A Tale of Two Frontiers

December 9, 2011
By

(This article was first published on Timely Portfolio, and kindly contributed to R-bloggers)

In a follow up to Evolving Domestic Frontier, I wanted to explore the efficient frontier including international indexes since 1980.  Life is great when your primary indexes (Barclays Aggregate and S&P 500) lie on the frontier as they did 1980-1999.  The situation becomes much more difficult with a frontier like 2000-now.

From TimelyPortfolio

If we examine return, risk, and Sharpe though, 1980 to now was really not that bad with annualized returns of all indexes stocks and bonds > 8% even including the last decade of “equity misery”.  As the S&P 500 shifted from the top of the efficient frontier to the bottom, it seems the focus over the last decade as been finding alternatives for the S&P 500. Strangely, the unbelievable riskless return of bonds has allowed some investors to claim and use bonds as one of these potential alternatives to the S&P 500.

From TimelyPortfolio
From TimelyPortfolio

Bonds as alternatives to equities have made even more sense when we look at correlations.

From TimelyPortfolio

However, bonds based on the yield to maturity of the Barclays Aggregate index suggest, even guarantee, forward returns of only 2.3%, significantly below the +8% generously provided for 30 years.  I believe the focus on alternatives should be alternatives for the guaranteed miserably low returns of bonds (WSJ Bond Buyers Dilemma).  The trick though is reducing risk (drawdown) of these alternatives to an acceptable level to most bond investors.  Max drawdown on bonds since 1982 has been 5%, which is virtually an impossible constraint for any risky alternatives, since in even very attractive secular buy-hold periods, drawdown generally is 20% to 30%.

From TimelyPortfolio

Our options are basically limited to cash, which at 0% return is unacceptable, unless we can discover a method to reduce drawdown on the risky set of alternatives to 20%, but really down to 10%.  How do we transform risky alternatives with historical drawdowns of 40%-70% to an acceptable bond alternative?  I think it requires tactical techniques blended with cash with a lot of client education and hand-holding.

R code from GIST:

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