SmartETF

A Look at New Asset Allocation and Hedged Equity ETFs

New asset allocation strategy? Don’t drink the punch! There is nothing new about this asset allocation strategy or methodology; nor is this quantitative based. First, Funds of ETF’s exist, there is nothing unique about an asset allocation fund of ETF’s. Second, New Frontier Advisors, the distribution arm of Nothfield, does not use a quant model to come up with their solution. It’s built on the same platform as all the other archaic asset allocation solutions designed in the 1950’s; what you call Mean Variance Optimization (MVO), Modern Portfolio Theory (MPT), and in some cases its updated versions called Black-Litterman Model (BLM) and Arbitrage Pricing Theory APT), such as you will find in the software offered by Zyphyr Associates.

Third, the methodology of resampling was developed by Richard Michaud in 1999 and adds little, if any, value to a generic asset allocation model. It only serves to average efficient frontiers that are based on averages (maybe the fund should be called the average of averages). MVO-Resampling works in 3 steps like this:

Step 1: a) Estimate returns, risk (using standard deviation) and dependency (linear correlation) for a set of assets using historical data. b) Run a Monte Carlo simulation to create a new data set. Calculate the return, risk and the dependency of the new data set.

Step 2: Create an efficient frontier using the new inputs. (Repeat steps 2 and 3 500 times).

Step 3: Calculate the average allocations to the assets for a set of predetermined return
intervals. This is the new efficient frontier (Oh yes, slap a U.S. Patent #6,003,018 on this methodology to make it look new).

In New Frontier’s whitepaper they highlight the ‘Fallacies of Mean-Variance’, yet they still rely on it. Why put a band-aid on a broken model? The REAL NEW STUFF is called Extreme Value Theory (EVT) and firms using this methodology have significantly out-performed your average of averages model. EVT is based on Noble Prize winning concepts from this millennium (2002), not from Markowitz’s work from 1952 & 59’ (yes, 50 years ago). Phillip Anderson, another recent Nobel Laureate in Physics, states “Much of the real world is controlled as much by the “tails” of distributions as by means or averages: by the exceptional, not the mean; by the catastrophe, not the steady drip.” “We need to free ourselves from “average” thinking”. In summary, it’s better than doing nothing…….in a rising market. These models suggest you will earn 10% a year based on 80 years of historical data; the average over that time frame. Note the domestic market is down for the past 10 years; so much for being average.

The ETF-Squared: It Reallocates For You

Wake up world, yes rebalancing frequently is inefficient (IN YOUR MODELS) using mean-variance models such as Modern Portfolio Theory (circa 1950’s) and Arbitrage Pricing Theory (circa 1970’s), ala Black-Litterman. How can one year of new data possibly effect a change on more than 50 years of data? The real questions is who would want to rely on the average price, risk, return and correlation of a security or asset class based on the average of 40 or more years? Can you name one company whose 40+ year historical average is currently performing the same? Why do you think Fama, Mandelbrot and now Sharpe have all debunked MPT? Only Markowitz is holding onto his dream.

I find it hard to believe people still put stock in these theoretical models, but then again you also believe in Normal Distributions. May I suggest you read The (Mis) Behavior of Markets by Mandelbrot or any of Taleb’s books.