Tag Archives: management

How To Optimize Warren Buffett’s Asset Allocation Advice

In Berkshire Hathaway’s 2013 annual letter to shareholders, Warren Buffett gave some retirement savings advice to investors. The Oracle of Omaha wrote in his letter to shareholders that he had given the trustee designated to manage the bequest his wife will receive, the following advice: “What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit … My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.” Buffett’s advice sparked a debate in the financial community. Many market commentators asked if this really was the most sensible asset allocation approach for retirees, or indeed any investors at all. Javier Estrada at the IESE Business School, Department of Finance, Barcelona, Spain set out to answer this question in a paper titled, “Buffett’s Asset Allocation Advice: Take It … With a Twist”. In particular, the paper set out to answer the following question: “Is the asset allocation Buffett advised for his wife appropriate for other investors? If yes, why? If not, why not?” The study considers several different variations of Buffett’s recommendation. Eight static asset allocations with varying stock/bond proportions are evaluated, with particular attention to the 90/10 split suggested by Buffett. A further two minor dynamic strategies are also considered with valuation based twists. What’s more, the study is designed around the needs and skills of the average retiree. For example, the dynamic strategies are trivial to implement, and the person managing the portfolio will only need information about the performance of stocks, or that of stocks and bonds, over the previous year, which is publicly and widely available. Asset allocation: Data The data used for the study is based on the two asset classes suggest by Buffett, stocks, and short-term US Treasury bills. Returns are annual, adjusted for inflation and account for capital gains/losses and cash flows. Over the 114 year period considered, from 1900 to 2014, stocks and US T-bills had mean annual compound real returns of 6.5% and 0.9%, with annual volatility of 20.0% and 4.6%. The test portfolio was rebalanced once a year and the study assumes an annual withdrawal is made proportional to the asset allocation. The analysis is based on an initial capital balance of $1,000, an initial withdrawal of 4% of the capital and subsequent withdrawals annually adjusted for inflation over a 30-year period. Asset allocation: Results The chart below shows the results of the eight static portfolios over the period studied. (click to enlarge) Asset allocation results Figures indicated that strategies with equity holdings between 100% and 40% have similar failure rates, but when the allocation of stocks rises above 30% failure rates increase considerably; to above 10% in most cases. Although there are varied opinions regarding what is an acceptable failure rate, most practitioners seem to agree that failure rates below 5% should be viewed as acceptable by most retirees. Upside potential is measured by the mean, median, P90, P95, and P99. Downside protection is measured by both P5 and P10. The author concludes with test with the observation that: “…although the 60/40 strategy never failed, the 100/0 and 40/60 failed 3.5% of the time, and Buffett’s 90/10 failed 2.3% of the time, there does not seem to be a substantial difference in the failure rates of portfolios holding at least 40% in stocks.” “…as far as static strategies is concerned, Buffett’s suggested allocation has a very low (although not the lowest) failure rate; a very high (although not the highest) upside potential; and provides very good (but not the best) downside protection when tail risks strike. Put differently, Buffett’s suggested allocation seems to provide a middle ground between the best performing strategy (100/0) in terms of upside potential and the best performing strategies (60/40 and 70/30) in terms of downside protection.” Adapting Buffet’s advice Javier Estrada goes on to look at two different dynamic asset allocation strategies, which are based on the static strategy recommended by Buffett, but with a few changes. The first change [T1] relates to the annual withdrawal to the behavior of the stock market in the previous year. If stocks have gone up, the retiree takes the annual withdrawal from stocks and then rebalances the portfolio back to the 90/10 allocation. Conversely, if stocks have gone down, the retiree takes the annual withdrawal from bonds and does not rebalance the portfolio. The second change [T2] relates the annual withdrawal to the relative behavior of the stock and bond markets in the previous year. Just like adoption above, if stocks have gone up in the previous year, (more so than bonds) this change calls for the retiree to take the annual withdrawal from stocks and then rebalances. However, if the returns from bonds have exceeded those from stocks over the previous twelve months, the retiree takes the annual withdrawal from bonds but does not rebalance. (click to enlarge) Asset allocation results As the author observes, results of the two twists considered are very similar. T1 has a slightly higher overall upside potential, and T2 provides a slightly better overall downside protection. Both T1 and T2 outperform the 90/10 allocation. Although, the three strategies have the same failure rate (2.3%). T1 and T2 provide retirees with both a higher upside potential (as measured by the mean, median, P90, P95, and P99) and better downside protection (as measured by both P5 and P10) than the 90/10 allocation. Conclusion Overall then, Buffett’s asset allocation advice is sound and simple. However, for those retirees that are concerned about holding such an aggressive portfolio, the two aggressive strategies may offer better returns. The author of the paper concludes: “…the two simple twists considered here improve both the upside potential and the downside protection of the 90/10 allocation. These two twists require retirees neither to collect vast amounts of information nor to make any valuation judgments but only to observe the performance of the stock market, or the relative performance of the stock and bond markets.” “Either way, retirees can, with little effort, improve upon the results of the 90/10 allocation. In fact, because the performance of the two twists considered is so similar, retirees may want to lean towards the first one (T1) and simply adjust their asset allocation according to the observed performance of stocks.” “…those retirees that find a 90/10 portfolio acceptable are likely to find that with an insignificant additional effort, observing the performance of stocks and implementing the first twist discussed, they are likely to improve the performance of their portfolios.” Rupert may hold positions in one or more of the companies mentioned in this article. You can find a full list of Rupert’s positions on his blog. This should not be interpreted as investment advice, or a recommendation to buy or sell securities. You should make your own decisions and seek independent professional advice before doing so. Past performance is not a guide to future performance.

Risk Parity Investors Concerned About Performance

By DailyAlts Staff Risk parity strategies are designed to perform irrespective of general market conditions, but this doesn’t mean that they’ll always outperform – not even during a downturn. The global swoon that began when China devalued its currency in mid-August and picked up steam through the latter part of that month and into September left a lot of risk-based portfolios battered and bruised – and this isn’t what their risk-conscious investors had in mind. In fact, according to Chief Investment Officer’s 2015 Risk Parity survey , 42% of risk-parity investors are “quite” or “extremely” concerned about performance – no other concern, from use of leverage to peer risk to transparency – comes close. And as a result of these concerns, just 19% of respondents said they planned to increase their risk-parity allocations in the next 12 months, while 16% said they planned on decreasing their allocations. About the Survey Respondents CIO’s survey involved 93 risk-parity investors from the U.S. (74%), Europe (18%), Canada (4%), and other countries (5%). Forty-seven percent had assets of more than $15 billion, while 23% had assets between $5 and $15 billion, and 24% had between $1 and $5 billion. Small users – those with less than $1 billion in assets – accounted for just 5% of respondents. Corporate pension funds were a plurality of respondents at a 37% share, while public pension / sovereign wealth funds and endowment and foundations represented 17% and 10%, respectively. Thirty-five percent of respondents were categorized as “other.” Investor Concerns Only 13% of respondents said they were “not at all” concerned about risk-parity performance, while 21% said they were “extremely,” 21% “quite,” 23% “moderately,” and 23% “a little” concerned. By comparison 62% said they were “not at all” concerned about there being “no explicit bucket” to put risk parity in, 50% were “not at all” concerned with “the passive approach some vendors take,” and 47% were “not at all concerned” that there “are not enough viable manager offerings.” Zero percent of respondents said they were “extremely” concerned about peer risk – compared to 21% for performance. To say performance is the major concern of risk-parity investors is an understatement. Allocating to Risk Parity Fifty-three percent of respondents said they fund risk parity from their equities “bucket,” making it the most popular answer. Interestingly, 24% said they have a dedicated allocation to risk parity – up from just 18% the prior year. Nineteen percent said they funded risk parity from their alternatives bucket, which was down from 25% in 2014. The bigger the investor, the more likely they were to have a dedicated risk parity bucket: Among respondents with over $5 billion in assets, 29% had dedicated allocations; while only 14% of respondents in the $1 billion to $5 billion group and zero-percent of the sub-$1 billion group funded risk parity from a dedicated bucket. These smaller investors funded risk parity from their equity and fixed-income buckets by a ratio of two-to-one. A plurality of respondents said they used an absolute return benchmark, i.e. “T-bills +x%.” This response grew in popularity from 25% in 2014 to 37% in 2015 – while using the traditional “60/40” portfolio as a benchmark fell in popularity. Conclusion Some pundits seriously question whether risk parity may have helped bring down markets in August. According to CIO, the fact that the question is being taken seriously should “warm the hearts” of risk-parity investors, since the still-tiny strategy has successfully “seeped into the collective consciousness of Wall Street and the media that cover it.” In CIO’s view, risk parity is still too small to have caused much damage – but the increased awareness could be good for the strategy going forward.

Investing In Airlines Without Nosediving

Summary Two alternatives for airline investors are to pick individual airline stocks or to purchase shares of an airline industry ETF. The ETF ameliorates stock-specific risk via diversification, but allocates only small amounts to some of the most promising stocks. We present a 3rd alternative: using the hedged portfolio method to create a concentrated portfolio of top airline stocks that strictly limits stock-specific as well as other kinds of risk. A Third Way Between JETS and Individual Airline Stocks The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down. –Warren Buffett It’s customary to quote Warren Buffett’s bearishness on the industry when writing about airline stocks, and the Buffett quote above, from the 2007 Berkshire Hathaway (NYSE: BRK.B ) shareholder letter , is my favorite. Seeking Alpha contributor Harm Elderman chose another good one in his recent article on the US Global Jets ETF (NYSEARCA: JETS ) (“Time To Re-Examine JETS: The Airline ETF”). Elderman’s article is worth reading in full, but this graphic he included does a great job of laying out the way the JETS ETF is diversified. That diversification, as Elderman notes, offers an interesting tradeoff. Elderman points out that, due to the way JETS is structured, particularly in the second point in the graphic above, his top airline pick at midyear, Hawaiian Holdings (NASDAQ: HA ), as a second-tier domestic airline, only gets a 4% allocation in the ETF. So a JETS investor would have gotten relatively little benefit from HA’s 35% year-to-date performance. On the other hand, had HA done as poorly as another airline mentioned in Elderman’s article, Avianca Holdings (NYSE: AVH ), which is down nearly 67% year-to-date, its impact on JETS’ performance would have been similarly limited. Nevertheless, as Elderman points out, JETS has outperformed the SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA ) year to date, up 6.13%, as of Tuesday’s close, versus DIA, which was down 1.24% over the same time frame, so it may be worthy of consideration for investors looking for exposure to the airline industry without incurring the risk of picking a handful of airline stocks on their own. In this article, though, we’ll look at a third way of investing in airline stocks, one that can give us bigger exposure to stocks like HA, but with less risk than owning the ETF. When Stocks Can Be Safer Than An ETF It may seem counterintuitive that owning a handful of airline stocks could be safer than owning an ETF that holds dozens of them, but that can be the case when you hold those stocks within a hedged portfolio. Although JETS ameliorates stock-specific risk via diversification, it’s still subject to industry risk and systemic, or market risk. You can strictly limit your potential downside due to any of those risks with the hedged portfolio method . Below, we’ll show how to use that method to construct a concentrated portfolio of airline stocks using JETS’ top holdings as a starting point, for an investor who is unwilling to risk a drawdown of more than 20%, and has $500,000 that he wants to invest. First, though, let’s address the issue of risk tolerance, and how it affects potential return. Risk Tolerance and Potential Return All else equal, with a hedged portfolio, the greater an investor’s risk tolerance — the greater the maximum drawdown he is willing to risk (his “threshold”, in our terminology) – the higher his potential return will be. So, we should expect that an investor who is willing to risk a 30% decline will have a chance at higher potential returns than one who is only willing to risk a 10% drawdown. In our example, we’ll be splitting the difference and using a 20% threshold (less than a third of the drop AVH shareholders have experienced so far this year). Constructing A Hedged Portfolio We’ll recap the hedged portfolio method here briefly, and then explain how you can implement it yourself using JETS’ top holdings as a starting point. Finally, we’ll present an example of a hedged portfolio that was constructed this way with an automated tool. The process, in broad strokes, is this: Find securities with relatively high potential returns. Find securities that are relatively inexpensive to hedge. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns). Hedge them. The potential benefits of this approach are two-fold: If you are successful at the first step (finding securities with high potential returns), and you hold a concentrated portfolio of them, your portfolio should generate decent returns over time. If you are hedged, and your return estimates are completely wrong, on occasion — or the market moves against you — your downside will be strictly limited. How to Implement This Approach Finding Promising Stocks If we were looking for securities with the highest potential returns, we wouldn’t limit ourselves to airline industry stocks; instead, we’d consider a much broader universe of stocks. But since we’re concerned with airline stocks here, we’ll start with the top holdings of JETS. To quantify potential returns for JETS’ top holdings, you can sign up for Harm Elderman’s premium research via Seeking Alpha’s Marketplace. Alternatively, if you are impecunious and willing to put yourself at the mercy of Wall Street’s sell side analysts, you can use their consensus price targets as a starting point for your estimates, adjusting it based on the time frame you’re using and whether you think it is overly optimistic or not. For example, via Nasdaq, here is the analysts’ 12-month consensus price target for Hawaiian Airlines: In general, though, you’ll need to use the same time frame for each of your potential return calculations to facilitate comparisons of potential returns, hedging costs, and net expected returns. Our method starts with calculations of six-month expected returns. Finding inexpensive ways to hedge these securities Our method attempts to find optimal static hedges using collars as well as protective puts going out approximately six months. Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-20% decline over the time frame covered by your potential return calculations. And you’ll need to calculate your cost of hedging as a percentage of position value. Select the securities with highest net potential returns When starting from a large universe of securities, you’d want to select the ones with the highest potential returns, net of hedging costs; you can do the same here, starting with the top holdings in JETS, but, in any case, you’ll at least want to exclude any of them that has a negative potential return net of hedging costs. It doesn’t make sense to pay X to hedge a stock if you estimate the stock will return 1.93x higher. In this case, the net potential returns were > 1.93x higher when hedged with optimal collars in each case. Here’s a closer look at the optimal collar edge on HA: This optimal collar is capped at 12.06% because that’s the potential return the site calculated for HA. The idea is to have a shot at capturing that, while offsetting the cost of hedging by selling someone else the right to buy HA if it goes higher than the site expects it to. As you can see at the bottom of the image above, the cost of the put protection on HA was $3,420, or 5.41% as a percentage of position value. However, if you look at the image below, you’ll see that the income from selling the call leg of this collar was $2,610, or 4.13% as a percentage of position value. So the net cost of the collar was $810, or 1.28%.[i] Note that, although the cost of this hedge was positive, the overall cost of hedging the portfolio was negative . Possibly More Protection Than Promised In some cases, hedges such as the ones in the portfolio above can provide more protection than promised. For an example of that, see what happened to a hedge on Sketchers (NYSE: SKX ) after that stock plummeted 31%. [i] To be conservative, this optimal collar shows the puts being purchased at their ask price, and the calls being sold at their bid price. In practice, an investor can often buy the puts for less (i.e., at some point between the bid and ask prices) and sell the calls for more (again, at some point between the bid and ask). So the actual cost of opening this collar would have likely been less. The same is true of the other hedges in the portfolio, the costs of which were calculated in the same conservative manner.