DIVERSITY STUDY 2: THE VERY DIVERSE "ADAPTIVE ASSET ALLOCATION" PORTFOLIO
In"Diversity Study - Three Examples" increasingly diverse fixed rebalanced portfolios were back-tested. There was no clear evidence that more diversity helped. Adaptive Asset Allocation (AAA) is an attempt to improve this by applying time diversity (market timing) to asset diversity. It has a 10 asset roster of possible investments (plus cash) but only invests in 5 at a time based on recent price history.
The categories for investments are:
The categories for investments are:
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AAA is described in "Adaptive Asset Allocation: A True Revolution in Portfolio Management By Adam Butler and Mike Philbrick" but gives results without specifying what funds were used to calculate the numbers. OI therefore assigned representative mutual funds with a long history to try to reproduce the results. Those funds are:
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The paper reports results from 1995 to 2012 (chart on left below) showing above average returns and lower volatility, the holy grail of a diverse portfolio. With the funds above, OI created its version of AAA with results from 2002 to the 2012 (to the right). The results are similar enough to establish that our version of the algorithm is representative. The results are outstanding. Note the modest drop during the 2008 2009 recession and roughly 10% average annual return. The algorithm moved from stocks to gold and real estate during the recession.
Then, soon after the paper was published, AAA began to flag. Asset prices began to stagnate and the algorithm bought and sold with bad timing or stayed in cash all of which reduced returns. So the most promising of all our market timing systems does not seem to do well in the current markets. Its diversity achieved above average results for 20 years however and if you, as a financial advisor, had put your clients money in AAA any time up to 2013 you would have been at the top of your profession. The current period may be a fluke and AAA may still be a great investment approach. It would be a lot of work for an individual investor but perfect for a mutual fund.
HOW DOES AAA WORK?
The general AAA rules are the following:
The general AAA rules are the following:
1. A broad range of 10 asset classes are candidates for investment. Some assets are expected to be in a rising phase and others a falling phase.
2. Invest in up to 5 assets at a time based on the best 6 month performance (compare asset price today with asset price six months ago). Rising assets tend to continue rising (so momentum theory tells us) so we invest in the 5 likely to continue rising. If fewer than 5 funds had positive price rise for the last 6 months, put 20%, 40%,60%, 80% or 100% in cash for the month depending on how many funds were positive. 3. Gather and reinvest dividends every month and rebalance (and reallocate to a new mix of assets if necessary). |
![](http://www.weebly.com/weebly/images/file_icons/xls.png)
data_set_aaa.xls |
THE GREAT RECESSION
The most striking feature of the chart above is how AAA (in yellow) sailed through the 2008 recession as if it didn't happen. AAA rotated through all 10 asset classes. Gold, domestic real estate, and emerging markets were winning investments while the stock market dropped 50% (AAA left the stock markets in Nov 2007 and returned to them in 2009 .) This is exactly what an Ordinary Investor wants from diversity. It also validates market timing in times of recession.
AAA Investments Oct 2007 Thru Nov 2010
The most striking feature of the chart above is how AAA (in yellow) sailed through the 2008 recession as if it didn't happen. AAA rotated through all 10 asset classes. Gold, domestic real estate, and emerging markets were winning investments while the stock market dropped 50% (AAA left the stock markets in Nov 2007 and returned to them in 2009 .) This is exactly what an Ordinary Investor wants from diversity. It also validates market timing in times of recession.
AAA Investments Oct 2007 Thru Nov 2010
10/31/07 | 11/30/07 | 12/31/07 | 1/31/08 | 2/29/08 | 3/31/08 | 4/30/08 | 5/31/08 | 6/30/08 | 7/31/08 | 8/31/08 | 9/30/08 | |
VFINX | 20% | |||||||||||
FIEUX | 20% | 20% | ||||||||||
EWJ | ||||||||||||
EEM | 20% | 20% | 20% | 20% | ||||||||
FBIDX | 20% | 20% | 20% | 20% | 20% | |||||||
TLT | 20% | 20% | 20% | 20% | 20% | 20% | 20% | 20% | 20% | |||
PURAX | ||||||||||||
PCRAX | 20% | 20% | 20% | 20% | 20% | 20% | 20% | 20% | 20% | 20% | ||
IYR | ||||||||||||
GLD hybrid | 20% | 20% | 20% | 20% | 20% | 20% | 20% | 20% | 20% | |||
FDRXX | 20% | 20% | 20% | 60% | 40% | 80% | 80% | 80% | ||||
10/31/08 | 11/30/08 | 12/31/08 | 1/31/09 | 2/28/09 | 3/31/09 | 4/30/09 | 5/31/09 | 6/30/09 | 7/31/09 | 8/31/09 | 9/30/09 | |
VFINX | 20% | 20% | ||||||||||
FIEUX | 20% | 20% | 20% | 20% | 20% | |||||||
EWJ | 20% | 20% | 20% | |||||||||
EEM | 20% | 20% | 20% | 20% | 20% | 20% | ||||||
FBIDX | 20% | 20% | 20% | |||||||||
TLT | 20% | 20% | 20% | 20% | 20% | 20% | 20% | |||||
PURAX | 20% | 20% | 20% | 20% | 20% | |||||||
PCRAX | 20% | 20% | ||||||||||
IYR | 20% | 20% | ||||||||||
GLD hybrid | 20% | 20% | 20% | 20% | 20% | |||||||
FDRXX | 80% | 80% | 60% | 60% | 60% | 40% | 20% | |||||
10/31/09 | 11/30/09 | |||||||||||
VFINX | 20% | 20% | ||||||||||
FIEUX | 20% | |||||||||||
EWJ | ||||||||||||
EEM | 20% | 20% | ||||||||||
FBIDX | ||||||||||||
TLT | ||||||||||||
PURAX | 20% | 20% | ||||||||||
PCRAX | 20% | |||||||||||
IYR | 20% | |||||||||||
GLD hybrid | 20% | |||||||||||
FDRXX |
source: AAA.xls, sourcedata page
Some Conclusions:
Some Conclusions:
- AAA and its diversity appears to solve the volatility problems. Stock market corrections, recessions and bubbles are smoothed out and the same applies to all 10 asset classes.
- AAA was at its best during the 2007-2009 recession.
- AAA has underperformed the stock market, balanced funds and SAA100 (simple VFINX,FADMX market timing portfolio) in the last 10 years. The strength of the US stock market since 2009 has benefitted other investments more than AAA. AAA at times may be 80% stock but is at most 20% in the US stock market.
- AAA has many more transactions than SAA to achieve its results and may not be suitable in a taxable or commissioned portfolio.
- AAA is the most flexible of the 3 market timing portfolios and has the best chance of thriving, particularly during recession-prone or stagnating periods.