Our Money Life Podcast Interview with Chuck Jaffe
On the heels of our publishing Adaptive Asset Allocation, over the past couple weeks, we were invited to join a number of excellent financial podcasts. We love these types of opportunities, and they differ from traditional media interviews in that we actually have the time for a meaningful discussion with the hosts and their audiences.
What follows is a lightly edited transcript of the interview, with links to the resources referenced in the interview. Enjoy!
Chuck Jaffe: It’s Big Interview time here on Money Life and I’m joined right now by Michael Philbrick. He is one of the authors of a book out now called Adaptive Asset Allocation: Dynamic Global Portfolios to Profit in Good Times and Bad.
Now if you want more information on the book, it is all linked up with the Money Life Show recent and upcoming guest page. You can also get more information by following Mike on Twitter. He’s @GestaltU, also @InvestResolve. You can also visit InvestResolve.com for more information on the firm. Michael Philbrick, welcome to Money Life.
Michael Philbrick: Thanks Chuck. Pleasure to be here.
Chuck Jaffe: So we’re starting with dynamic global portfolios to profit in good times and bad. You actually have to start – before we even get to dynamic portfolios, with how do we determine what is good times and bad, and then how dynamic a portfolio are we talking about. Give my audience an understanding of when we talk dynamic portfolios, it’s not day trading but it’s also not buy and hold forever. So where in the middle does it fall?
Michael Philbrick: Right. We really offer a span from passive to active. In the book, we cover our most active strategy which is the adaptive asset allocation…and it’s quite adaptive. It’s going to understand the entire world of opportunities and then it’s going to put those pieces together in an optimal way that considers the risk, the correlation and the expected returns of those assets. And it’s going to do so in order to mitigate large losses and make sure that the investor comes out with a pretty reasonable return. So it’s very adaptive.
Chuck Jaffe: That said, when we talk about it being adaptive and what it can do, how does somebody quantify why they take this on? Is this a strategy that’s going to deliver improved returns? If so, what kind of expectation do you set for somebody? Is this going to deliver less volatility? What is it that someone gets when they go from standard asset allocation to adaptive asset allocation?
Michael Philbrick: Good question. Let’s start with a standard asset allocation model like the global market portfolio. So Sharpe contended that the only passive portfolio is the global market portfolio, which holds assets in proportion to market cap weight.
If we start there and we look at from 1995 to today, we see an annualized return of about 6.5 percent and standard deviation of about 9 percent with a max drawdown of 33 percent. If you apply the methodologies that we talk about in the book, you can boost returns to in excess of 15 percent with the same 8 percent standard deviation, and max peak to trough loss goes from 33 to 9 percent.
So it’s a pretty significant boost in risk-adjusted returns but it also requires turnover in the portfolio. So the global market portfolio has no turnover. Adaptive asset allocation, the turnover is in excess of 100 percent per year.
Now, you have to have tax considerations come into play and so there’s a number of things to consider along the way but there’s certainly a boost in risk-adjusted returns along the way from the entirely passive to the fully adaptive model in the book.
Chuck Jaffe: You talked about tax concerns. Is this the kind of strategy that somebody wants to be implementing in their tax advantage savings and like say, “OK, I will become adaptive in what I do within my 401(k) or my self-directed IRA? That way I don’t have to worry about tax concerns and I don’t have to see anything there and I’ve got that big chunk of assets and I know that that way, I’m being somewhat more resolved to stay the course and make money in all conditions?”
Michael Philbrick: I think so. I mean that’s certainly the place to start. But let’s step outside the IRA and say someone has got a large sum of money to invest. A 33 percent loss in a million dollar portfolio is $330,000. So to the extent someone can experience that type of loss in a truly passive portfolio and they’re OK with that, then that’s great. That person should let taxes determine – to some degree – what their investment process is.
But we run into a lot of clients that can neither afford to have those types of losses nor want the behavioral stresses that come from having the type of losses often associated with passive portfolios. So it’s something that each investor has to weigh and balance and decide for themselves.
Chuck Jaffe: You talk about the various asset classes. How much does an adaptive asset allocation strategy rely on commodities, alternative investments, things outside the stocks, bonds and cash realm?
Michael Philbrick: Part of the portfolio’s process is being adaptive. At times, you can have quite an allocation to asset classes like international real estate, gold and commodities. At other times, those allocations go to zero.
For the optimal investor on the adaptive asset allocation front, they have to have two key advantages over the general market. One is the mandate flexibility to be able to have those shifts within their portfolio. The other is portfolio agility. We manage a couple hundred million dollars and so until we get to billions of dollars, it’s not going to be that difficult moving around in and out of the markets as if we were a ghost. We don’t have a lot of impact on the market.
So if you have those two advantages in your portfolio, then you can afford to be more adaptive. You also have to be willing to accept the tracking error that comes with owning something that’s different than the S&P for example.
[Editorial Note: While debriefing on the interview, it became clear that we partially missed the point of this question. Specifically, while we use what some might consider “alternative” asset classes – gold, foreign real estate, emerging market bonds – it’s important to note that we don’t use alternative structures. Our investment universe is composed of the largest, most liquid ETFs that give us access to desired sources of return. At this point, however, we do not use hedge funds, exotic derivatives, and the like.]
Chuck Jaffe: For investors who are looking at this, the key decision of course is always how you’re moving. So, right now, are we in good times or bad times?
Michael Philbrick: I would say we’re sort of right in the middle. So if we look at allocations today, the portfolio is very balanced. It’s half-exposed to very safe US government bonds and half-exposed to risk assets. So I would say that generally when we look at our models, today would be a day where I would say it’s not giving you a very strong indication either way. It’s saying be balanced.
Chuck Jaffe: For investors who are wondering what they’re going to be balanced in, are they looking at things that have been having good times? In other words, keeping their risk assets in stuff that has shown some momentum or are they looking at things that are now perhaps value-priced where there’s less momentum? Because you can have risk assets in the stuff that has been going up or you could be buying oil stocks which have been beaten down but might now be bargains.
Michael Philbrick: It’s important to step back and understand a little bit of how adaptive asset allocation works. It is a mean variance optimized portfolio. The problem with most implementations of a mean variance approach is that the inputs aren’t very good.
Whenever you do a mean variance optimization, you need three inputs. You need to have a return estimate, a volatility estimate and a correlation estimate. We go into this in the book, but as you can see from those inputs, we’re not value investors. We employ momentum as a way to get a better return estimate. We also look at volatility and correlation. We only look at historic numbers. So we look at the last anywhere from 10 to 60 days on volatility and correlation and then we build the optimal portfolio with those enhanced inputs.
At the moment, you’re going to see a portfolio that contains US stocks, a little bit of gold, international real estate, US real estate, seven to ten-year treasuries in the US and longer term treasuries. That’s kind of where it is today and that does change. So I would caution listeners not to go out and put that portfolio in place because it changes. We observe and we adapt to what’s going on.
You don’t need to predict where the prices are going to be. You just need to observe what they’ve done in the magnitudes of the moves and then adapt the portfolio to what’s going on currently. That provides a pretty stable, successful, smooth ride when it comes to your investments.
Chuck Jaffe: How do you differentiate between adapting and having what amounts to a “kneejerk” reaction? I mean if we see a violent move on the market today or tomorrow, what is the difference between adapting and overreacting?
Michael Philbrick: For starters, we are 100 percent systematic and quantitative in our decision making. So prices change today and tomorrow. They will move and there will be a magnitude of the move. There will be the relationship between those assets and the size of the move.
All we do is plug that into the machine. It spits out a new portfolio. If that portfolio is significantly different than the portfolio of the day before, we adapt and change the portfolio. If not, we leave it alone and so there’s no gut reaction for us. It’s entirely based on systems and we base everything in evidence. So we’re looking for evidence that supports that methodology. If you look at momentum, there’s 200 years of studies on momentum being an effective way to look at returns as well as volatility and correlation. That’s how we do that.
[Editorial Note: Again, we’re not sure we sufficiently answered the question. While it’s important to underline our systematic approach, we think it’s also important to emphasize the fact that when you watch markets in real time, it’s impossible to differentiate “genuine” moves in asset prices from “fake-outs.” In essence, when taking a systematic approach, there is literally no such thing as an “overreaction”; there are only reactions.
When the market moves, our tactical portfolios adapt. Sometimes those moves reverse, in which case our tactical portfolios re-adapt. In other cases, we find ourselves ahead of major changes in market dynamics. Regardless, adoption of a systematic process is optimal because the biggest threats to long-term success aren’t the relatively small misses in an adaptive portfolio. Rather, the primary threats to long-term success are woefully under-diversified portfolios, and the poor decisions motivated by the emotional stresses when it inevitably suffers a material loss.]
Chuck Jaffe: Well Michael, great stuff. I appreciate you joining me. Thanks so much for coming on to Money Life.
Michael Philbrick: Thank you.
You can still pick up your copy of Adaptive Asset Allocation: Dynamic Global Portfolios to Profit in Good Times and Bad at Amazon or wherever quality books are sold.