asset returns are predictable. By varying how often the weights are reset, we estimate

In the previous post on using R for portfolio analysis and design, we discovered that global diversification across asset classes has been modestly beneficial relative to a basic 60%/40% US stock/bond allocation. The global aspect didn’t add a lot of value because US equities during the sample

A recent paper (“Evaluating Trading Strategies”) on the hazards of backtesting in The Journal of Portfolio Management has been receiving a fair amount of attention lately, inspiring some folks to go off the deep end and argue that econometric analysis of investment strategies is always a bad

I’ve been analyzing a 60/40 US stock/bond portfolio in R in a series of posts and today’s installment picks up from the previous post by adding a global strategy. The goal is enhancing the 60/40’s return while keeping risk at a comparable if not lesser level. Overly ambitious? Perhaps, but

In a previous post I reviewed the basics of using the PerformanceAnalytics package in R for evaluating a simple 60/40 US stock/bond portfolio based on a pair of ETFs. Let’s round out that preliminary review by exploring a few additional applications before moving on to a deeper level of analysis

Suddenly business as usual for small-cap investing is in need of a makeover, thanks to a new research paper (a landmark study for asset pricing) that revisits, reinterprets and ultimately revives the case for owning these shares — after controlling for quality, i.e., “junk”. Cliff Asness of

Traders and investors tend to operate in parallel universes, using different analytical toolkits and looking at markets from radically different perspectives. But sometimes there’s common ground. David Varadi’s recent investigation of what he calls error-adjusted momentum (EAM) to normalize

Earning a respectable investment is hard. Holding it on to it is even harder, according to a variety of studies over the years that have analyzed the portfolios that investor build and own. The news is at once disturbing and baffling. Disturbing because a large population of individuals have earned

Once upon a time there was only one factor—the market, a la the capital asset pricing model. But after a half century of crunching the numbers since CAPM was born, “now we have a zoo of new factors,” as Professor John Cochrane observed a few years ago. In theory, identifying more factors opens

How’s that rebalancing strategy working out for ‘ya? Results will vary, of course, depending on when we run the analysis, the architecture of the strategy, and a number of other variables. Deciding if the results are satisfying or disappointing could be due to any number of factors, such as the