How Adaptive Asset Allocation Works
Adaptive asset allocation is a dynamic rebalancing strategy that adjusts to market movements so your allocation relative to the market is maintained.
Its primary benefit is maintaining the risk level of your portfolio relative to the market. During the 2008-2009 market decline, traditional rebalancing would have resulted in continued purchasing of equities as the market declined - in order to keep your portfolio at a constant equity allocation. With adaptive asset allocation, your equity allocation would have steadily decreased as markets declined. It has the added benefit of lower turnover and transaction costs, compared to traditional rebalancing strategies.
How it works:
It's February 1984. The U.S. market portfolio¹ is 60% equity and 40% bonds. Given your risk preferences and the market portfolio, you decide on an asset allocation of 50% equity and 50% bonds. In other words, you desire an asset allocation that is slightly less risky than the market portfolio. As the market portfolio changes over time, your portfolio will too.
The table below shows how your portfolio allocation, specifically your equity allocation, would change over time using adaptive asset allocation and traditional rebalancing:
Equity Allocation in Portfolio Over Time
| (Initial Portfolio) Feb 1984 |
Oct 1990 | Mar 2000 | Feb 2009 | ||
|---|---|---|---|---|---|
Market Portfolio |
60% | 48% | 75% | 43% | →dynamic |
Adaptive |
50% | 38% | 67% | 33% | →dynamic |
Traditional |
50% | 50% | 50% | 50% | →static |
- At inception, both adaptive and traditional asset allocations are at the desired allocation of 50% equity.
- From 1984 to 2009, the market portfolio varied widely, with the proportion of equities ranging from a low of 43.2% to a high of 75.1%, as shown in the chart below²:
- Traditional rebalancing to 50% equity, represented by the straight horizontal line, ignores market fluctuations. Based upon your risk preference, 50% equity would have been too conservative relative to the market as equity values increased in 2000, and too risky as equities declined during 2008-09.
Note that adaptive asset allocation is not a market timing system. Under some market conditions, this strategy may result in higher returns compared to buy and hold and other rebalancing strategies, but lower returns, under other scenarios. Adaptive asset allocation simply offers a more consistent way to manage your portfolio risk by taking into account changes in market conditions.
1. In this context, the market portfolio is a theoretical portfolio consisting of all stocks and bonds available to U.S. investors, with each asset held in proportion to its market value relative to the total market value of all assets. In prosperous economic times, the market portfolio tends to have a larger proportion in stocks than bonds, as the value of stocks increase and investors sell bonds and buy more stocks. In times of economic crises, investors often sell their stock holdings and purchase bonds, resulting in a decrease in the aggregate value of stocks, and an increase in the aggregate value of bonds. Hence, the market portfolio's proportion in stocks and bonds fluctuates over time.
2. Modified from Sharpe, William, 2010, "Adaptive Asset Allocation Policies." Financial Analysts Journal, vol. 66, no. 3 (May/June 2010): 45-59