Building Better Portfolios

Advisors should “build portfolios that are more resilient to turbulence even if they do not know when it is going to happen,” Kritzman told conference attendees.

To illustrate how that can be done, Kritzman presented three portfolios, each designed to provide a 7.1% return based on historical data.  The first was a “Traditional” portfolio, consisting of 50% US stocks, 30% US bonds, 10% foreign stocks, and smaller percentages of other asset classes.  The second was called the “Normal Optimal,” and it was constructed with standard asset allocation software (using a mean-variance approach).  It was more diversified, with a much lower allocation to US equities (29%), and higher allocations to non-US equities (26%) and fixed income.  The third portfolio was the “Turbulent Optimal” portfolio, and it was derived assuming a turbulent environment will prevail.  It differs from the Normal Optimal portfolio in that it has an even greater exposure to non-US equities (37%) and added exposure to commodities (12%) and REITs (6%).  Kritzman’s data show that “hard” assets, like commodities and REITs, perform better in turbulent times.  As you shift from a non-turbulent to a turbulent period, Kritzman noted, the benefit of geographic diversification is amplified.

To analyze these portfolios, Kritzman looked at the chance of a bad outcome (defined as a 15% or greater loss) over a five-year period.  Although all portfolios are constructed to produce the same theoretical return, the Traditional and Normal portfolios have far greater chances of bad outcomes during the period.  In fact, the probability of a 15% loss during a five-year period characterized by turbulence is 25% for the Traditional portfolio, versus 12% for the Normal Optimal portfolio and only 9% for the Turbulent Optimal Portfolio.

Since advisors do not have the infinite time horizons of endowments, the within-horizon risk is “a more meaningful description of a portfolio’s exposure to loss,” Kritzman said.  Advisors can build portfolios that are more resilient to market turbulence “without giving up significant wealth.”

Protecting Alpha in Turbulent Markets

In addition to constructing more resilient portfolios, advisors can use certain strategies to protect and enhance alpha during turbulent periods.  For instance, Kritzman’s research shows that value performs much better than growth, and large cap much better than small cap, during turbulent periods. 

Value normally outperforms growth, as Eugene Fama and Ken French demonstrated in 1992.  But Kritzman showed that in turbulent periods the value premium soars to 23 basis points, rather than value’s typical one basis point deficit in calm periods.  Essentially, the value premium found by Fama and French exists only in turbulent periods; in calm periods it is negligible.

While Fama and French found that small cap outperforms large cap overall, Kritzman shows that turbulence reverses that effect.  Large cap has a 14 basis point advantage over small cap in a turbulent market, versus a 37 basis point premium for small cap during quiet periods.

Kritzman’s results held up quite well in the turbulent months of September and October.  The Russell 1000 (large cap) outperformed the Russell 2000 (small cap) by 180 basis points, although both indices were down substantially.  The Russell 1000 value outperformed the Russell 1000 growth by 380 basis points.  These relationships held in non-US markets as well, as the MSCI EAFE large cap index outperformed the corresponding MSCI small/mid cap index by 510 basis points.  The MSCI value index outperformed its growth counterpart by 30 basis points.

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