Active vs. Passive Portfolio Management
Classic Modern Portfolio Theory (MPT) is a passive portfolio management system where one selects a set of uncorrelated assets, sets allocation percentages for each, and periodically rebalances the portfolio’s assets to bring allocations back in line with original targets. It is believed the market is inherently an unpredictable random walk. Thus MPT advocates buy-and-hold diversification.
Tactical Asset Management
Tactical Asset Management actively alters a portfolio’s asset composition and/or allocation weights in response to changing market conditions. Because market cycles are tied to economic cycles and different market sectors do better during different phases of the economic cycle, the rationale for sector rotation is easily understood. Sectors provide the power strokes for a portfolio just like pistons in an engine. Although most professionals practicing sector rotation by periodically adjusting allocation weights to over-weight or under-weight market sectors, it turns out that optimum algorithmic trade performance is achieved by utilizing True Sector Rotation, where only the trend leader is owned from among a set of candidates. Not only are returns improved, but risk is reduced simply by avoiding the trend laggards. Furthermore, by combining multiple True Sector Rotation Strategies into a single portfolio, remnant volatility is further reduced. Risk is reduced by (a) diversification within a fund, (b) avoiding trend laggards, and (c) averaging the remnant volatility of multiple home-run hitters. Of course, return remains as the average of multiple home-run hitters.
Holistic Risk Management — Safety First!
Risk is not a one-dimensional problem cured by a single act of diversification. There are numerous sources of risk related to companies, funds, strategies, markets, political events, natural disasters, and even personal matters. Holistic Risk Management for investment algorithms examines and addresses the relevant sources of risk within an entire system utilizing a layered Portfolio-of-Strategies to measurably improve investment performance. AlphaDroid was designed to reduce risk on many levels, as described in our white paper “Conquering the Seven Faces of Risk“.