Investment Process

Modern Portfolio Theory, developed by Harry Markowitz during the 1950’s, was the first quantitative approach to asset allocation. Since then, the advancements in technology, mathematical algorithms, and experience have led to today’s most advanced portfolio optimization methodology, EVT (Extreme Value Theory). When frequent extreme events keep being described in news reports as “once-in-a-thousand-years”, or “once-in-ten-thousand-years,” common statistical methods and a common understanding of markets seem to be lacking. EVT not only accepts that extreme events occur; EVT allows their frequency and severity to be modeled and the associated risk to be managed. Fundamentally, traditional models assume that markets are static; EVT begins with the assumption that markets change and that recent market information is more valuable than long-term average data.

Smart Portfolios’ state-of-the art optimization solution using EVT is called Dynamic Portfolio Optimization. DPO replaces traditional asset allocation models with advanced analytics resulting in superior performance and risk management. The complete Smart investment process includes:

Here’s a paradox: The investment management industry acts as if the most frightening decision to make is that assets should sometimes be converted to safe investments in Treasury's and cash equivalents. Is it because a tactical retreat is an admission of fear? Is it to keep that responsibility on the shoulders of the investor? Is it simply because common analytical models are weak?

A second paradox: Although it is the result of complex analysis using state-of-the-art analysis, Smart Portfolios delivers a large part of its value by the simplest asset allocation decision: increase the fraction of the portfolio invested in cash equivalents or Treasury's.

Finally, a third paradox: Although it’s conventional wisdom that an investor needs to accept higher risk to get a higher return, the highest return through a market cycle may be achieved by reducing risk at the right times (when risk is not being adequately compensated).

Risk management is the primary focus of Smart Portfolios. it is the only way to achieve superior risk-adjusted returns. We use state-of-the-art mathematics to forecast overall market risk as well as the risk and expected returns of our managed portfolios. Smart Portfolios recognizes the trade-off between risk and return. Our strategy allows for the portfolio mix to be adjusted to compensate for the increases or decreases in forecasted risk-adjusted return. Smart Portfolios runs frequent (monthly or more often) diagnostics to measure the change in the portfolio’s risk and return balance. In addition, we schedule quarterly back-testing and stress-testing of the models to identify any need for changes to the portfolio universe and/or to recalibrate the models’ risk metrics.

Smart Portfolios screens a broad range of competing funds in each specified asset class or sector to identify which are best suited for consideration in the asset allocation model. We refer to that narrower range of investment choices, composed of dozens instead of hundreds of potential choices, as the model’s “universe.” Screening factors include: liquidity, diversity, volatility and expense ratios. In addition to the traditional analytical tools used to analyze securities, Smart Portfolios uses its advanced mathematics to compare funds for historical, current and forecasted risk and return.

Smart Portfolios initiates the Dynamic Portfolio Optimization (DPO) process with a pre-screened universe of funds representing various asset classes and sectors. Unlike other asset allocation models that select assets from the top-down (first asset class, then sector, then fund), Smart Portfolios’ bottom-up approach starts by analyzing each potential investment individually. That individual “univariate” modeling process analyzes the historical and forecasted risk and return of a security assuming a fat-tailed distribution to more accurately assess risk and substitutes GARCH modeling for traditional mean-variance analysis so that changes in economic and market conditions will be factored into the analysis (not just assumed away).

The second step, known as bivariate modeling, compares the relationships between pairs of securities. Traditional models compare securities using simple linear correlation, which describes the average relationship between two securities over an extended period of time. Those models’ assumption of constant correlation ignores the fact that correlation increases in volatile markets, which is why passive diversification strategies fail during big sell-offs. The Smart DPO model’s bivariate step upgrades this process by integrating a dynamic correlation function, called Copula Dependency. The Copula function heightens the DPO sensitivity to increases in volatility and thus triggers a reduction in portfolio exposure when volatility rises.

The final step in the optimization process, multivariate modeling, models the behavior of an entire portfolio of securities. Smart incorporates an advanced ranking system to create the optimal asset mix (the “efficient frontier”). Many allocation models refer to the optimal mix as the “efficient frontier,” but Smart’s multivariate model, using the DPO process, understands that the efficient frontier is continuously changing and that it may be very different from what it was last year or even last month; DPO determines the optimal risk-adjusted portfolio under current economic and market conditions. This optimization process is run periodically (monthly) to maximize portfolio efficiency.

2004
Dynamic Portfolio Optimization (DPO)
Smart Portfolios
2002
Extreme Value Theory (EVT)
Mandelbrot
1994
Value-at-Risk (VaR)
J.P. Morgan
Black-Litterman Model
Black-Litterman
1988
Multiple Macro APT
1987
Macro w/Lagged Variables APT
1982
Macro Arbitrage Pricing Theory (M-APT)
1979
Consumption CAPM (C-CAPM)
Breedon
1976
Arbitrage Pricing Theory (APT)
Roll & Ross
1973
Inter-Temporal CAPM (I-CAPM)
Merton
1964
Capital Asset Pricing Theory (CAPM)
Sharpe
1959
Moderm Portfolio Theory (MPT)
Markowitz
Mean Variance Optimization
Markowitz / Sharpe