Dick Michaud earned his doctorial degree in mathematics and statistics by writing a thesis on optimization techniques for computer-aided design applications.

Once he entered the workforce, however, the young scientist decided to apply his research in optimization strategies to a different field. Specifically, Michaud decided to delve into complaints that standard techniques didn't provide good results in the world of high finance.

His research led to the 1999 launch of New Frontier Advisors. The investment shop, which was founded by Michaud and two partners, had about $1 billion in assets under management entering 2009. Its managers run portfolios using a novel optimization strategy Michaud and his son, Robert Michaud, developed called "Resampled Efficiency." 

What Optimizers Try To Do

The origins of this strategy are detailed in his book, "Efficient Investment Management," first published by Harvard Business Press in 1989. 

Michaud says that his research represents an update of the pioneering efforts by Harry Markowitz, the Noble Prize-winning economist, commonly known as the "Father of Modern Portfolio Theory." 

As described by the Nobel committee, Markowitz's great breakthrough was figuring out "how wealth can be optimally invested in assets which differ in regard to their expected return and risk, and thereby also how risks can be reduced."

In other words, Markowitz focused on the link between the risk of an asset, its potential return and the correlation it had with other assets. He created early portfolio optimization algorithms that used estimates of the risk and return of different asset classes to build theoretically "optimal" portfolios.

For his part, Michaud considers his work as an enhancement of Markowitz's research. "Theoretically, [Markowitz's optimization techniques] work very well. But keep in mind, his main optimization theories were formed 50 years ago," added Michaud.

The next-generation optimization analyst found that with the reams of economic- and market-related data available these days, computers tend to accept too many numbers that don't relate well to one another. 

"Computers take everything so literally," said Michaud. "For example, when you type in an index return of 10.1%, it reads that number as being quite different than 10%. Of course, you and I realize that in a practical sense, there's hardly any difference at all."

To overcome that problem, he borrowed a mathematical technique used by optimizers in other fields called resampling, which is based on a specific type of Monte Carlo simulation. At its core, this resampling technique allows optimizers to consider and incorporate the possibility that the statistical inputs entered into an optimization model are wrong.

Simply put, resampling allows managers to assign a greater range of probabilities to various outcomes. The goal is to produce a more realistic portfolio based on a more realistic efficient frontier.  

"We're basically using investment data in a more natural way for computers to handle," said Michaud.

What That Means For A Portfolio Today

New Frontier uses exchange-traded funds in its portfolios. They're built for different parts of the efficient frontier and referred to as strategic portfolios. "We don't try to forecast. Using various statistical techniques and the latest information, we try to determine the best relationships between different asset classes to get more effective risk-return profiles," said Michaud.

That means not taking big bets in sector- or country-specific stock ETFs. The process doesn't deviate much from fixed-income benchmarks in terms of maturities and sectors, either.

"We're basically using the power of optimization technologies and rebalancing techniques to add to long-term returns for portfolios," said Michaud.

Within that context, the firm's Treasury portfolios are currently tending toward overweighted positions in midrange maturities rather than short or long term. In corporate fixed-income funds, its portfolios are slanted to shorter-term maturities.

On the equities side, New Frontier's optimizing techniques are currently overweighting value in large-caps. And in small-cap stocks, its portfolios are doing just the opposite.

"These aren't big overweights at all," said Michaud. "We're finding very small biases right now. Our optimizers are very sensitive to uncertainty in the markets. So it doesn't tend to overemphasize parts of the market that don't have very specific or strong signals."

The firm is also slightly underweighting international stocks compared to domestic stock ETFs. "It's a little bit of a recent phenomenon. We've tended to be a little bit more neutral in the past," said Michaud.

Tweaks Based On New ETFs

The firm tends to make a bulk of its changes at the beginning of the year. It monitors portfolios each month, and usually by midyear, a few other changes are required, Michaud said. "The portfolios don't get turned over completely almost ever," he added. "Tweaks are made from time to time, but this is a low-turnover strategy."

The only times major changes in positions are made come when new ETFs are added. "Over the course of the five years we've been running ETF portfolios, we've typically added two or three new ETFs—normally at the beginning of the year," said Michaud.

For example, ETFs following roughly the same asset classes might be swapped out. That can be a result of better tracking error and better pricing in newer issued funds. But Pioneer will also add new ETFs that open access to different asset classes to broaden their portfolios' broad diversification.

"We're trying to optimally invest in global economic growth on a risk-adjusted basis," said Michaud. "The ETFs we have in our strategy are meant to represent risk factors associated with the global economy."

Those include gold, REITs, commodities and high-yield bonds, among others. "We consider commodities as a way to reduce risk rather than adding to returns," said Michaud. "As long-term investors, we don't have a view on pricing for oil or gold or anything else. But we monitor how commodities are impacting other markets and asset classes."

He added that alternative asset classes such as solar power and clean energy funds are something his analysts are continuing to monitor. But they prefer right now to use commodities in any alternative asset classification.

"We don't have large positions in commodities, but they're very useful for our investors in controlling overall portfolio risk," said Michaud.

Putting It All Together

A key part of maintaining New Frontier's portfolios and adding value over time, he adds, is its patented rebalancing process. It starts with determining all of the possible optimal portfolio points along the efficient frontier at any given time. "We end up creating a distance measure—a need-to-trade probability. If we have a 10% probability, it's probably not enough to trade. If it's 90%, then it probably is a good idea," said Michaud.

That ratio tells New Frontier whether statistically the portfolio it now holds is very similar or very different from the one they'd like to have over time. "It's a very different way of thinking about rebalancing," said Michaud. "It's much different than using calendars or bands and ranges that are commonly used in the investment community."

He believes that the strategy isn't prone to trading as much as most other active managers, though. That's due to the fact that New Frontier considers all of its investments as core. That's different from tactical investors who set up satellite positions that can be traded more often. "They're shorter-term-oriented investments. But all of our investments are made with a long-term focus," he said.