Portfolio construction – value versus risk

The mantra of diversification – and the free lunch it supposedly brings – is so ingrained into the investment world that we just take for granted the idea that mixing assets makes sense. There is a miracle, Nobel prize winning formula, that you just push the button on and out comes the perfect portfolio. For the longest time, this has been represented by the 60% Equities, 40% Fixed Income(obviously all American) “Balanced Fund”. But how balanced is it really?

In my previous piece, I talked a bit about the economic impact that inflation can have on assets. While I highlighted a period of bad outcomes, the converse occurred from the early 1990s, when the Fed finally got serious about fighting the inflation scourge and bonds and equities surged (in price) everywhere(well, except Japan equities but that is another story). The one force, driving both assets – this time for the good. This also coincided with a substantial increase in awareness and exposure to equity markets pretty much everywhere except continental Europe. Data also became available so we could track the returns of assets, and thus was born the magic of the historic covariance matrix.

But again, how balanced was a 60/40 US Balanced Fund? If we look at the economics, it is clear that inflation can drive both assets together - but what if we just look at the statistics? Measuring risk (and in this case, I am only speaking of volatility as a poor proxy for true risk), is more of an art than the textbooks on portfolio construction imply. When we are thinking about volatility, we are really talking about the future. Using historical data to estimate this is only viable if you believe the future will look pretty much like the past you have captured in your data set.

So, the key question to address is: How well does the past predict the future?

Well it turns out at that when it comes to estimating returns, the past is a poor predictor of the future – that old disclaimer at the end of every performance table(“Past returns are not representative blah blah”) is worryingly true. If anything, high historical returns at an asset class level tend to coincide with rising valuations, which are pretty much guaranteed to produce low returns over the future medium term.

When it comes to risk, it gets a bit tricky. Portfolio volatility is really 2 things in one –how volatile are each of the individual assets and how do they move together.As highlighted earlier, if there has been one economic force driving both equities and bonds in the same direction (positive correlation), then you better hope that the medium-term future looks a lot like the past or a large part of your volatility prediction will be wrong. The other part – the underlying volatility of each asset – also plays a major role in the title of this piece. If I have 60% of my portfolio in US equities and 40% in bonds, because equities are just so much more volatile than the average bond, 90% of my risk is coming from the equity exposure. My “balanced fund” is really just a low risk equity fund.

While this idea is hardly revolutionary, it has been the catalyst for the creation of a new type of “balanced fund” – risk parity products. These products weight the asset by the amount it contributes to the total portfolio risk (generally without reference to likely future returns). It also requires the use of leverage (you need a lot more bonds than equities to give them the same amount of risk in a portfolio) and requires the inclusion of a much broader mix of assets.

If your portfolio construction methodology isn’t handling the art as much as the science or doesn’t have a way to model a diverse range of environments – both economic and statistic – then your portfolio has likely been optimised by IT people, not portfolio construction people. And on that I leave you with a very, very big, Caveat Emptor.

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