Defensive Position Rotation: Achieving Financial Goals with Less Volatility

The strategic and tactical rigidity underlying modern portfolio theory (MPT) contributed to huge losses during the 2008 financial crisis. Diversification is the only MPT risk management technique, but diversification weakens as the need to be defensive increases, and it is at odds with striving for superior portfolio growth.

Defensive position rotation (DPR) is an alternative portfolio-construction philosophy that adapts to changing market conditions and can increase risk-adjusted returns over time. Two portfolio risk-management methods of DPR (“just-in-time” and “just-in-case”) preserve capital in down markets and avoid or hedge underperforming positions in up markets. This improves portfolio efficiency, as represented by higher Sharpe ratios. The potentially superior results of DPR allow portfolios to be judged by absolute-return performance standards: the intuitive standard used by most clients.

DPR tools and funds can help clients make higher-efficiency investment choices in the face of fears about past portfolio performance and future macroeconomic uncertainty.

I will review the failings of MPT and how DPR addresses them, and then describe how advisors can implement a DPR-based strategy on their own.

Modern portfolio theory and portfolio efficiency

In the realm of human activity, we widely observe adaptation to changing conditions. People use umbrellas when it begins to rain. Cars require frequent changes in spark timing, fuel-to-air ratio, valve timing, etc., to increase motor efficiency amid changing driving conditions . But I have not observed adaptive phenomena in the application of modern portfolio theory (MPT) to the management of portfolios of securities.

The rigidity of MPT, which requires a static asset allocation with periodic rebalancing and no adaptation to changing economic or market conditions, is based on the assumption that price changes of securities are random and can’t be predicted. MPT is based on statistical functions that do not include the time domain. Trends, if they exist, can’t be detected.

Without the ability to predict future prices or even to make an educated guess, MPT followers are left with diversification through asset allocation as the only risk-management tool. Asset allocation is only effective in protecting portfolios in times of dramatic market declines if asset classes demonstrate low correlation (independence of price movement). Since correlations may become very high during these dangerous times, protection is limited at the very time it is most needed.

While MPT’s goal is to generate market returns (for a given level of risk), diversification may limit (or even be a drag on) returns. A portfolio’s return is a weighted average of the returns of all the assets held. One way to improve average returns is to jettison under-performing assets. In MPT, this will not happen, because diversification is the foundation of the approach and is a justification for holding assets that are underperforming. Put differently, the MPT risk-management technique (diversification) can be at odds with striving for higher growth.

MPT’s fundamental assumptions of rational investor behavior (based on the efficient market hypothesis) are undermined by findings in behavioral finance showing that investors can be far from rational.

Defensive position rotation

As an advisor, I observed the loss of client wealth in the 2008 market decline, while I dutifully continued to rebalance their MPT-based asset-allocation portfolios. I had been using prudently asset-diversified and valuation-observant portfolios, but the crisis made a mockery of the entire process. As client wealth vanished, my clients (and I) questioned what I knew about guiding and protecting clients’ finances.

After the crisis, my concerns over market, interest-rate and purchasing-power risk (inflation) led me to an MPT-alternative: defensive position rotation (DPR).

DPR contrasts with MPT because it takes an active approach to capital protection. It is more sophisticated than MPT and may not be for everyone. Instead of relying on low correlations among assets, DPR addresses protection by adopting active methods, such as tactical flexibility, to preserve capital during declining markets. The emphasis is on how risk-adjusted returns are changing as the investment environment changes.

Efficiency, a measurable concept, describes how well inputs (time, effort, cost, etc.) achieve a task or output. Miles-per-gallon is an efficiency measure. For investment performance, a common measure of efficiency is the Sharpe ratio, which measures the excess return per unit of risk. DPR’s dynamic approach, which frequently revisits assumptions and allocations, has the potential to raise investment efficiency by giving greater return per unit of volatility (higher Sharpe ratios).

DPR can take several different forms. I’ll discuss two of the dominant ones: just-in-time and just-in-case.