Dynamic Asset Allocation for Practitioners Part 1: Universe Selection

In 2012 we published a whitepaper entitled “Adaptive Asset Allocation: A Primer” in which we built upon the simple, robust momentum framework proposed by Mebane Faber in his 2009 study “Relative Strength Strategies for Investing.” Our approach utilized a portfolio optimization overlay to this framework which served to stabilize and strengthen the dynamic mix of high-momentum assets, providing a powerful way to enhance absolute and risk-adjusted returns.

In this series, we’re going to take a relatively deep dive on the fundamental principles of Adaptive Asset Allocation. The goal is to investigate just how deep the roots of this investing approach go, and provide an intuitive baseline for Global Tactical Asset Allocation strategies in general.

How We’ll Explore Adaptive Asset Allocation

Our process consists of a few basic steps. First, decide on a consistent universe of liquid assets for evaluation. Perhaps surprisingly, selecting the right asset universe for investigation is quite a nuanced proposition, and we plan to discuss it at length later in this series. For now, we provide a brief overview of considerations and define our testing universe.

Next, rank assets by some form of momentum, and hold the strongest assets. We’ll be looking at a wide range of nominal and risk-adjusted momentum metrics to see if any of them stand out. Finally, we must decide how to combine our strongest assets to achieve optimal performance, given specific goals and objectives.

It’s important to keep in mind that any one of these steps is, in and of itself, an entire field of study. Our goal is to find a useful balance between the breadth and depth of each topic, providing actionable intelligence to forward-thinking advisors.

Please note this series is a living thing and will evolve over time. For now, it is our plan to divide the series into five intuitive modules:

  1. Universe Selection
  2. Momentum, Part 1: Price
  3. Momentum, Part 2: Risk-adjusted
  4. Optimization
  5. Final Construction


The universe of assets that is selected for investigation can have a large impact on results and conclusions. With such a dizzying array of instruments to choose from, investors may feel it is prudent to simply include all sufficiently liquid ETFs. However, this approach may produce large unintended biases, which would corrupt our investigation.

To ensure we structure our analysis to focus on the value of active asset allocation decisions with minimal bias, we need clear goal posts. First, our universe should be macro-consistent, which means it must cover the full spectrum of liquid global asset classes, from every major economic region. This ensures that, to the greatest extent possible, we are evaluating a ‘closed system’ of capital allocation, with minimal capital leakage. Perhaps more importantly, it minimizes our susceptibility to survivorship bias, which involves selecting only those assets that have done well enough through history to merit our attention.

Second, our universe should be diverse, and rooted in sound fundamental theory. Specifically, a well-specified universe should have sufficient breadth, including assets whose returns are designed to respond differently to various economic environments. Given that economic growth and inflation surprises are the main fundamental drivers of asset prices, it is essential to include assets that can thrive in any combination of growth and inflation regimes. Figure 1 organizes a representative universe of global asset classes based on how they would be expected to respond to inflation and growth.

Figure 1. The Fundamental Drivers of Asset Returns

Source: ReSolve Asset Management

Third, while it is critical that all assets and economic regions be represented in our investment universe, the universe must also be free from bias. This means minimizing the potential for overlapping bets. The importance of this step cannot be overstated, and is often overlooked by nascent system developers and major asset managers alike.

To understand why this step is so critical, consider a global tactical manager that, in an effort to broaden his investment universe, decides to include the 50 most liquid U.S. listed ETFs. This universe captures a wide variety of asset classes, including commodities, gold, and global equity and bond markets. However, 37 of these 50 securities (74%) are essentially bets on U.S. equities, differentiated by sectors, smart beta, industries, capitalization, issuer, etc.