The challenge with traditional asset allocation today is not the concept itself, it is the implementation and sizing of the investments inside of the allocation.
When constructing an equity allocation, many Wall Street firms focus on constructing a portfolio around “the efficient frontier.”
In “theory,” the efficient frontier blends various asset classes into a portfolio that will generate the highest possible return with the least amount of risk. The two data points needed to plot where an asset class sits on the frontier are past performance and standard deviation (volatility). The equity asset classes most often used in the wealth management industry for efficient frontier investing are U.S. Large, Mid and Small Cap, Developed International, Emerging Markets and potentially Real Estate Investment Trusts. Theoretically, a proper mixture of diverse equities along the efficient frontier line will give investors more returns for less risk.
IN THE REAL WORLD OF INVESTING, when markets sell off, all equity assets tend to correlate to one (they all go down together). Equity returns are lumpy and discontinuous. Volatility is the price of admission for equity investors. Rather than trying to control the volatility of equities, volatility should be understood and allocations to equities should match individual risk tolerances.
In addition, most investment models are stuck in tight ranges around their own efficient frontier and are not open to the idea of eliminating entire asset classes, but instead will slightly overweight and underweight positions. We believe it is as just as important what our clients do not own versus what they do own: what happens when we do not like an asset class? For example, if we think international will underperform U.S. equities, we will eliminate international equities, versus the standard practice of only underweighting international. Why would one want to allocate dollars to an asset class they think will underperform? We run a best ideas portfolio, centered around low-cost, tax efficient, factor-based strategies.
Understanding that asset allocation is both art and science, we will continue to construct equity portfolios around our best ideas, versus an efficient frontier that works in theory but not in practice.
Alternatives are typically defined as investments other than stocks and bonds. While the definition is broad, our focus is narrow. While not without their own unique risks, we believe there are opportunities for outsized, risk-adjusted returns in niche illiquid strategies where managers have a deep knowledge of a business or market segment.
We have the experience and expertise to source these types of investments along with the platform to implement them.
i St. Louis Federal Reserve, August 2000
ii St. Louis Federal Reserve, August 2020