Portfolio Design

A Modern Approach to Asset Allocation

Richard C. Marston

• Publisher: Wiley
• Year: 2011
• Print ISBN: 9780470931233
• eBook ISBN: 9781118007051
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Portfolio Design – choosing the right mix of assets appropriate to a particular investor – is the key to successful investing. It can help you accumulate wealth over time, while cushioning the blow of possible economic downturns.But in order to successfully achieve this goal, you need to be familiar with all of the major asset classes that go into modern portfolios and learn how much they add to portfolio diversification.Thoughtful asset allocation provides discipline to the investment process and gives you the best chance of building and safeguarding wealth.Wharton Professor Richard C. Marston, 2014 recipient of the Investment Management Consultants Association's prestigious Matthew R. McArthur Award, will guide you through the major decisions that need to be made when designing a portfolio and will put you in the best position to balance the risk-reward relationship that is part of this endeavor.

Portfolio Design isto be read by investment advisors.The book is rich in information about individual asset classes, including both traditional assets like stocks and bonds as well as alternative assets such as hedge funds, private equity, real estate, and commodities.So it should appeal to all sophisticated advisors whether or not they are trying to qualify for one of the major investment designations. In fact, the book is designed to be read by any advisor who is as fascinated as Marston by the investment process.

Chapter 1

Asset Allocation

An Introduction

Asset allocation has different aims depending on the investor. A younger investor may want to build wealth over time, taking risks that would not be sensible for an older investor. Investors in retirement often want to hunker down to make sure that no unreasonable losses occur. The assets these two investors choose may not differ overall, but the relative weights given to each asset in the portfolio will surely differ a lot. For example, a younger investor will hold a higher proportion of equities than an investor nearing retirement. Institutional investors also differ in their investment strategies. One endowment, perhaps a family foundation, may want to preserve wealth if there are few opportunities to raise more funds in the future. Another endowment, perhaps a university endowment, may follow more aggressive investment policies knowing that there is a steady flow of additional funds from future donors.

This tradeoff between return and risk is central to all asset allocation. It’s a genuine tradeoff even though some investors believe they can achieve returns without taking on risk. Asset allocation aims to find ways to make the tradeoff as attractive as possible. One key concept is the correlation between one asset and another. Almost every portfolio has substantial investments in both stocks and bonds because they tend to be low in correlation with one another. Many portfolios include both foreign and domestic assets for the same reason. Similarly, many portfolios include alternative investments such as real estate or commodities because they tend to have relatively low correlations with equities and bonds.

Investors should aim to form portfolios so that if one set of assets suffers low returns in a given period, perhaps another set of assets will provide higher returns. When the economy is booming, for example, equities tend to thrive as do other investments with equity-like characteristics. When the economy turns down, bonds tend to shine. Or perhaps there are equities from other parts of the world that do well.

Since Markowitz’s studies in the 1950s, portfolio management has focused on ways to maximize returns for any given level of risk.1 Investors should try to form portfolios that have the highest returns possible for that level of risk. But it’s just as important to minimize risk for a given target return. There may be several types of assets that would provide the target return, but there is usually a portfolio mixture of these assets that will minimize risk.

To develop such portfolios, it’s important for investors to have well-formulated estimates of asset returns. And perhaps more important are the estimates of risk and correlation. To obtain these, it’s not enough to just take long-run averages of each asset class. It’s important to study each type of asset in detail to understand why it has earned those returns and in what circumstances.

To show what this means, consider the two most basic assets, stocks and bonds. Investors need to ask how much equities or bonds can earn in the long run. We can certainly calculate long-run average returns for each asset class. But these long-run averages would be very misleading if inflation has varied over the sample period. If inflation is running over 10 percent per year, should an investor be pleased with a 12 percent return? So long-run estimates of returns should be done in real, not nominal, terms. But what period should we study?

If we were to examine bond returns in the 1980s to present, we would be enamored with bonds. They are terrific assets with high real returns and relatively little risk. In the long run, by which we mean periods stretching back through the post-war period or back to 1926 (when the Ibbotson SBBI dataset begins) or stretching back to the late nineteenth century, real bond returns are much lower.2 In those longer periods, real bond returns typically average only 2 percent to 2.5 percent per year. Should we base our estimates of future bond returns on the recent past or on longer periods of history? As explained in Chapter 2, the answer is that the last 30 years have seen a one-time capital gain on bonds as inflation has fallen from double-digits to current levels. Basing future estimates of bond returns on the recent past would be foolhardy.

What about stock returns? Again, the time period chosen is important. In Chapter 2, we will show that post-war stock returns are higher than they have been in the long run. And more importantly, stock returns have been inflated by a rise in price-earnings ratios that may not be sustainable in the long run. Asset allocation requires that the investor understand these assets enough to assess how well they will perform in the future.

INGREDIENTS OF ASSET ALLOCATION

Investing has evolved over the last few decades. First, there is the shift away from individual stock selection toward diversification of stock holdings. Instead of choosing the 10 or 20 best stocks for the portfolio, an investment advisor is more likely to make sure the portfolio is properly diversified between different types of stocks. More specifically, the advisor deliberately balances different styles of stocks, choosing both growth and value stocks and large-cap and small-cap stocks. One reason for this shift in the approach to investing is the realization that investment styles go in and out of favor. For several years or more, growth stocks may outperform value stocks and investors become enthusiastic about new technologies (as they did in the early 1970s and late 1990s). But then value stocks thrive, and investors must switch their allegiances. This shift toward style investing was also driven by the discovery that value stocks provide a value premium over growth stocks and that small-capitalization stocks provide a small-cap premium over large-cap stocks. These premiums will be analyzed in detail in Chapters 3 and 4. Chapter 3 will show how small-cap stocks fit into the overall stock market and will present evidence about whether there is a premium for small-caps. Chapter 4 will examine value and growth stocks and present evidence on the value premium.

In the 1980s, investment in foreign equities gained favor. Capital controls had been lifted making it possible for investors in the industrial countries to spread their investments to other industrial countries. In doing so, investors were able to invest in a wider variety of firms and industries than would have been possible by sticking to U.S. stocks alone. And, because correlations between U.S. and foreign stocks were relatively low, investors were able to reduce risks in the overall portfolio. By the 1990s, interest in emerging stock markets also increased. Chapters 5 and 6 will examine these investments and will show how they help to diversify U.S. portfolios.

Fixed income investments have evolved even more than stock investments. Forty years ago, Treasury and corporate bonds were dominant in fixed income portfolios (along with municipals for taxable investors). There were high yield bonds, but those were typically “fallen angels” rather than newly issued bonds. Mortgage-backed bonds didn’t exist because securitization of mortgages was just beginning. Today, Treasuries represent less than 16 percent of the U.S. bond market and corporate bonds another 20 percent. Chapter 7 examines this modern fixed income market in detail.

In Chapter 8, all of these traditional assets are combined in what we call a strategic asset allocation, a long-run portfolio allocation based on long-run returns. Modern portfolio theory has given us optimization methods that allow us to mix assets together in a portfolio in an optimum way. Many investors need to be able to estimate the expected return on a portfolio. For example, foundations need to estimate expected returns in order to formulate spending plans. And estimates are needed by individuals in developing their plans for saving for retirement and for spending during retirement years. This chapter will outline methods for estimating long-run returns for a diversified portfolio.

One of the themes of this book is that future capital markets are unlikely to provide investors with the high returns of the 1980s and 1990s. Bonds are likely to earn their long-run average (real) returns rather than the high returns experienced since the early 1980s, and stocks may not even reach their post-war average returns. So it’s natural for investors to look to alternative investments for salvation. There are many alternative investments that might entice investors. But four have gained most attention. These are hedge funds, private equity, real estate, and commodities. Chapters 9 through 12 will study each of these asset classes.

In the last 15 years, hedge funds have become very popular among wealthier individuals as well as many institutional investors. We don’t have much data on hedge fund returns and the data that we have available is not of high quality. Yet the asset class itself is fascinating to study because so many different investment strategies are represented. This is the ultimate investment for those who believe in alpha, the excess return attributable to investment expertise rather than systematic returns in the market or investment style. Chapter 9 will examine hedge funds.

Investors in private equity have privileged access to ownership in firms not available to the general public. By private equity, we usually mean investments in venture capital and buyout firms. Venture capital provides access to young firms with promising futures. These firms are typically in the technology or bio-technology sectors, but they can be in any industry and any part of the country. Buyout firms are partnerships that invest in older ...

Table of contents

• Cover
• Series
• Title Page
• Copyright
• Dedication
• Preface
• Acknowledgments
• About the Author
• About the Book
• Disclaimers
• Chapter 1: Asset Allocation
• Chapter 2: Long-Run Returns on Stocks and Bonds
• Chapter 3: Small-Cap Stocks
• Chapter 4: Value and Growth Investing
• Chapter 5: Foreign Stocks
• Chapter 6: Emerging Markets
• Chapter 7: Bonds
• Chapter 8: Strategic Asset Allocation
• Chapter 9: Hedge Funds
• Chapter 10: Venture Capital and Private Equity
• Chapter 11: Real Assets—Real Estate
• Chapter 12: Real Assets—Commodities
• Chapter 13: Asset Allocation with Alternative Investments
• Chapter 14: Investing and Spending by Foundations
• Chapter 15: Investing and Spending in Retirement
• Chapter 16: The Discipline of Asset Allocation—Rebalancing
• References
• Index