Designing multi-asset portfolios

While there are no shortage of limitations and no “right” answers, portfolio theory nonetheless remains, rightly, the bedrock of traditional multi-asset portfolio design.

This is the second in a series of articles by Henry Cobbe, head of research at Elston Consulting,  exploring the world of index investing. Henry is the co-author of How to Invest With Exchange-Traded Funds.

Portfolio theory in a nutshell

Portfolio theory, in a nutshell, is a framework as to how to construct an “optimised” portfolio using a range of asset classes, such as equities, bonds, alternatives (neither equities nor bonds) and cash. An “optimised” portfolio has the highest unit of potential return per unit of risk (volatility) taken.

The aim of a multi-asset portfolio is to maximise expected portfolio returns for a given level of portfolio risk, on the basis that risk and reward are flip sides of the same coin.

The introduction of “alternative” assets that are not correlated with equities or bonds (so that one “zigs” when the other “zags”) helps diversify portfolios, like a stabiliser. Done properly, this can help reduce portfolio volatility to less than the sum of its parts.

While the framework of Modern Portfolio Theory was coined by Nobel laureate Harry Markowitz in 1952, the key assumptions for portfolio theory, namely asset class mix, returns, risk and correlations, are, by their nature, just estimates.

So using portfolio theory as a guide to designing portfolios is only as good as the quality of the input assumptions selected by the user. And those assumptions are ever-changing. Furthermore, the constraints imposed when designing or optimising a portfolio will determine the end shape of the portfolio for any given optimisation. And those constraints are subjective to the designer.

So, portfolio design is part art, part science, and part common sense.

While there are no shortage of limitations and no “right” answers, portfolio theory nonetheless remains, rightly, the bedrock of traditional multi-asset portfolio design.

What differentiates multi-asset portfolios?

A portfolio’s asset allocation is the key determinant of portfolio outcomes and the main driver of portfolio risk and return. Ensuring the asset allocation is aligned to an appropriate risk-return objective is therefore essential. Getting and keeping the asset allocation on track for the given objectives and constraints is how portfolio managers – whether of model portfolios or of multi-asset funds – can add most value for their clients.

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There are no secrets to asset allocation in portfolio management. It is perhaps one of the most well-studied and researched fields of finance.

Stripping all the theory down to its bare bones, there are, in my view, three key decisions when designing multi-asset portfolios:

1. Strategic Allocation: to meet given objectives and constraints, and the quality of research, assumptions and design that underpin that strategy
2. Static or Dynamic approach: how the asset allocation is adjusted (or not) to adapt to changing markets and conditions; what drives the adjustment; and the extent of those adjustments
3. Access preferences: how to access asset class exposure in a way that is efficient, transparent and good value for money

Strategic Allocation 

Strategic allocation is expected to answer the key questions of what are a portfolio’s objectives, and what are its constraints.

The mix of assets is defined such as to maximise the probability of achieving those objectives, subject to any specified constraints.

Objectives could be, for example:

• Absolute return: an objective to deliver a stated level of return
• Real return: an objective to deliver a return in a specified excess of inflation
• Relative return: an objective to deliver a return relative to a benchmark or peer group
• Matching return: an objective to match a future set of one-off or regular withdrawals
• Income yield: an objective to deliver a certain level of income yield
• An outcome: an objective whose outcome is defined in words, rather than figures.

Constraints could be:

• Absolute volatility: the strategy is to remain within a certain range of explicit volatility
• Relative volatility: the strategy is to remain proportionate to the volatility of a certain benchmark
• Value at risk: the strategy is to remain within a certain range of value at risk (potential loss over a given time frame)
• Maximum drawdown: the strategy is not to breach a certain level of peak-to-trough declines

Constraints can also relate to the composition of a portfolio, for example:

• Including or excluding certain asset classes, exposures, sectors or securities
• Setting minimum and maximum weights to asset classes, exposures, sectors or securities
• Portfolio turnover constraints
• Counterparty considerations
• Fee budget

When building a strategic asset allocation, managers need a robust set of capital market assumptions for each asset class and the relationship between asset classes. Ideally these should be term-dependent, to align to an appropriate term-dependent investment objective.

Strategic allocations should be reviewed possibly each year and certainly not less than every five years. This is because assumptions change over time, all the time.

Static vs dynamic

One of the key considerations when managing an allocation is whether to adopt a static or dynamic approach.

A strategy with a “static” allocation means the portfolios is rebalanced periodically back to the original strategic weights. Frequency of rebalancing can depend on the degree of “drift” allowed, but constrained by the frictional costs involved in implementing the rebalancing.

A strategy with a “dynamic” approach means the asset allocation of the portfolio changes over time and adapts to changing market or economic conditions. Dynamic or tactical allocation can be with a return-enhancing objective or a risk-reducing objective or both, or optimised to some other portfolio risk or return objective such as income yield. 

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For very long-term investors, a broadly static allocation approach will do just fine. Where very long-term time horizons are involved, the cost of trading may not be worthwhile. As time horizons shorten, the importance of a dynamic approach becomes increasingly important. Put simply, if you were investing for 50 years, tactical tweaks around the strategic allocation, won’t make as big a difference as if you were investing for just five years. This is because risk (as defined by volatility) is different for different time frames, and is higher for shorter time periods, and lower for longer time periods. There is also just common sense: if you are saving up funds to buy a house, you will invest those funds differently if you are planning to buy a house in three years' time or 30 years down the line. Time matters so much as it impacts objectives and constraints, as well as risk and return. 

Access preferences

Managers need to make implementation decisions as regards to how they access particular asset classes or exposures – with direct securities, higher-cost active/non-index funds, or lower-cost passive/index funds and ETFs.  Fund level due diligence as regards underlying holdings, concentrations, round-trip dealing costs and internal and external fund liquidity profiles are key in this respect.

Types of multi-asset strategy

There are a broad range of multi-asset strategies available to investors, whose relevance depends on the investor’s needs and preferences. For self-directed investors, these multi-asset portfolios are made easier to access and monitor through multi-asset funds, many of which are themselves constructed wholly or partly with index funds and/or ETFs.

We categorise multi-asset funds into the following groups (using our own naming conventions based on design: these do not exist as official “multi-asset sectors”, unfortunately):

Relative Risk

Relative risk strategies target a percentage allocation to equities so the risk and return of the strategy is in consistent relative proportion to the (ever-changing) risk and return of the equity markets. This is the most common approach to multi-asset strategies. Put differently, asset weights drive portfolio risk. Examples include Vanguard LifeStrategy, HSBC Global Strategy and other traditional multi-asset funds. 

Target Risk

Target risk strategies target a specific volatility level or range. This means the percentage allocation to equities is constantly changing to preserve a target volatility band. Put differently, portfolio risk objectives drive asset weights.  Examples of this approach include BlackRock MyMap funds.

Target Return

Target return strategies target a specific return level in excess of a benchmark rate, for example Libor, and take the required risk to get there. This is good in theory for return targeting, but results are not guaranteed. Examples of this approach include funds in the Target Absolute Return sector, such as ASI Global Absolute Return.

Target Date

Target-date funds adapt asset allocation over time from higher risk to lower, expecting regular withdrawals after the target date. This type of strategy works for a “ready-made” age-based fund whose risk profile changes over time. Examples of target-date funds include Vanguard Target Retirement Funds, and the Architas BirthStar Target Date Funds (managed by AllianceBernstein)*.

Target Income

Target income funds target an absolute level of income or a target distribution yield. Examples of this type of fund include JPMorgan Multi-Asset Income.

Target Term Funds

These exist in the US, not the UK, and are a type of fund that works like a bond: you invest a capital amount at the beginning, receive a regular distribution, and then receive a capital payment at the end of the target term.

For self-directed investors, choosing the approach that aligns best to your needs and requirements, and then selecting a fund within that sub-sector that has the potential to deliver on those objectives – at good value for money – is the key decision for building a robust investment strategy.

The (lack of) secrets

The secret is, there are no secrets. Good portfolio design is about informed common sense. It means focusing on what will deliver on portfolio objectives and making sure those objectives are clearly identifiable by investors.

Designing and building your own multi-asset portfolio is interesting and rewarding. Equally there are a range of ready-made options. The most important question is to consider to what extent a strategy is consistent with your own needs and requirements.

* Note: funds referenced do not represent an endorsement or personal recommendation. Disclosure: until 2015, I was involved in the design and development of this fund range, but receive no commercial benefit from these funds.

Henry Cobbe is a freelance contributor and not a direct employee of interactive investor.