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The QD Portfolio - Exhibit II

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  • The QD Portfolio - Exhibit II

    I'm continuing my short series on asset allocation studies, with a report published by Ibbotson Associates in March 2006. This paper is a more rigorous study than the Christopher Moth paper (my Exhibit I).

    Whereas Moth based his conclusions on a single optimization exercise over historical data, Ibbotson combines a similar optimization with three analyses of hypothetical, forward-looking returns for commodities. (That sounds implausible, but you should check the paper to see how they separate commodity investment yield into subcomponents, and model each one as a separate building-block of yield.) Moth's historical dataset is quarterly returns 1973–2000. Ibbotson's is annual returns 1970–2004. Moth's commodities benchmark is GSCI, while Ibbotson uses a blend of four benchmarks, and discusses the construction of each one. Moth was published in 2000, and Ibbotson's in 2006. Clearly in the years between, investors became more interested in alternative asset classes. The Ibbotson paper cites many other researchers who investigated commodities during the early 2000s. Needless to say, I think it is worth a few hours to read and re-read this great report.

    Anyone investing in commodity-based ETFs would be wise to learn about the various factors in the design of these vehicles, and the Ibbotson paper is a good starting point.

    There are a lot of results in the paper, and I was bewildered at first as to how to incorporate this great research into my own portfolio. Cutting to the chase, the key findings are in table 17 on page 44. This is a blend of the historical and forward-looking analyses. The researchers calculated an asset allocation policy for six investment styles, by keeping the risk (standard deviation) constant and optimizing the policy for the best returns. For example, the conservative portfolio's goal is to have a constant 5% standard deviation in returns, so what is the best expected return we can obtain for this amount of risk?














    Asset ClassConservativeModerateAggressive
     With
    Commodities
    Without
    Commodities
    With
    Commodities
    Without
    Commodities
    With
    Commodities
    Without
    Commodities
    Treasury Bills22.77%27.34%1.17%3.89%1.07%3.68%
    TIPS10.24%17.64%7.21%17.80%2.29%5.93%
    U.S. Bonds18.93%15.74%5.53%8.31%0.29%1.43%
    International Bonds16.54%21.07%7.80%14.62%2.20%5.52%
    U.S. Stocks15.48%9.69%30.65%36.79%18.13%39.57%
    International Stocks6.11%8.52%22.05%18.58%57.05%43.88%
    Commodities9.93%0.00%25.59%0.00%18.97%0.00%
           
    Expected Return6.62%6.19%9.48%8.83%11.26%10.88%
    Standard Deviation5.00%5.00%10.00%10.00%15.00%15.00%
    Sharpe Ratio0.4000.3140.4860.4210.4420.418

    This is a nice presentation because you can compare side-by-side what happens if you include or exclude commodities as an asset class. For conservative and moderate-risk investors, you get a nice boost in expected returns (with no additional risk), by shifting some of your assets from bonds to commodities. The benefit of commodities is not as great for someone with an aggressive risk profile.

    Now let's compare the Ibbotson portfolios to the Moth portfolio. The most striking difference is that Moth's optimization rules out international stocks from the portfolio. He argues that they are too highly correlated with U.S. stocks, and have worse return/risk. However, Ibbotson includes the years 2001–2004 in their study, and therefore do not reach the same conclusion. In fact, in Ibbotson's aggressive portfolio, over half is allocated to international stocks! I take this as a sign that the risky portfolios suggested by these studies are not reliable. Artifacts in the historical data create distortions, which are magnified in the two studies' riskiest portfolios.

    In my own portfolio, I have decided to incorporate both studies' moderate portfolio recommendations. What better way to embrase a recommended diversification policy, than to diversify among several? In fact I have taken the average of four different studies, and will write about the last two here in the coming weeks.

  • #2
    Re: The QD Portfolio - Exhibit II

    QD, have you ever researched some of the more simple things like Coffee House Investor and Yale University Lazy Portfolio?

    (Forgive my functionality, but I have a hard time talking about abstract assets, I prefer specific funds and positions).

    A reporter for marketwatch tracks 7 of these "lazy" portfolios

    http://www.marketwatch.com/news/stor...st=printBottom

    I know of course a big disadvantage is that none of these have any PM positions. I'm going to check out what your report says on how the PM etf's are structured though because I'm still considering an etfs like SLV and GLD.

    Comment


    • #3
      Re: The QD Portfolio - Exhibit II

      Great article! But as you said, they only pay polite attention (if any) to the stagflation risk, by including a smidge of REITs. No real assets or inflation-indexed securities in the mix at all.

      David Swenson is going to be the topic of my next write-up.

      Comment


      • #4
        Re: The QD Portfolio - Exhibit II

        It's kind of dry stuff QuigleyDoor. I ask very respectfully, as I've appreciated the open quality and genuine spirit of inquiry of all your posts here. Do you describe yourself as a "quant", or a "big picture" kind of guy - or are you into both?

        There are some super 'Quants" out there - Louis Navellier of MPT Review is one, and he's made something like 50,000% for his subscribers over 25 years. No moss growing on that guy, certainly.

        The "quant" stuff has my eyelids drooping though, (and I'm feeling guilty as to whether I'm missing something vital!). The "big picture" stuff gets my blood racing and I'm all over it. I like the "genghis khan sweeps Europe" and "Rome falls" stuff, but I just can't get worked up about tweaks to a stock portfolio or analysing commodity sector returns down to the basis point.

        That's why I can't for the life of me follow all the 'asset allocation model' and "401K strategy" discussions around here without getting drowsy!

        What's wrong with me? Help!

        Comment


        • #5
          Re: The QD Portfolio - Exhibit II

          Originally posted by Lukester View Post
          It's kind of dry stuff QuigleyDoor.
          I feel like I've put people to sleep simply by posting a table of figures with 4 digits of precision. I was just copying and pasting from the source report. I am not now managing any assets to such hairsplitting precision.

          That said, I got the habit for this stuff when I worked on a global bond desk, and was charged with managing forex exposure on portfolios holding securities in at least 10 different currencies. One guy wanted forex exposure to be within 10 bps of his tactical target, and another guy kept on saying trading costs were washing out the gains unless our tolerance was up to 25 bps.

          I ask very respectfully, as I've appreciated the open quality and genuine spirit of inquiry of all your posts here. Do you describe yourself as a "quant", or a "big picture" kind of guy - or are you into both?
          No multiple choice questions, please.

          I have studied modern portfolio theory, and I believe it works. I'm not doing any original research, just evaluating what's out there. I'm hoping for some good feedback, constructive feedback on whether I'm making any mistakes. Or maybe I can help someone construct their own portfolio.

          I limit my speculative plays to about 10%. All this portfolio construction stuff is simply to gain some assurance of good returns, low risk, and low cost with the other 90%. The asset allocations that were proffered by my retirement plan were flawed, so I set out to find a better one.

          The "quant" stuff has my eyelids drooping though, (and I'm feeling guilty as to whether I'm missing something vital!). The "big picture" stuff gets my blood racing and I'm all over it. I like the "genghis khan sweeps Europe" and "Rome falls" stuff, but I just can't get worked up about tweaks to a stock portfolio or analysing commodity sector returns down to the basis point.
          I also like to think with historical and macro perspective. Actually I find the "meso" perspective (e.g. how do 100s of people manage to accomplish anything) to be more fascinating than the macro, but that's another topic.

          I try to separate investments from macro/futurist thinking. So many things might come to pass. Believing any one of them has overwhelming likelihood seems foolish. Or rather, I find myself believing just about everything I read (and my sources are diverse), so when I step back and try to make decisions, I cannot embrace any particular thing. Except math, falsifiable scientific theories, and a priori phenomena.

          That's why I can't for the life of me follow all the 'asset allocation model' and "401K strategy" discussions around here without getting drowsy!

          What's wrong with me? Help!
          I don't think I can offer that kind of advice. Everyone is different. My idea about "what is wrong with you" would simply reveal my assumptions about the world more than it would help. Everybody has different problems, and it is very hard for anybody to grasp the variety, without rigorous training of some kind.

          Anyway, I enjoy your provocative comments in this forum. Take a break if you need to, but please don't quit.
          Last edited by quigleydoor; August 01, 2007, 06:27 PM.

          Comment


          • #6
            The QD Portfolio - Exhibit II

            Quigley - You sound like Dr. Spock, with all the bases covered. I just dropped Louis Navellier into the post for the heck of it, but it looks like by chance he's very much within your interests with his MPT Review. Still going strong after 25 years.

            Great answers - very comprehensive.

            I do need a vacation, but it's not necessarily from I-Tulip. I need a vacation from my work, and the city I live in. I always hated short holidays - the long weekend and one week variety? I'm worried once I go on a real holiday I'm going to bust loose and never come back.

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