White paper — Portfolio Optimization: Thinking ‘Outside the Style Box’
Swan Research — Innovative Portfolio Optimization
Swan is focused on helping provide financial advisors with the thought leadership necessary to differentiate themselves and make their businesses stronger and more valuable. The purpose of this document is to highlight our theoretical view that a diversified hedged assets portfolio is a more effective and efficient way to optimize a portfolio than traditional portfolio optimization.
The goal will be to present evidence to support the following portfolio management perspectives:
• Traditional portfolio optimization is flawed and potentially misleading and the efficient frontier is of limited use
• Traditional portfolio optimization leads to fairly indistinguishable asset allocations
• Traditional portfolio optimization fails to minimize losses, as they are built to minimize volatility
• An alternative approach to portfolio optimization (such as the Defined Risk Strategy), that directly addresses
market risk, can lead to more effective and efficient portfolios
• Portfolio results can be improved through the use of hedged assets
• A defined risk portfolio, built upon the concept of maximizing return while minimizing an investors’ possible
level of “pain”, could introduce a paradigm shift away from traditional portfolio optimization
“Mean Variance Optimization (MVO) is currently the most common methodology for creating portfolios based on MPT. In essence, the process mathematically determines the optimal weightings amongst a list of available asset classes to yield portfolios that have the highest expected
return for a given level of risk. This is computed based on the inputs of the returns and standard deviations of each of the available assets, and the correlations amongst those assets. While MVO is a popular tool for creating efficient portfolios, it can be a victim of its own inefficiencies.” (The Kitses Report, July 2008, Michael Kitses)
Portfolios created via MVO favor individual assets with high return-to-risk estimates. Therefore, using MVO tends to magnify errors in estimates. Portfolio optimization is built upon the assumption that asset classes will continue to exhibit past patterns of return, correlation, and variance.
However, as experienced in 2008 and seen in Exhibit 1, past patterns do not always persist. This can lead to outcomes very different than the expectations. Note the long-term correlation of assets prior to the Financial Crisis (correlation measures how closely two different investments move in conjunction with one another; if one is seeking to diversify an investment portfolio, lower correlations or negative correlations are desired).
Swan believes it is important that investors have a better understanding of Modern Portfolio Theory, how it is broadly used to construct portfolios, and the implications of applying MPT versus different approaches to portfolio construction when considering their own investments, portfolios and long-term goals.
This paper endeavors to provide a broader understanding and the alternative approach to portfolio construction and optimization inherent in the Defined Risk Strategy.