Classical Asset Allocation — Defensive (CAA-DEF)
Developed by Keller, Butler & Kipnis · Markowitz + Momentum · Low-Med Risk
The Defensive variant of Classical Asset Allocation applies the same CLA optimization framework as the offensive variant but targets a substantially lower portfolio volatility — approximately five percent annualized. Published by Keller, Butler, and Kipnis in their 2015 SSRN paper (#2606884), CAA-DEF produces portfolios with a fundamentally different character: heavily weighted toward bonds and low-volatility positions during most market environments, with only modest equity exposure even during strong bull markets.
The lower volatility target constrains the optimizer to select portfolios near the conservative end of the efficient frontier. At this target level, the optimizer can only allocate to equities when their expected returns (as estimated by the 13612U momentum composite) are sufficiently high to justify the volatility they contribute. During typical market conditions, the volatility budget is largely consumed by the inherent risk of any equity allocation, meaning bond and cash positions dominate the portfolio most of the time.
This conservative positioning produces a strategy with bond-like volatility and modest but consistent positive returns across most market environments. The maximum drawdowns are substantially smaller than the offensive variant — typically in the single digits — because the portfolio is structurally underweight equities. The trade-off is equally clear: during extended equity bull markets, the strategy significantly underperforms both the offensive variant and passive equity benchmarks, as the volatility constraint prevents the optimizer from allocating sufficiently to capture the full equity premium.
The same eight-asset universe, 13612U expected return estimates, and twelve-month daily covariance matrix are used as inputs. The only difference between the offensive and defensive variants is the target volatility parameter — a single number that fundamentally changes the portfolio's risk-return profile. This parameter sensitivity is both a feature and a limitation: it provides precise control over the portfolio's risk budget, but the "correct" target depends on an investor's risk tolerance and time horizon, for which there is no objectively optimal value.
How It Works
Low Volatility Target
The CLA optimizer constructs the efficient frontier from the same momentum-derived expected returns and covariance matrix used by the offensive variant, then selects the portfolio matching an annualized volatility target of approximately five percent. At this target level, the optimizer produces portfolios with substantially less equity exposure than the offensive variant, as equity assets contribute disproportionate volatility per unit of allocation.
In practice, the defensive variant holds between zero and twenty-five percent in equities during most months, with the remainder allocated to intermediate bonds (IEF), short-term Treasuries (BIL), and gold (GLD). Only during periods of unusually strong equity momentum combined with low realized volatility does the optimizer allocate more substantially to stocks — and even then, the five percent volatility cap limits the total equity contribution.
Portfolio Composition Across Regimes
During equity bull markets with normal volatility, the portfolio typically holds ten to twenty percent in equities, forty to sixty percent in bonds, and the remainder in cash and gold. This composition produces returns that are modest but consistently positive, driven primarily by fixed income income and whatever small equity allocation the volatility budget permits.
During equity bear markets, the portfolio automatically reduces its already-small equity allocation as equity volatilities rise and momentum turns negative. The rising volatility of equities consumes more of the five-percent volatility budget, forcing the optimizer to reduce equity weights even before momentum signals turn decisively negative. This volatility-driven de-risking provides implicit early defensive positioning that pure momentum strategies lack.
During rate-rising environments, the portfolio faces a more nuanced challenge. Bond prices decline (generating negative momentum and higher volatility), which pushes the optimizer toward shorter-duration and cash positions. However, the lower volatility of cash and short-term bonds means they consume less of the volatility budget, allowing the optimizer to maintain meaningful positions even as their momentum is weak.
Risk-Return Profile
The defensive variant's five-percent volatility target produces a strategy with characteristics that more closely resemble a bond portfolio than an equity portfolio. Compound returns tend to be in the mid-single digits with maximum drawdowns in the low single digits — a profile suitable for capital preservation objectives, retirement income portfolios, or as the conservative anchor within a multi-strategy allocation.
The mathematical elegance of the CLA approach means the transition between risk environments is smooth and continuous rather than binary. As conditions evolve, the optimizer gradually adjusts weights along the efficient frontier, producing portfolios that adapt to changing conditions without discrete switching events. This smooth adaptation eliminates the whipsaw problem that plagues binary tactical strategies while maintaining responsiveness to genuine regime changes.
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