Build Your Own Investment Portfolio, Part 7

Teresa, March 20, 2008 @ 9:30AM ET | Link | RSS | Read via Email | Start a Discussion  

In Part 6, we analyzed what investors might consider to be an advanced article on portfolio construction and asset allocation.

Let’s review the two core principles upon which we build a portfolio:

Principle #1: Asset Classes Defined According to Function

David Swensen said it best, stating “Careful investors define asset classes in terms of function, relating security characteristics to the role expected from a particular group of investments.” Furthermore:

Purity of asset class represents a rarely achieved ideal. Carried to an extreme, investors define dozens of asset classes, creating an unmanageable multiplicity of alternatives. While market participants disagree on the appropriate number of asset classes, fewer tend to be better. Portfolio commitments must be large enough to make a difference. Committing less than 10 percent of a fund to a particular type of investment makes little sense; the small allocation holds no potential to influence overall portfolio results. Investors trade off the benefits of precise definition of an asset class with the costs of employing large numbers of classes.

Functional attributes play the dominant role in defining asset classes, with structural and legal characteristics taking secondary positions. Asset class distinctions rest on broad sweeping differences in fundamental character; debt versus equity, private versus public, liquid versus illiquid, domestic versus foreign, inflation sensitive versus deflation sensitive. Ultimately investors attempt to group like with like, creating relatively homogenous groups of investments that provide fundamental building blocks for the portfolio construction process. — David Swensen, Pioneering Portfolio Management

Assets expected to react in similar fashion to a given economic environment belong to one asset class. An all-weather portfolio should diversify among asset classes that are expected to respond differently to an ever-changing economic environment.

Principle #2: Use a Proven Framework to Allocate the Assets

In Part 6, we explained the shortcomings of equal weight allocation and introduced classic frameworks such as CAPM, APT and MPT. The past decade has seen the introduction of advanced asset allocation frameworks (see Part 2, further reading) such a risk parity portfolios.

The InVivo tradition of excellence springs from a commitment to research and development, mainly because my own investment and trading performance is the chief beneficiary of my work. It should come as no surprise that we developed our own dynamic asset allocation program.

The skeptical reader wrote to say that he does not trust “black boxes”, as if the factors that cause hedge funds to blow up during every market debacle could even remotely be connected to an asset allocation program. The fact is that speculative statistical arbitrage of exotic debt instruments leveraged 30 times has nothing to do with an algorithm that calculates the allocation of a person’s unleveraged investment portfolio.

While we cannot provide the details of our rebalance algorithm, suffice to say that it works. I would not use it on my own money if it didn’t, but I wanted to show readers how something as mundane as deciding how much of each asset class to buy can make a big difference.

We devised an elegant (always-long, no cash) experiment to demonstrate the effectiveness of our rebalancing program. We allocated funds within one asset class by using applying our algorithm on the Select Sector SPDRs and compared the results with the performance of SPY, the S&P 500 ETF.

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Select Sector SPDRs are ETFs that divide the constituent stocks of the S&P 500 Index into nine sector index funds. Any out- or underperformance in the SPDR portfolio can be directly attributed to our algorithm. Our SPDR allocation dampened the ups and downs of the market roller coaster and outperformed SPY over the long haul.

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Furthermore, the volatility of returns (discussed in Part 3) was reduced considerably.

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The lesson here is that we must focus on principles and not get caught up splitting hairs. A strong portfolio requires exposure to equities and several other asset classes in order to achieve diversification enough to deal with unanticipated inflation, deflation and currency risk. Portfolios must be rebalanced with discipline using a proven method. It is not enough to put lipstick on a pig; we must make it fly.

In the next and final installment of the series, we will put together a real-world, all-weather portfolio for our archetype client and show you the results.

CLICK HERE to read Part 8.

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