Asset Allocation ETF Portfolio

October 1, 2014

There is a growing industry-wide interest in funds that allocate between major asset classes using ETFs as the primary investment vehicles. Classes often include U.S. Equity, International Equity, Fixed Income, and Real Assets. Momentum and volatility models are among those used to determine allocation percentages.

McKinley Capital is a pioneer in the application of innovative and sophisticated momentum strategies. The McKinley Capital approach to momentum investing differs from generic industry models in its use of risk adjustment techniques, penalty functions, and dynamic momentum term-structure rotation. Generic momentum models, while historically effective long-term, have been plagued with occasional large losses (referred to as negative skew). These losses have generally occurred at major market inflection points. As an example, the early 2009 time period was difficult for equity strategies due to the v-shaped transition from a serious down market to a rapid but non-earnings related rally. Proprietary risk adjustment and other techniques can be used to mitigate this risk without sacrificing the upside. For example, McKinley Capital can forecast times when a momentum investment strategy is likely to be less effective. During these periods, the firm can focus less on momentum and more on other aspects of its investment process.

Can McKinley Capital use its proprietary process to successfully manage a broad-based asset allocation fund? To answer this question, the firm created a benchmark as the composite of the MSCI ACW Index and the Barclay’s 7 to 10 Year Treasury Index in a 60% to 40% ratio. Quarterly returns were computed from January 2002 to June 2014. As reported in the Table below, the annualized benchmark return was 7.88%, with a standard deviation of 9.89%, a Sharpe ratio of 0.646 and, by definition, a zero information ratio. For comparison, the annualized S&P 500 return over the same time period was 6.49%, with a standard deviation of 14.94% and a Sharpe ratio of 0.334.


1410 Asset-01 Tab
McKinley Capital constructed and tested three alternative active strategies. The first strategy, labeled “Alpha 12”, assigned asset class policy weights of 35% to U.S. Equity, 30% to International Equity, 30% to U.S. Fixed Income and 5% to Real Assets. 22 ETFs or their corresponding indexes were considered and divided into the four classes1. There was no allocation to cash. An individual ETF policy weight was computed by dividing the corresponding class policy weight by the number of ETFs in the class. Each of the 22 ETFs was ranked from one to 22 using McKinley Capital’s proprietary momentum indicator. Active weight (difference from policy weight) was assigned to each ETF based on its momentum rank. Bands were established for class weights. In testing this strategy, the firm assumed a conservative 50 basis point transaction cost per side. The portfolio was rebalanced quarterly and averaged 13% quarterly turnover. The results are reported in the Table above. The annualized strategy return was 9.49%, with a standard deviation of 12.18%, a Sharpe ratio of 0.657 and an information ratio of 0.43. The Chart below shows the class weights over time.


1410 Asset-02 Chart

1 U.S. Equity – Consumer Discretionary (XLV), Consumer Staples (XLP), Energy (XLE), Financials (XLF), Healthcare (XLV), Industrials (XLI), Materials (XLB), Technology (XLK), Utilities (XLU). U.S. Fixed Income – Intermediate Treasuries (IEF), TIPS (TIP), Investment Grade (LQD), High Yield (HYG), Mortgages (MBB). International Equity – Europe (VGK), Canada (EWC), Japan (EWJ), Pacific Ex-Japan (EPP), Emerging Market (EEM). Real Assets – Gold (DGL), Real Estate (IYR).

The second strategy, labeled “Modified Alpha 12”, was constructed in the exact same way with the exception of the ranking model. Instead of ranking only by momentum, the ETF ranking algorithm included a short term momentum reversal component and a volatility component. The annualized strategy return was 8.77%, with a standard deviation of 10.37%, a Sharpe ratio of 0.702 and an information ratio of 0.37.

In the third strategy, labeled “Optimized Alpha 12”, the ETFs were ranked only by momentum. Instead of algorithmic weighting, weights were determined using a proprietary mathematical optimization system. Each of the 22 ETF weights was constrained to the range of 1% to 12% and bands were used for each class. The annualized strategy return was 9.51%, with a standard deviation of 8.53%, a Sharpe ratio of 0.941 and an information ratio of 0.59.

It appears that investment models employed by McKinley Capital have the potential to perform in the context of a broad-based, asset allocation fund. As always, your McKinley Capital account representative is available to discuss its research and investment process and to answer your questions.



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