By Tim Pickering – CIO and Founder; Brennan Basnicki, CFA, CAIA, CMT, SCR – Director and Product Specialist, Partner; Auspice Capital Advisors Ltd, Calgary, Canada.
I often find analogies applicable in investing from other parts of life. Many come from general business and entrepreneurship, some come from life lessons. Some are well known and may even seem cliché, and some are more esoteric, the kind you learn the hard way.
A classic quote is that "Fair isn't everyone getting the same thing, fair is everyone getting what they need in order to be successful". In some ways I agree, in some ways, I don't, but in the case of being successful in life and business, it is important to recognize people all bring different talents, experiences and even potentials. If we treat everyone equal, where everyone gets the same, it is a recipe for mediocrity, or even failure as depicted in the picture. That may be fine to set a benchmark or average, but if you are wanting to rise above, achieve more, or have a successful business, you can't be average to stand out and thrive.
The same goes for investment returns. If we look at a basket of assets, even a very diverse basket, assigning equal weights is a recipe for underwhelming results. Most investors don’t invest equally 50:50 into equities and bonds, they opt for a 60:40 mix, recognizing the different roles and attributes of each.
However with the low-interest rate environment the forward utility of bonds has diminished, and alternatives are increasingly being sought. The merits of an alternative depends on the investment, and there are many choices. If we try to equal weight based off popular categorizations, we achieve very little. This was the initial experience for many institutional investors investing in anywhere from 8-15 categories of alternatives. As investors, we tend to approach portfolio construction from an equality standpoint, particularly with intra-asset class allocation. A 20% allocation to alternatives may be decided upon, and then each alternative allocated an equal weight, say 1/10th of the allocation, or 2% of the portfolio.
Allocating equal amounts feels good and is easy but achieves little in terms of diversification. Ultimately many investors simply receive repackaged equity beta at higher fees and lower volatility.
If we focus on an objective – maximizing for portfolio returns, we end up at a very different allocation. For example, consider the below simplified portfolios with equities (MSCI ACWI), bonds (BB US Agg), and CTA (AMFERI), rebalanced yearly since January 2007:
Per the table, the first step away from an equal stock/bond allocation to 60:40 improves returns but introduces higher volatility and drawdown. If we determine the optimal allocation for the highest returns, and ignore all other considerations, we arrive at an 80:20 equity/CTA allocation. If we collectively consider all attributes, importantly risk, we generally arrive somewhere consistent with the fourth example. This combination has the 2nd best returns and best risk metrics.
In our experience, this is almost often the case. CTA, be it Auspice or another manager/index, tends to heavily weighted in portfolio optimizations even when standalone returns are lower than other alternatives. An equal allocation to CTA and other strategies within an alternatives portfolio generally produces inferior results. An optimal allocation tends to overweight CTA, significantly. It is no surprise that some of the largest, most successful plans such as the California State Teachers’ Retirement System (CalSTRS) and the Employees’ Retirement System of the State of Hawaii (HIERS) have over 5% of their portfolio in CTAs as part of larger “Risk Mitigation Strategies (“RMS”) and “Crisis Risk Offset” (“CRO”) portfolios.
In order to be successful in portfolio construction, equal doesn't work, its arbitrary. Fair based on the attributes, role, and collective outcomes is a better path for an unknown future.
All posts are the opinion of the contributing author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CAIA Association or the author’s employer.
About the Author:
Brennan Basnicki, Director and Partner at Auspice, was in the first cohort to complete the Sustainability and Climate Risk Certificate (SCR) offered by the Global Association of Risk Professionals (GARP) in 2020. He has also completed four further certificates in climate action and sustainable finance.
Tim Pickering is Founder and CIO at Auspice, a quantitative investment specialist established in 2006 in Calgary. He was elected to the Board of the Calgary chapter of Pheasants Forever, a globally respected habitat organization dedicated to wildlife, land management, conservation, and education.
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