Asset Allocation & Portfolio Construction
A simple asset allocation model can guide investors’ portfolio decisions. However, as investment strategy and tactics become more advanced, the shortcomings of an asset allocation model are revealed, and the need for risk exposure management becomes more apparent.
The typical Stocks-Bonds-Cash asset allocation model will work for many investors. Here, an investor in his thirties might invest 60% of his portfolio in stocks, 30% in bonds, and 10% in cash. The logic is that, historically, stocks have had the greatest return potential and should therefore have the highest weighting in a portfolio. Yet, stock returns come with the greatest risk (volatility), so an investor should still have some investments in steady, fixed income products.
Within the stocks and bonds categories, the investor can further diversify his holdings to mitigate risk. Investors can invest across different styles (growth, value) and sizes (small cap, large cap) of stocks. Similarly, investors can diversify their fixed income portfolio across quality (low, medium, high) and interest rate sensitivity (limited, moderate, extended). Again, this method will work for many investors, specifically those who have a long only strategy and take few active, tactical positions.
Yet, many shortcomings exist in this model. First, like the capital asset pricing model, the simple asset allocation breakdown is backward looking. It assumes that historical returns for stocks and bonds are likely to persist without considering structural shifts in the economic landscape. Second, it fails to accurately portray advanced tactical strategies. For example, consider an investor with $10,000 in stocks and initiates a $2,000 short position. The investor’s balance is now
| $10,000 | stocks long |
| $-2,000 | stocks short |
| $2,000 | cash |
The account value is still worth $10k, but the investor is now gross $12k. How does one accurately portray this in a pie graph? Paired trades run into similar situations.
Now consider derivative positions where an investor sells a cash secured put with a strike price of $55 and collects a small premium worth $150. The current value is the $150 premium, but the exposure is the underlying $5,500 from the strike price. Another example involves spread trades, which also tend to be misrepresented in the asset allocation pie graph. An investor can sell a $55/65 call spread for a $420 premium, but risks $1,000 in doing so. Should the asset allocation pie chart use the premium or the value risked? Either way, it seems too simplistic.
This problem becomes magnified with futures positions. Futures contracts entail significant leverage, and the investor does not actually own an asset. Instead, he owns a contract that can increase or decrease in value.
What matters in all of these examples is not the asset allocation, but the exposure an investor has. Using dollars or percentage of assets fails to account for the risks an investor undertakes. A better model can be employed that incorporates an investor’s risk exposure that appropriately nets out offsetting positions (paired trades, derivative positions where appropriate).
By viewing a portfolio on a percentage of net risk exposure, an investor accounts for all of the tricky situations above (shorts, paired trades), maximizes derivative risk, and reflects current futures risk. It also avoids using questionable, backward looking risk measurement tools, such as Value at Risk. For these reasons, the Top Five page now uses risk exposure instead of assets owned.
Using risk exposure as our guide, a portfolio of risk factors replaces a portfolio based on asset classes. Taking a page from endowment investing, the five major risk factors are public equity, fixed income, private equity, absolute return, and real assets. I modify this a bit by omitting private equity, since I currently lack the means to invest in it, and adding cash, since most investors have this.
| Equity | Historically provides the most return potential; is volatile |
| Fixed Income | Low, steady income payments; assumes interest rate risk |
| Cash | Funds ready to be deployed, provides no meaningful investment purpose; includes various currencies and gold |
| Absolute Return | Value and event specific investing; adequate but lower returns and volatility than equity |
| Real Assets | Inflation protecting, cash generating assets such as real estate, timber, and oil & gas |
Once portfolio risk factors are established, we can look at the duration of how long we expect to be exposed to each risk factor. For example, an investor who trades 100% of his equity positions every few weeks will have a different foundation than an investor who passively trades a few positions throughout the year. I use three duration categories: Core, Tactical, and Short-Term.
| Timeframe | Examples | |
| Core | 5 years + | Any stable, core position intended to be held for years |
| Tactical | 18-36 months | Most investment themes; income generating securities subject to changing valuation |
| Short-Term | 3-6 months | Short-term, newsworthy trades; cash secured puts/covered calls |
A model based on risk factors provides an accurate, current risk exposure for the portfolio. Moreover, clarifying an expected holding period eases future capital and investment decisions. Finally, this model will help to clarify how future trades fit into the portfolio.
Here is an improvement from the 60-30-10 model:
In this portfolio, an investor is 35% exposed to equities, 20% exposed to absolute return and fixed income, 15% exposed to real assets, and 10% exposed to cash. We also see that the investors intends to hold half of his portfolio exposure for over five years, whereas 15% of the portfolio can be expected to have a different exposure within 3-6 months. Tactical, thematic investments round out the remaining 35% of exposure.
