800.364.2468 :: brintoneaton.com Constructing a Portfolio that Successfully Manages Downside Risk Jerry A. Miccolis, CFA ®, CFP ®, FCAS CIO, Brinton Eaton

800.364.2468 :: brintoneaton.com

Constructing a Portfolio that Successfully Manages Downside Risk

Jerry A. Miccolis, CFA®, CFP®, FCASCIO, Brinton Eaton

Annual

Conference

May 23, 2012

800.364.2468 :: brintoneaton.comCompany confidential 2




Juan Carlos ArtigasGlobal Head of Investment ResearchWorld Gold Council



Kenneth R. Solow, CFP®

Chief Investment OfficerPinnacle Advisory Group



Erick GoralskiDirector, Global Markets, ICG Structured InvestmentsDeutsche Bank Securities, Inc.




Modernized Modern Portfolio Theory


Company confidential 7


Modernizing MPT

More realistic asset distributions Non-normal/fat tails

More representative investment horizons Multi-period/compound returns/risk drag Rules-based rebalancing

More meaningful risk measures Shortfall risk Conditional VaR

More useful dependency measures Correlations copulas


Asset class relationships are complex

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We’ve moved from correlations…

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…to copulas

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Dynamic Asset AllocationConstructing a Portfolio that Successfully Manages Downside Risk



Our sector rotation strategy is an example of DAA

Stable-weighting

Exit/entry signaling Trade-offs between stability and responsiveness Three “momentum” algorithms

Each has its own strengths/ weaknesses Rules that determine which algorithm to use at different times Dynamically move between responsiveness and stability based

on market characteristics

Filtering To avoid too-frequent trading

Parameters optimized based on 1990-2007 data Tested “out of sample” with 2008-2011 data


How does this strategy compare to the S&P500 Total Return Index?

14Company confidential

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S&P 500 TR Sector Rotation

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How does this strategy compare to the S&P500 Total Return Index?

15Company confidential

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Enlightened Tail Risk HedgingConstructing a Portfolio that Successfully Manages Downside Risk



Our three criteria for an effective buy-and-hold tail risk hedge

Sudden appreciation in severe market downturns “Severe” denoting sudden, substantial, unexpected decline in

market value across most major asset classes, as in 4Q08 (i.e., when diversification doesn’t help)

Appreciation to a degree sufficient to meaningfully offset the decline No “give-back” during market recovery!

Very low cost Minimize diversion of funds from productive use No sacrifice of upside portfolio potential!

Minimal disruption to portfolio Maintain what works in vastly more likely markets “Don’t throw the baby out with the bathwater!”


Our criteria in a picture

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S&P 500 Total Return Index Ideal Equity Tail Risk Hedge


Some combinations are promising

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Implied Vol Strategy Realized Vol Strategy Difference Strategy Combined Tail Risk Hedge


The combined effect can be game-changing

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S&P 500 Sector Rotation Sector Rotation + Combined Tail Risk Hedge

Annualized Return

Annual Standard Deviation

Maximum Drawdown

S&P 500 2% 26% -55%Sector Rotation 11% 18% -22%

Sector Rotation + Combined Tail Risk Hedge 17% 14% -15%




For further reading on these ideas…

Documents

800.364.2468 :: brintoneaton.com Constructing a Portfolio that Successfully Manages Downside Risk Jerry A. Miccolis, CFA ®, CFP ®, FCAS CIO, Brinton Eaton