Constraints of convention – Does a portfolio design have to be static? by Jeffrey Knight, CFA, Columbia Management
- A 60/40 portfolio may appear to be balanced, but when viewed through a risk lens it is clear that the equity allocation comprises a disproportionate amount of the risk.
- As a static strategy, the very thing that has helped risk parity succeed over time may prove to be its biggest liability going forward, and that is all those extra bonds.
- Instead of always being accountable to the same neutral portfolio, why not shift accountability to a starting point defined by current market conditions?
There was a charming story from the world of youth sports featured in Malcolm Gladwell’s book “David and Goliath: Underdogs, Misfits and the Art of Battling Giants.” Vivek Ranadivé is an MIT educated, software engineer who found himself in the misfit role of head coach for his 12 year old daughter’s basketball team. Vivek was from Mumbai and grew up with cricket and soccer. Without any preconceived notions about how the basketball was “supposed” to be played, Vivek was puzzled that teams allowed their opponents to advance the ball up the court uncontested most of the time. Vivek decided that his team, made up of Silicon Valley daughters, most of whom had never even played basketball before, would play a full court press all of the time — from the opening tip off to the end of the game. The opposing teams were dumfounded. Long story short, the team would eventually make it all the way to the national youth basketball finals.
The advantage that Vivek’s team brought to bear against the competition is one that applies to investments as well. Specifically, they defied the “constraints of convention.” Everybody knows that basketball teams don’t press all game long. The full court press is saved for special occasions. This cultural fact pattern was so broadly believed and accepted that other coaches apparently failed to even consider a strategy that stood afoul of these conventions. There is no rule against a full time press. It is not a real constraint. But nobody does it because, well, nobody does it. It is too unconventional. At least for Vivek’s team, relaxing that constraint proved to be very valuable.
These constraints of convention exist within the investment business as well. We should be ever on the lookout for them, for in the parlance of an engineer like Vivek, the shadow price of these constraints can be very high indeed.
One example is the idea of what constitutes a balanced portfolio. For many years, investors had long believed that a portfolio of 60% stocks and 40% bonds was balanced. On the surface it appeared to be. However, when looking through a different lens — a risk lens — it was clear that the equity allocation comprised a disproportionate amount of the risk. In order to address this equity concentration, risk parity emerged and introduced two significant breakthroughs. First, determining portfolio allocations based upon risk contributions rather than simple dollar allocations. In doing so, risk parity under-emphasized equity and placed a higher reliance on bonds, which has been useful in an environment where interest rates have been falling for many years. The second breakthrough was incorporating leverage into a strategic asset allocation. De-emphasizing equity was unconventional enough, but incorporating leverage into a strategic asset allocation was something that just wasn’t done. It was easy enough to do, but like Vivek’s full court press it was a strategic option that just wasn’t considered relevant due to its cultural absence. By relaxing the no leverage constraint, portfolio design could separate the proportional allocation of risk from the absolute level of risk. The result should be, and in practice has been, better diversified portfolios and more efficient returns.
Ironically, the opportunity to once again recognize, and defy, conventional constraints exists today with the very strategy that I just outlined — risk parity. That is, risk parity itself suffers from its own constraint of convention, which makes it vulnerable to the peculiarities of today’s markets. Simply, risk parity is a static strategy. As a static strategy, the very thing that has helped risk parity succeed over time may prove to be its biggest liability going forward, and that is all those extra bonds.
I raise the question — does a portfolio design have to be static? Is that a rule? I’m not talking about an active overlay, either. I am talking about replacing a static policy portfolio with a policy function. Where the policy portfolio — or benchmark — itself changes in a hard-wired and significant way, adapting to market conditions. For example, if bond yields fall too far, the policy portfolio should reorient around a less bond intensive starting point. If stocks are particularly attractive, then the neutral, core portfolio should be more equity intensive. In short, starting with a risk parity approach, but incorporating an adaptive policy function allows the strategy to reallocate in a meaningful way based on prevailing market conditions. Instead of always being accountable to the same neutral portfolio, why not shift accountability to a starting point defined by current conditions?
Such an approach could be indispensable in the coming years. Interest rates are, of course, very low today. Five-year Treasuries today yield less than 1.7%, even as inflation runs well north of 2%. I frankly don’t think that bonds deserve as large a role in portfolio strategy as they did in 2008. These low yields, meanwhile, are forcing investors into riskier assets, and stock markets are trading at record levels representing ever more demanding valuations. Credit spreads are nearing record narrow levels. All the while we are moving closer to a reversal, perhaps, of central bank policies designed in part to levitate these asset classes. Market conditions are likely to change. Portfolios that adapt will stand a better chance of navigating those changes. A full court press against the constraints of convention may well be the key to investment survival.