Portfolio construction is both an art and science. The science of portfolio construction evolved over time producing different asset allocation methods. The science of investing has had its share of major steps forward, and for portfolio construction, it all began with Harry Markowitz’s paper on the mean-variance optimization. That laid the foundation for work by William Sharpe, which led to the development of Modern Portfolio Theory (MPT). Both Markowitz and Sharpe, along with economist Merton Miller, earned the 1990 Nobel Prize in Economics. In his paper, Markowitz introduced the concept of the Efficient Frontier – the curve representing all portfolios that maximize the expected return for a given level of risk, or, alternatively, minimize the risk for a given level of expected return.
Strategic asset allocation is supposedly the most important aspect of the investment process. Traditionally, strategic asset allocation means to “buy and hold” and then periodically rebalance the portfolio by selling higher performing investments and purchasing lower performing ones to bring the portfolio back to its original asset allocation. Creating a diversified, multi-asset class portfolio is usually a two-step process:
Step One: Asset Allocation
The first step is making the asset allocation decision. Asset allocation is the first and foremost step in translating the client’s circumstances, objectives, and constraints into an appropriate asset class level portfolio for achieving the client’s goals given the client’s tolerance for risk.
Step Two: Select Investments
The next step is to select the underlying investments for each asset class (e.g., individual securities, ETFs, mutual funds, etc.) to create a diversified, multi-class portfolio to implement the target asset-class level allocation. The framework of this two-step process allows separation of two key decisions
- Determination of target weights for each asset class, and
- Choosing the implementation vehicles with underlying investments based on specific objectives, e.g., active vs. passive, asset location, etc.
The traditional approach of strategic asset allocation – where investment in each asset class is rebalanced regularly back to target allocation – does not typically come with the flexibility of overweighting or underweighting an asset class. Tactical Asset Allocation (TAA) strategies have become popular since early 2000 because most TAA managers predicted and benefited from the bursting of the “tech” bubble in the early 2000s. TAA actively adjusts a portfolio’s strategic asset class targets based on short-term market forecasts in accordance with model-based risk-reward expectations. In general, TAA strategies attempt to maximize risk-adjusted returns by identifying and taking advantage of relative mispricing or short-term inefficiencies across asset classes. A TAA portfolio attempts to add value by overweighting asset classes that are expected to outperform and underweighting asset classes that are expected to underperform in the near term on a relative basis.
The signals for TAA can come from a variety of fundamental research and/or technical study (e.g,. macroeconomic / business cycle indicators, valuation expectations, market sentiments, momentum signals, etc.). The recession of 2008 highlighted one troublesome factor of strategic and tactical asset allocation: the high correlation between assets during the meltdown resulted in the collapse of many asset classes in tandem, leaving many investors with insufficient diversification to offset the meltdown in stocks, corporate and high-yield bonds. One of the greatest lessons taught by the 2008 financial crisis was the importance of alternative investments that offer negative correlation to traditional stocks and bonds. Alternative investments provided support during market drawdown like that of 2008. I recently spoke with InvestmentNews, about how 2008 was such a difficult time for people, largely because their risk allocation did not align with their portfolio. New alternatives – e.g., risk parity, which balances risk in a portfolio by equalizing risk contribution of each asset class – emerged during that time with a focus on risk allocation. A healthy dose of alternative investments is key to diversifying market risk. Adding alternative asset classes can help reduce the large risk allocation to equities and may provide greater diversification benefits than a traditionally “diversified” portfolio with stocks, bonds and cash. Some alternative investments arguably also provide scopes for higher excess return over traditional long-only strategies.
The Alpha and Beta Separation
Besides the revolution of alternative investments, another investment paradigm also emerged: alpha and beta separation. No matter what’s in your client’s portfolio, it can be described in terms of risk and reward. For many investors, the most important decision is whether or not to merely invest and take the risk and reward in a particular market. This is simply known as beta. The alpha, on the other hand, is excess return – the “elusive edge” to beat the market. The decoupling of alpha and beta led to another concept: Core-Satellite portfolio construction. When constructing a portfolio, a financial advisor might begin by developing a long-term core allocation (providing “beta” exposure) and then selecting the satellites with actively managed components to capture specific market segments in an attempt to add “alpha” or reduce volatility. This can be explained with the following examples:
Alpha / Beta Separation
Over time, the traditional concept of beta or “market risk” has been repackaged as “smart beta” capturing factor exposures (e.g., size, value, momentum, low volatility) using systematic, rules-based approaches. On the other hand, most investors still believe they can outperform the market only through stock-picking skills without adhering to the discipline of portfolio construction. In 1986, the seminal paper by Brinson, Bower and Hood indicated the importance of asset allocation, which explained 93.6% of the variation in portfolio returns. Investors remain in this state of ignorance and tend to be greedy and chase performance when selecting securities. Our investment decisions, which should be made as dispassionately as possible, are often driven by our emotions – of which greed and fear often take precedence. The science of asset allocation has become complex since the advent of Markowitz and Modern Portfolio Theory. It cannot be easily solved with financial engineering since the portfolio decisions are made by humans, who regularly find rational decisions beyond their grasp. One of the most important jobs of the investment advisor is protecting investors from themselves by creating an asset allocation approach that can keep them invested and avoid wrong decisions (e.g., selling risky investments at the wrong time). One of the most popular modern approaches to this problem is the “bucket approach.”
What is the Bucket Approach?
The “bucket” approach to investing has emerged as a popular asset allocation methodology in the financial planning and advisory community because it is specifically designed to account for actual investor behavior, known as mental accounting. The essence of the bucket approach is to divide a client’s portfolio assets into several pools – or “buckets” – each with different planned goals (e.g., “needs,” “wants” and “wishes”) and time horizons (e.g., “now,” “soon” and “later”), and then design a separate asset allocation policy for each “bucket.”
A time-horizon-based bucketing approach for wealth management is designed to address psychologically the safety of near-term liquidity needs, the intermediate need of income or an allocation in line with risk tolerance of the client, and finally, the goal of long-term growth of capital. In practice, a floor level of assets is designated as a short-term “spending bucket” in cash or short-term securities that have little or no investment risk. On the ceiling, equity allocation facilitates long-term growth with longer horizon, which allows more time to recoup losses from a market downturn. Further, from a portfolio management perspective, a bucket plan merges “goals-based investing” into the investment process with a concept known as “time diversification.” This introduces risk discipline and managing a client’s expectation in a prudent manner. A true bucketing approach allows planned withdrawals from less risky assets in the near to intermediate term, thus creating less sensitivity to equity volatility than a systematic withdrawal from a calendar-based rebalancing.
The bucketing plan – if implemented right – protects the portfolio from sequence of returns risk. In designing a portfolio for a client, it’s important to consider both art and science, including the components of Investment Policy Statement (IPS) – e.g., return requirements, risk tolerance, liquidity needs, tax considerations, etc. On the other hand, to create the best practical portfolio, asset allocation practices should incorporate the investor’s goals and time horizon from a financial planning perspective. Finally, it’s important for an advisor to consider the aspects of behavioral finance to help clients stay tuned in to their investment programs, minimize regrets and enjoy long-term investment results.