Carver, Smart Portfolios

Robert Carver, author of Systematic Trading, has turned his attention to the thorny problem of portfolio construction. In Smart Portfolios: A Practical Guide to Building and Maintaining Intelligent Investment Portfolios (Harriman House, 2017) he deals with such topics as how to blend assets with different levels of risk, the reasons that forecasting returns is so difficult, and how to calculate the true costs of your investments.

One problem that investors face is that not only is the future uncertain, the past is as well. This is a point that Carver drives home multiple times. He shows, for instance, that “the uncertainty of the past is largest for risk-adjusted returns. We can be 95% confident that the estimated relative Sharpe Ratio (SR) of the two assets was within a range of around 0.5 SR units. For US stocks and bonds this uncertainty range is -0.16 to 0.36. This is a huge degree of estimation error: our estimates of Sharpe Ratio are effectively worthless.” By contrast, “the uncertainty of standard deviation estimates is much lower than for the Sharpe Ratio,” and “in typical financial data estimates of bond and equity correlations are 95% likely to be within a range of around one-third (actual range -0.12 to 0.21).”

To manage the problem of past parameter uncertainty in portfolio construction, he assumes that risk-adjusted returns are identical for all assets, he uses risk weighting to account for differences in asset volatility, and he employs a technique he calls handcrafting to handle correlations sensibly.

In over 500 pages Carver takes the reader through both theoretical considerations and practical applications. He shows how to build a smart portfolio top-down, contingent on portfolio size, from an institutional investor to a person with $40,000. He introduces two forecasting models (momentum and yield) to aid in the construction of a portfolio. And he addresses the need for maintenance, such as smart rebalancing and portfolio repair.

Smart Portfolios is a sophisticated but not overly technical treatment of a topic that every investor has to come to grips with. As such, it is a recommended read.