How To Avoid Making The Portfolio Assumptions That Harm Clients
June 24, 2016
by Scott MacKillop
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My article, The Portfolio Management Assumptions That Harm Clients, generated a provocative conversation thread on APViewpoint following its publication in April.
One of the themes in the conversation was summed up by the venerable Bob Veres, who told me that he had read my article (my heart soared) and then quickly followed with, “you pointed out quite a few problems but didn’t really offer any solutions” (my heart sank).
This article is my attempt at redemption. I don’t want to be known as a person who stirs the pot and then walks away. And so it is that I offer up my perfect little portfolio (PLP). Showing how my firm has implemented the ideas in my original article will be more instructive than discussing those ideas in the abstract.
Introducing… (drum roll)… my PLP
My PLP is not perfect, nor is any portfolio. But my PLP has some very laudable characteristics that deal with the issues I raised in my first article as well as some other troublesome problems that I did not address. There are many other ways to address these issues. My PLP is only one of them.
I confess “my” PLP is not actually mine. It is the product of our investment committee, which includes seven members (five CFAs, a Ph.D., a CFP/CIMA/CAIA and a JD – for those of you who are counting, one of the CFAs is also a Ph.D. She is also a concert violinist.). Four members are independent outsiders, so we’ve had some spirited debates about how to build our PLP.
We manage portfolios at various risk levels, but for the purposes of this article, I will look at our “balanced” portfolio, which has a 60/40-type risk level. The portfolio has a “core-plus-satellite” structure. Let’s start by looking at the core. We will look at the satellites later.
The core consists of 36% Vanguard Total Stock Market ETF (VTI), 24% Vanguard Total International Stock ETF (VXUS), 24% iShares Core US Aggregate Bond ETF (AGG) and 16% Vanguard Total International Bond ETF (BNDX). The core can represent between 50% and 100% of the portfolio. In other words, we are not obligated to add any satellites but may do so at our discretion.
Having a starting point
In my previous article, I addressed what I called the “asset class selection problem.” This problem refers to the fact that many portfolios appear to have no logical starting point.
Instead, they are an amalgamation of asset classes that are thrown together without any logic, discipline or identifiable process. The operating assumption seems to be that if we keep throwing “diversifiers” into the mix, we will reduce volatility and somehow get a better result.
There are a few problems with this approach. First, asset classes that appear relatively uncorrelated become more correlated during periods of extreme market movement.
Second, some “diversifiers,” like managed futures, have no real long-term expected return. Including them permanently in a portfolio may provide a modest reduction in volatility but is almost certain to reduce long-term return. Clients cannot perceive these reductions in volatility, but they certainly will perceive the reduced terminal value of their account.
Third, there are some times when it is better to own one asset class than others. Forcing a portfolio to hold 12 to 15 asset classes at all times means you will be holding some of them when it is not wise to do so.
Finally, every asset class that is added to an account costs the client money. Transaction costs associated with buying, selling and rebalancing are a guaranteed drag on performance.
The core of our PLP is our logical starting point. It is designed to replicate the global market portfolio. Nobel Prize-winner Harry Markowitz developed the concept of the “optimal portfolio.” Nobel Prize-winner James Tobin developed the idea that there was really only one “super-efficient” optimal portfolio. Nobel Prize-winner Bill Sharpe identified Tobin’s super-efficient portfolio as the global market portfolio (GMP).
With all that Nobel-ity behind it, the GMP is a good starting point.
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