Building an effective Total Portfolio with Alternatives
A collection of concepts for CIOs, Advisors and Consultants
At its very core, portfolio construction is the exercise of assembling and managing a collection of risk premiums in a manner that allows an investor to meet their long-term objective - this objective could be wealth compounding, wealth creation, wealth preservation, or meeting future cash flows, whether its an individual’s retirement, a pension fund or insurance companies’ future cash flow obligation, or an endowment’s operating budget.
The coming decade presents challenges and opportunities for allocators, in particular with alternatives and private assets becoming a ‘core’ part of most portfolios.
Unlike an unconstrained hedge fund, fiduciaries at large institutions and wealth managers have to deal with the portfolio construction problem in a constrained environment, with constraints that are often non-economic - from actuarial/regulatory assumptions, to governance structures, to behavioral considerations of their end clients.
A common refrain one can find in private asset marketing materials is ‘if done correctly’ private assets can add value. Indeed, if done correctly private markets and alternatives add significant value.
It’s now time to take the next step and be explicit about how private assets can be ‘done correctly’ within a total portfolio context, and the pitfalls if ‘not done correctly’.
In order to take the next step, the following are my high-level thoughts on designing a process for Total Portfolio Portfolio Construction and Investment Management.
First - identify what you are investing for - pure wealth, constrained wealth, meeting future cash flows (liabilities)
Then identify what is the “naive” portfolio that would match that - e.g., an immunizing portfolio that matches cash flow or duration so you can “sleep at night”
Do you need anything more than what the naive portfolio offers? Why/why not? Use that to then determine how much additional return / wealth you need over that, and how much additional risk (defined as worst case outcome) can you tolerate
Then construct a “growth portfolio” for that excess return - this growth portfolio will be a combination of optimal diversifying betas, and alpha (excess returns over the diversifying betas that you cannot get from a linear combination of these betas). Traditional Mean/Variance type approach may be misleading at this stage, and better tools are needed that better align with the objective in Point 1.
How much Alpha do you need relative to beta in order to achieve your objectives? What is the cost (risk, fees, liquidity) of that Alpha, and what’s the best way to allocate your “cost budget” to maximize the alpha.
Should you optimize alpha and beta separately?
Now for that growth portfolio, rethink your traditional asset allocation / manager selection approach to instead become one of “Linear” , “superlinear” and “staying power”
Most of your “linear” returns should come from capital allocated to a diversified portfolio of factors & risk premiums - these may be both public and private, since they share similar factor exposures
There may be an additional ‘skill premium’ but that is scarce, and evaluate what is your edge in identifying such ‘skill premium’, and whether that skill premium gets diversified away, or the odds are too low to be significant
This linear portfolio should take advantage of diversification. However, in order to benefit from the better risk-adjusted returns offered by a diversified portfolio, the portfolio needs to be levered to the appropriate risk level
A small portion of your portfolio (sized as a “call option premium”) should focus on ‘imagination’ - those opportunities for superlinear returns - and that is where your manager research team or your direct investments team can add value - perhaps taking a venture-like approach to investing - focus on maximizing your exposure to the probability of achieving ‘right-tail’ outcomes
Conversely, limit ‘left tails’ in those asset classes where upside similar across all investments and value is driven by managing downside (e.g. debt).
And then you protect the downside of your total portfolio based on your behavioral tolerance so that you have staying power, either via tail hedging, diversification or position sizing.
Risk Management is not necessarily a quantitative exercise. Therefore use tools like counterfactuals and pre-mortems to get a better sense ahead of time of how you would react if a bad outcomes happens. Remember, we are not focusing on whether an outcome will happen, but rather how you would react if that outcome happened. This approach can lead to insights that over time shift the odds in your favor.
Finally “Measure What Matters”. Our industry has evolved to the point where there are multiple performance and risk metrics that can be measured over multiple horizons, to the point where anyone can choose any metric that makes them look good. However, not only are multiple metrics confusing, but decisions based on those metrics may not necessarily help with your goals. Instead, its important to measure what matters for your objective, and define the key results you want to focus on that are related to that objective (see OKRs). In private markets, IRR is a metric used to evaluate most strategies, but may be misleading in context of overall wealth creation or risk management.
Reflecting on these 15 points becomes even more important given the added dimensionality that private market investments bring to the total portfolio.
Private market allocators don’t have the luxury of shifting their allocation frequently. Therefore “thinking twice” and taking the time to define your investment criteria can improve the quality of your private asset portfolio. Often this might mean not simply being a ‘taker’ of private funds, but rather working with private fund manager to determine what’s the best fit for your particular portfolio.
The advantage we have today is that investment technology, data, and analytics have advanced to a point where it is feasible to build and manage the above process, but requires deep collaboration between the asset allocator and the asset manager. Asset managers need to be willing to rise up to the challenge and use their investment skill and technical capabilities to collaborate and help allocators with each step of the process.
When you apply this framework and take a long-term view, some interesting unconventional thinking emerges - both for public markets and private investing.
A few unconventional thoughts in no particular order:
In a growth portfolio, do TIPS make sense for inflation protection? Conventional wisdom argues for holding inflation-linked bonds as part of a strategic asset allocation. The reasoning is that during inflationary periods, TIPS can protect a portfolio. However, lets go deeper into that line of thinking. A long-term portfolio (as opposed to a tactical trade) is exposed to trend-inflation as opposed to inflation ‘shocks’. In a high ‘trend inflation’ environment relative to what is already priced in the markets, it may be likely that growth assets such as equities may pick up the inflation factor, and also pay you an additional risk premium. Therefore TIPS may be more appropriate within the context of an ‘immunizing portfolio’, where they are used to explicitly match future inflation-linked cash flows, and not as a source of excess return.
Should Private Markets be considered a single ‘asset class’? or should allocations to private assets (equity, real estate, equity, venture, etc.) be determined based on their excess returns over public factors and their ability to increase probability of accessing right tail events while limiting left tail. Taking that one step further, should a private market investment be considered on an IRR basis, or rather for its ability to outperform its public market equivalent (after considering factor, sector and leverage)?
Is traditional call overwriting truly adding value? Over the long-term if the equity risk premium is positive, a strategic allocation to call overwriting is selling the equity risk premium and replacing it with volatility premium. Therefore, such a trade would work only if the long-term compounded benefit of the volatility premium earned is greater than the equity premium lost. However, because typical call writing programs (especially the largest programs) do not hedge their delta exposure, and tend to sell volatility in part of the vol surface with lowest volatility premium (namely at/slightly out of the money calls), over the long-run an investor is in fact losing value relative to a traditional stock-bond portfolio. If the goal is to add diversifying risk premiums then a better approach might be to maintain equity exposure and add more sophisticated strategies that captures volatility and other risk premiums as an overlay on top of an investor’s strategic beta.
What responsibilities should the allocator retain and what responsibilities can/should be delegated to a manager as part of their mandate? Once the allocator clearly defines the objective and risk parameters, they can decide what investment decisions they need to own, and what they can pass along to an investment manager. Investment Managers need to be prepared to take on broader mandates.
Should you make room for luck in your portfolio? Investing is inherently a probabilistic exercise, so perhaps instead of taking a deterministic view (e.g. “I only invest in funds with 20% IRR”) taking an approach that allows you to play the probability distribution (what happens if I am wrong? what happens if there is something good that I cannot foresee today?) may lead to manufacturing serendipity, and potentially better long-term outcomes.
Building a framework to answer questions such as these, and many more, is now possible using improved tools and analytics, and the responses can be examined in the context of an allocator’s specific governance structure.