ETF Portfolio composer

Why efficient frontier is broken?

Today it is widely recognized that asset allocation is the major service provided to the investors by the investment professionals. Yet the dominant quantitative approach which is based on Harry Markowitz’s mean-variance optimization (MVO) technique failed to offer the protection needed the most, especially in the event of 2008 financial crisis.

Common sense calls for diversification in a portfolio. But in practice, MVO can lead to highly concentrate allocations to just a few asset classes and it’s overly sensitive to small changes in input. Other than a portfolio optimizer, what people really get is an “estimation error maximizer.”   

Further, as people painfully learnt in the financial crisis, many different economic sectors can go wrong all at once, quite contrary to what traditional theory hold. This leads to wild swings among the correlation of different asset classes.  A strategic portfolio based on static assumption about the return and covariance matrix thus exposes itself to estimation error and fundamental error simultaneously.

Several different solutions are discussed by the industry, including resampling, constraining weights, shrinkage, Bayesian (like Black-Litterman algorithm), etc.

Our proposal

Other than fine-tuning inside of MVO frame, we propose to base the asset allocation on the calculation of possibility of relative loss and absolute loss. For the investors and investment professionals as well, the investment risk is defined as the set of these two possibilities. The portfolio should be set the way to minimize the combination of these two risks. Further, the distribution of these two risks changes with the macro economy and capital markets.

The portfolio should not be guided by our ignorance of the future. Rather, decision should be guided within a scientific framework where directional projection of the return/risk ratio of various asset classes is made and investors’ risk preference is considered. The solution we offer is characterized by following three pillars:

§  Radical diversification

§  Adaptive to changing macro environment

§  Scientific way to allocate risk budget

RiskFile ETF Portfoio Composer is our major offer to serve global investment industry. By build all RiskFile’s innovative techniques into one integrated solution, Composer is designed to help investment advisors (IAs) to convert themselves from a salesperson to a consultant. Our market-leading decision making framework allows IAs to have a better understanding of macro situation and advise their clients with individualized portfolio proposal.

Click to download User’s menu (PDF file) and sample report (PDF file) generated from the ETF Portfolio Composer.