ETF Trends
ETF Trends

Note: This article appears on the Strategist Channel

By Giralda Advisors

In our earlier installments in this series (see archive here), we described the Risk-Managed Investing (RMI) approach to equities as embedding volatility dampening and/or downside risk mitigation directly within the equity investment itself. Previously, we also outlined (RMI and Investing in a Rising Rate Environment and RMI and the Liquid Alternatives Landscape) how RMI could be part of a solution to the portfolio problem caused by the disappointing prospects for non-equity asset classes, particularly fixed income and liquid alternatives. We described (RMI, Volatility Drag, and Sequence Risk and Alpha Generation through Risk-Managed Investing) how RMI could address such financial planning challenges as volatility drag and sequence risk, and add long-term alpha over complete market cycles. We calibrated how low the cost of risk management needs to be in order to be worthwhile (The Tolerable Cost of Risk-Managed Investing) and explored a range of RMI solutions in the marketplace (RMI Applications: Sector Rotation Using ETFs, RMI Applications: Tail Risk Hedging, and Marketplace Review of Risk-Managed Investments).

Over our final three installments on the subject of RMI, we will attempt to tie things together in a portfolio construction context. In this current piece, we discuss portfolio optimization once RMI solutions are introduced into the picture. The following installment will examine the implications for portfolio performance benchmarking and scorekeeping, and the capstone piece will explore the question “Is 80/20 the new 60/40?”.

A Brief Review of Portfolio Optimization

Modern Portfolio Theory (MPT) was born in the early 1950s with the published works of Harry Markowitz. MPT expressed the goal of portfolio construction as finding the “efficient frontier” — the set of portfolios that formed a theoretical boundary beyond which it was not possible to find a higher-return portfolio at the same or lower levels of risk or, equivalently, a less risky portfolio at the same or higher levels of return. MPT led to a shift in focus from evaluating individual assets in isolation to considering the way in which various investments behaved in concert and how their interaction affected the risk/return profile of the overall portfolio.

To find one’s way to the efficient frontier, an investor needed to estimate the expected return and volatility of each asset that was a candidate for inclusion in the portfolio.  Additionally, and this was the key breakthrough of MPT, the investor needed to estimate how the behavior of one asset was correlated to the behavior of each of the other assets.  All of this was mathematically derivable from prior history.  Improvements, particularly in the estimation of volatility and cross-asset interrelationships, have come along over the years — see, for example,  “Next Generation Investment Risk Management: Putting the ‘Modern’ Back in Modern Portfolio Theory” (Miccolis and Goodman, Journal of Financial Planning, January 2012).  In one way or another, MPT-inspired “optimal portfolios” have been in the mainstream of professional investment management for more than 60 years now.

Diversification as a Risk-Management Device

While the practice of “not putting all of one’s eggs in a single basket” predated MPT, the theory did add mathematical rigor to the notion that diversification added value to the portfolio.  Specifically, with the right mix of poorly correlated assets, one could construct a portfolio that had an expected return near the average expected return of its component assets but well below the average volatility.  Thus, the value of diversification could be clearly seen as reducing risk, and the risk-management benefit of diversification could actually be quantified.

Accordingly, one of the major upshots of MPT has been the rise in popularity of “diversifying assets” such as liquid alternatives.  These diversifying assets could afford to have only fair return prospects of their own if their correlation with high-return (and presumably high-risk) assets was very low.  In other words, the power of diversification at the portfolio level was seen to be so great that it made attractive certain middling-return assets that might not be so appealing on their own.

Another Perspective on Diversification

The above discussion suggests another way to view diversification and portfolio optimization.  In this view, the investor constructs a portfolio by starting with its most essential component.  We believe most would agree that, for the preponderance of investors, that essential component is equities.  Equities represent the growth engine of the portfolio, the component most likely to keep the portfolio ahead of inflation over the long run and make its owner’s financial plan work.

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