Rydex Introduces "Essential Portfolio Theory"GeneralFancy name but essentially what they're trying to preach is diversification across asset classes-- not only stocks and bonds but also real estate, commodities, and much more. In doing so, they intend to provide value through diversification, hopefully moving up that efficient frontier through the use of relatively less correlated assets. Additionally, though, one must ask the question-- would individual investors even know what the efficient composition should be of these asset classes, even if one knows that diversification is a good thing? Probably not. Rydex can spend some bucks on a few geniuses and then spread the overhead over the hopefully large number of people who end up buying into the ETF's. Obviously this is something an individual investor could only do through concerted effort and much more resources expended.
Rydex's claim is that a strategy like this one used to only be available to institutional investors, but Rydex intends to bring them to individual investors. This makes sense. I wonder just how much turnover there is relative to some of the more traditional indexation strategies, but my guess is that it isn't bad.
People InvolvedPrinceton professor
John Mulvey is helping Rydex in the construction of EPT-based portfolios. Given the information provided about his
consulting background, and his expertise in large-scale optimization models, it seems pretty clear that he is doing some linear or non-linear programming for portfolio optimization purposes. For those who are unfamiliar with how these programs work I'll attempt to shine some light on the subject.
Linear and non-linear programs maximize something called an objective function subject to a set of constraints. For example assume that you are an institutional money manager and cannot put more than 1% of your wealth in any individual stock, no more than 10% of your wealth in any particular sector, cannot go short, can only invest in equities in the US and in China, and know that your investor base is primarily looking for a slow and steady return with little volatility. One could structure a linear program to create an efficient or optimal portfolio, given some past price (and perhaps volume) data on the instruments you are allowed to invest in. Rebalancing could be done every so often by re-running the program which is trained on perhaps some sort of a rolling time horizon and/or forgetting time (both of which can also be tweaked, although one must watch out for non-stationarity and overfitting as usual). The optimal program would probably be something along the following:
Minimize the volatility of your portfolio holdings {X(1),X(2),X(3),...X(N)}, where X(1...N) comprise the weightings of each stock which can be in your portfolio, subject to the constraint that
(1) your expected annual return is R(target),
(2) {X(1),X(2),X(3),...X(N)} must all be less than or equal to .01,
(3) {S(1),S(2),(3),...S(n)}, your corresponding sector weightings, must all be less than or equal to .1,
(4){X(1),X(2),X(3),...X(N)} must all be greater than or equal to 0 to avoid going short,
...
etc etc. 1...N encapsulates the constraint on the universe of potential holdings, and R(target) is probably a spread off of the risk free rate.
Turning to an EPT portfolio, then, one will probably see something similar to this. Perhaps they are trying to maximize returns subject to a minimum level of volatility. Their investment universe 1...N is most certainly quite large to account for the broad number of asset classes being drawn upon. Their rebalancing time is probably pretty big so as to keep turnover low. Finally it is only reasonable to assume that they are factoring in the differential transaction costs between these different asset classes, because it is most certainly more expensive to trade, say, a corporate bond in a local Brazilian paper company than it is to buy up a handful of shares of IBM.
Finally, given the fact that I assume these EPT portfolios are going to be around for a while, I would assume that the portfolios would be conditioned to be multi-period optimal as well through the use of simulation or a variant of the Kelly criterion or something like that.
Last Bits of News on This and Bigger Picture PerspectiveNot much else to say. Mulvey and Reilly, the Director of Fund Research at Rydex, spoke in Manchester on June 27th and June 28th regarding EPT as part of a very large conference which included the likes of Colin Powell. So the word has been out for a few months already.
Overall it seems that the ETF world is moving in the direction WSDT is moving in. These Rydex ETF's and some of the promotional material they've been spitting out smack of a more active, more broadly diversified, generally more innovative breed of ETF's. Like I've said before, conditional on WSDT releasing something of value with little overlap to these other more innovative ETF's, this sort of movement is indeed quite good. When Rydex goes over the news wire saying that Modern Portfolio Theory could use some help given the competitive nature of today's market environment, and that more needs to be done by the individual investor should the individual investor want to meet his or her investing goals over the longer term, Rydex is basically saying (IMHO) "I will pony up a lot of money to educate these stupid people who just don't understand that they are investing sub-optimally on a risk adjusted basis and could use the helping hand of firms like ours and WSDT who provide lower cost, more efficient investment products."
That being said, still left wondering what WSDT is going to do.
-Dan
ps. Funny to note-- so on the one hand you have WSDT which is heavily based out of Wharton, whose head of fund research is a Wharton professor. On the other hand you have Rydex which is coming out with innovative indices and is drawing on the brainpower of a Princeton professor. It seems we cannot escape this rivalry between Princeton and Wharton (go Wharton!).
