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For internal use only Private Wealth Management Deutsche Bank Asset Allocation Why Dynamic Asset Allocation is winning the race? Arnaud de Servigny
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Asset Allocation

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Asset Allocation. Why Dynamic Asset Allocation is winning the race? Arnaud de Servigny. A review of the current Asset Allocation paradigm . Modern Portfolio Theory R.I.P.!. - PowerPoint PPT Presentation
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Page 1: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank

For internal use only

Asset AllocationWhy Dynamic Asset Allocation is winning the race?

Arnaud de Servigny

Page 2: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank

A review of the current Asset Allocation paradigm.

Modern Portfolio Theory R.I.P.!

Page 3: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

On The Efficient Frontier, there is a high degree of certainty and therefore a high degree of concentration!

3

Page 4: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

The efficient frontier usually relies on a limited number of support assets

4

Page 5: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

There is very little year on year stability of the Efficient Frontier

5

Page 6: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

Out-of-sample, the efficient frontier usually drifts to much more modest & sub-optimal performance

6

Page 7: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

Over the past 20 years there has been a trend of growing out-of-sample under performance of the MPT

7

Page 8: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

The Market portfolio (CAPM) & the MPT portfolios are equally not doing well

8

Page 9: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

Why doesn’t it work? There is no variance stability of main asset classes!

1 The critical values for the 90%, 95% and 99% level tests are respectively below 1.22, 1.36 and 1.63, for an rejection (21”0 of no break.

9

Page 10: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

A test to see if we face a fat tail problem or a regime switching problem?

10

Page 11: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

« Through the cycle » correlation and covariance do not exist!

11

Page 12: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank

Let us try to look at the world differently!

Page 13: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

Regime Switching models in a nutshell

13

Page 14: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

Out-of-sample performance of a 3 asset Regime Switching model

14

Page 15: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

Time

Regime 1Recession

Regime 2Growth

An “all weather” mean-variance optimisation fails to capture regime changes and therefore fat tails & the dynamics of fat tails

“Through the Cycle “ Average

Fat tailed “through the cycle” distribution

15

Page 16: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

Time

Regime 1Recession

Regime 2Growth

EWMA Estimation of monthly mean / covariance matrix

An Unknown complex multi-regime environment can be approximated by a regularly re-estimated Mean-Variance framework updated with latest information (EWMA estimation)

Monthly mean variance process

Uni

t of ti

me

delta

( t)

Uni

t of ti

me

delta

( t)

Uni

t of ti

me

delta

( t)

Uni

t of ti

me

delta

( t)

Uni

t of ti

me

delta

( t)

Uni

t of ti

me

delta

( t)

16

Page 17: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012 17

A Case Study

A full out-of-sample Analysis

In one case 4 asset classes (CashTB, IG Bond, HY Bond, US Equity ), in the other 9 (CashTB, Gov Bond, IG Bond, HY Bond, Dev Equity, EM Equity, Commodities, Real Estate, Hedge Funds)

The targeted volatility level in the portfolio is 8%

4 methodologies:Equally weightedMean-Variance reestimated every year based on a 10-year sliding windowMean-Variance reestimated every year using a memory decay estimation method (EWMA)Mean-Variance reestimated every month using a memory decay estimation technique (EWMA)

Page 18: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

Who better copes with the 8% target vol out-of-sample?

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 20110.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%Risk Control (9 assets)

Mean Variance EWMA yearly Eq Wgt EWMA monthlyVo

latil

ity (T

arge

t vs

Actu

al)

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 20110.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%Risk Control (4 assets)Mean Variance EWMA yearly Eq Wgt

Vola

tility

(Tar

get v

s Ac

tual

)

18

Page 19: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

What is the true level of asset diversification in each approach?

2001 2002 2003 2004 2005 2006 2007 2008 2009 20100.9

1.1

1.3

1.5

1.7

1.9

2.1

Diversification (4 assets)Mean VarianceEWMA yearly Eq WgtEWMA monthly

Conc

entra

tion

inde

x

2001 2002 2003 2004 2005 2006 2007 2008 2009 20100.9

1.1

1.3

1.5

1.7

1.9

2.1

Diversification (9 assets) Mean VarianceEWMA yearly Eq WgtEWMA monthly

Conc

entra

tion

inde

x

19

Page 20: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

Tail Risk

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-20%-18%-16%-14%-12%-10%-8%-6%-4%-2%0%

Max Monthly drawdown(9 assets)

Mean Variance EWMA yearly Eq Wgt EWMA monthly

Mon

thly

retu

rn

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-20%

-15%

-10%

-5%

0%

Max Monthly drawdown (4 assets)

Mean Variance EWMA yearly Eq Wgt EWMA monthly

Mon

thly

Ret

urn

20

Page 21: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012 21

The Return Dynamics

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-40%

-30%

-20%

-10%

0%

10%

20%

30%9 asset portfolio performance

Mean Variance Equal Weight

EWMA yearly (L=0.85) EWMA monthly

Out

of S

ampl

e an

nual

retu

rn

Mean Variance EWMA yearly Eq Wgt EWMA monthly EWMA monthly0.00

0.20

0.40

0.60

0.80

1.00

10yr sharpe (9 assets)

Page 22: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

A clearer picture!!!

Mean Variance EWMA yearly Eq Wgt EWMA monthly EWMA monthly0.00

0.20

0.40

0.60

0.80

1.00

1.20

10yr sharpe (4 assets)

Mean Variance EWMA yearly Eq Wgt EWMA monthly EWMA monthly0.000.100.200.300.400.500.600.700.800.901.00

10yr sharpe (9 assets)

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Page 23: Asset Allocation

For internal use only

Private Wealth ManagementDeutsche Bank Arnaud de Servigny

CFA – 4th July 2012

What is the degree of stability in the portfolios?

Mean Variance EWMA yearly Eq Wgt EWMA monthly0.0%

50.0%

100.0%

150.0%

200.0%

250.0%

300.0%

350.0%

Asset rotation (9 assets)

Aver

age

rota

tion

Mean Variance EWMA yearly Eq Wgt EWMA monthly0.0%

50.0%

100.0%

150.0%

200.0%

250.0%

300.0%

Asset rotation (4 assets)

Aver

age

rota

tion

23

Page 24: Asset Allocation

For internal use only

24Data as of 20.06.2012

Market Prices: Long-term results