I’ll Take a Chair with Three Legs over Two, Please

Ever since the great financial crisis of 2008, investing has been easy. Since January 1, 2009, the S&P 500 has returned 15.0% and the Bloomberg US Aggregate Bond Index has returned 4.2%, annualized. 1 Anyone holding a 50/50 portfolio of stocks and bonds during that time would have received an annualized return of 9.6%!

With the S&P 500 setting record highs and interest rates dropping to all-time lows, are recent returns likely to persist? Each year, JPMorgan publishes capital market assumptions designed to “aid investors with strategic asset allocation…over a 10- to 15-year investment horizon.”2 For 2021, JPMorgan is assuming a 4.1% return for U.S. large cap equities and a 2.1% return for U.S. Aggregate Bonds. These figures suggest that a 50/50 portfolio would return approximately 3.1%, annualized, over the next 10–15 years. That would be a huge disappointment when compared to the 9.6% realized since 2009. Would such a modest return even keep up with inflation? What should a wise investor do now?

In this paper, we examine the two traditional, investable asset classes and the need for a third true alternative asset class. Then we recommend that investors include hedge funds in their portfolio to further diversify the source of returns, adding stability to the portfolio and thus improving the portfolio’s risk-adjusted rate of return.

Investable Asset Classes

We can generalize the investment world as having two main asset classes—fixed income and equity— defined by the primary risk they take:

  • Fixed income (credit risk free) is an investment that earns a contractual rate of return depending solely on the lending period (i.e., the interest rate risk). Interest rate risk is tied to the duration of the contract, and returns typically increase as the duration increases (i.e., as interest rate risk increases).
  • Equity is the ownership of any residual value after all liabilities are repaid, and its return is tied primarily to market growth (i.e., the market risk).

All other factors being equal, if you anticipate market growth, equities should provide a positive rate of return. This makes sense, given that equities are nothing more than the leftovers. If the market grows and liabilities are fixed, then market growth leads to more leftovers. On the other hand, if you anticipate that the market will shrink, the contractual rate of return of fixed income should be more attractive.

Thus, traditional portfolios are composed of these two traditional asset classes, each providing a positive rate of return but performing better under different market conditions (i.e., growing markets versus receding markets). They have worked well together historically, but they may not provide the portfolio stability going forward. The problem in today’s market environment is that both asset classes have low expected future returns and may be correlated to one another due to artificially low interest rates.

In a world in which we use only these two investable asset classes, investment asset allocation is challenging under the current circumstances. For example, how can anyone allocate money to fixed income with an expected return of only 2.1% and significant downside risk if interest rates rise? Ideally, we would have a third option: an investable asset that derives its return from an alternative, uncorrelated source of risk. The addition of such an asset to the portfolio can improve the risk/return dynamic. We need an investment that is not highly correlated with interest rates or the equities markets, but rather has an independent return, a.k.a. an “alternative asset.”

Alternative Investments

It seems everyone is selling alternative investments these days, but what is an alternative?

  • An alternative is an asset or strategy that provides a return unexplained by the price movements of equities and fixed income (a.k.a. equity market returns, or “beta”). It is often the result of one’s ability to identify and capture mispricings in the market or securities (i.e., “alpha” risk).

To be a good diversifier, an alternative investment must generate its return from something other than interest rate risk or market risk. In the world of high finance, a return not explained by interest rates or equity returns is called “alpha.” Thus, the true benefit of an alternative asset is the unexplained return (alpha) it provides.

Many of the most commonly offered “alternatives” are nothing more than substitutes for their public and more liquid brethren. Private equity, for example, is nothing more than an equity investment in a non-publicly traded company. Do private equity returns produce alpha? Yes, investing in private companies has historically yielded greater returns than those predicted by the market risk factor. However, a significant portion of private equity returns are simply levered equity market returns. Thus, it is more accurate to include private equity as a replacement for some portion of the public equity allocation than to view it as a true alternative asset. The same can be said for private real estate, private lending, etc.

Few alternative investments generate mostly alpha returns. Fortunately, we have a valuable alternative for adding alpha to a portfolio: hedge funds.

Hedge Funds

“Hedge fund” is the generic term applied to a private fund that produces returns via trading strategies or investments in securities. The basic characteristics of a hedge fund include the following:

  • A private partnership structure
  • A defined liquidity structure (usually quarterly)
  • A fee structure that includes a management fee (typically 1.0–2.0%) and an interest in the profits (typically 20%)

There are many hedge fund strategies, and their returns are derived from different proportions of market, interest rate, and alpha risk. Exhibit 1 briefly describes the most popular hedge fund strategies. Creating a true alternative asset class for a portfolio would require distilling a portfolio of alpha- generating strategies. This is easy to understand but difficult to do in practice, largely due to the common criticisms of hedge fund investing discussed below.

Criticisms of Hedge Funds

Hedge funds are subject to four common criticisms:

  • High fees
  • Complex structures
  • Lack of full investment transparency/attribution
  • Limited redemption availability

High fees are the most contentious argument against hedge fund investing. If you can inexpensively replicate the returns of hedge funds, then this argument holds weight. For example, many long/short equity hedge fund portfolios are net long equities resulting in returns driven primarily by equity market returns. It is certainly less expensive and easier to access market returns via an equity index fund or exchange-traded fund than via a hedge fund—but hedge funds provide a less expensive way to access alpha.

Research has shown that, on average, long-only equity managers underperform3,4,5 largely because they cannot generate excess returns after fees. Therefore, simply gaining exposure to the market return as inexpensively as possible is a preferred strategy for long-only equity investing. However, alpha returns are not market returns. Alpha returns are generated purely through the manager’s ability to generate returns not explained by the market. Thus, the fees paid to hedge fund managers should be compared only to the alpha they generate.

Consider this example: A hedge fund provides an 8.0% gross alpha return and charges a fee of 2.8%, thus netting a 5.2% alpha return. In this scenario, an investor is paying 2.8% for 5.2% of alpha, or roughly $1.00 for each $1.86 in alpha return. That math works.

Some may wonder, “Why would I pay 2.8% for a 5.2% net return when I can just invest in the SPY, earn 15%, and pay only 0.09% in fees?” But the logic is flawed as that analysis compares apples to oranges. The SPY doesn’t create any alpha return and is set up specifically to provide the equity market return.

To compare these two strategies, let’s assume SPY has a positive net alpha return of 0.01%. Using the same math as before, spending 0.09% to generate 0.01% of net alpha return means you pay $9.00 for each $1.00 of alpha return. In this example, we’re comparing apples to apples, and hedge funds appear less expensive than index funds. However, we must use hedge funds correctly for this to be a valid comparison.

The hedge fund world is broad and often opaque, leading us to the second criticism of hedge funds: their complexity. Indeed, hedge funds are complex, and understanding their trading strategies may require an advanced degree. This complexity may be a good argument against investing directly in hedge funds, but it is not a good argument against the hedge fund asset class. Professional management of a portfolio of hedge funds can provide the due diligence needed to mitigate the risk associated with the complexity of hedge funds. For this reason, many hedge fund investors rely on a professional allocator or a fund of funds to build a portfolio of hedge funds.

The third criticism of hedge funds focuses on their lack of transparency. Many hedge funds conceal their investments for competitive reasons, thus complicating oversight. However, large pools of capital are able to dictate terms around transparency and other factors, thereby receiving enough information to manage risk exposure. Such leverage is usually driven by the sophistication of the investor and the size of the investment (i.e., the larger the investment, the more likely the investor can dictate terms).

Limited liquidity is the fourth and final common criticism of hedge funds, but it is overcome through diversification. Redemption periods vary across funds and strategies; therefore, this risk can be managed by maintaining a fully diversified portfolio in which other sources of liquidity are available.

This review of the common criticisms of hedge funds reveals that a certain level of expertise and access is not only valuable but also required to build an effective, alpha-focused hedge fund portfolio.

The Best Way to Access Hedge Funds

The best way to access a diversified hedge fund portfolio is to secure the services of a professional to build a portfolio via direct investment (usually requiring a minimum of $50 million) or via a professionally managed fund of funds. A fund of funds is often criticized for layering fees on fees. However, professionals merit their fees; their ability to aggregate larger pools of capital and negotiate better terms may actually lower the cost of the underlying funds.

Given the forecasted low returns of stocks and bonds, the current market presents an opportune time to invest in hedge funds. When the two traditional asset classes are expected to provide low future returns, it makes sense to pursue hedge funds as a valuable alternative. Yet at the end of the day, it doesn’t matter how well the traditional asset classes are performing. Hedge fund performance is independent of them. Therefore, most qualified portfolios can benefit from the addition of well- selected, well-managed hedge funds.

Summary

Alternative assets represent a broad category of investments, and hedge funds are the best alternative for adding a truly unexplained source of return. Building a portfolio of hedge funds can distill the overall return primarily to “alpha”—a return not explained by interest rate or equity market risk. Adding alpha to a portfolio can further diversify the source of returns, adding stability and thus improving the portfolio’s risk-adjusted rate of return.

In today’s market environment with the S&P 500 setting record highs and interest rates dropping to all- time lows, adding an uncorrelated source of return in the form of hedge funds is not only prudent, but also necessary. Given the complexity of hedge funds, leveraging a professional is the best strategy for adding them to any investment portfolio.

Endnotes

  1. Annualized returns from January 1, 2009, through December 31, 2020.
  2. JPMorgan. (2021). Long-Term Capital Market Assumptions Matrices. Retrieved from https://am.jpmorgan.com/content/jpm-am-aem/emea/ch/en/adv/insights/portfolio- insights/ltcma/matrices.html.
  3. Jensen, Michael C. (1968). The Performance of Mutual Funds in the Period 1945-1964. Journal of Finance, 23, 389–416.
  4. Malkiel, Burton G. (1995). Returns from Investing in Equity Mutual Funds 1971 to 1991. Journal of Finance, 50, 549–572.
  5. Carhart, Mark M. (1997). On persistence in mutual fund performance. Journal of Finance, 52, 57–82.

Disclosures:
This information is provided, on a confidential basis, for informational purposes only and does not constitute an offer or solicitation to buy or sell any security. It is intended solely for the named recipient, who, by accepting it, agrees to keep this information confidential. An offer or solicitation of an investment in a private fund will be made only to accredited investors pursuant to a private placement memorandum and associated documents. There can be no guarantee that a client will achieve the intended investment returns or objectives. There are associated risks with all investments and those risks are described in the investment advisory agreement. The information contained in this material does not purport to be complete, is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Past performance is no guarantee of future results. Autumn Lane Advisors, LLC is not a law firm, CPA firm, or insurance agency and does not provide legal advice, tax advice, or insurance products.

© 2020 Autumn Lane Advisors, LLC. All rights reserved. This material may not be reproduced, displayed, modified, or distributed without the express prior written permission of the copyright holder. Send email requests to info@autumnlanellc.com.

The Tortoise, the Hare, and Modern Portfolio Theory

While watching my children run around the backyard this past weekend, my mind began to wander. I found myself reflecting on this crazy year. The funny thing is I also found myself thinking about how a fable illustrates one of the greatest values of modern portfolio theory. The events over the last 80+ days exemplify one of the benefits of diversification. Diversification facilitates a more consistent rate of return (i.e. a lower variance in returns). Aesop’s fable of the “Tortoise and the Hare” illustrates how consistently moving forward is better than the variable progress of the faster hare. These two concepts (diversification and lower variability) also help explain why I started Autumn Lane Partners.

Here are just a few news headlines from this year so far:

I doubt many of us knew these things would occur beforehand, just as I doubt any of us can predict whether or not Great Britain will leave the E.U. The unknown scares most people, so we often look for sage advice. When it comes to investing, many turn to Cramer or the other investment gurus of Wall Street. From my perspective, Cosmo Kramer would provide just as valuable of advice. I do not intend to demean market forecasters, but am simply pointing out that too many factors are at play to accurately and repeatedly predict the future of the overall market.

So, how should we invest in a world where the markets can fall 10% in the first 42 days only to then rally over 11% the next 42 days? The answer is simple and often repeated; we should build a diversified portfolio. The two reasons for this are:

  1. As demonstrated in the first quarter of 2016, we do not know what is going to happen tomorrow; and
  2. There is a cost to the variance of returns (said another way, there is a benefit to “slow and steady”).

It is the second point that Aesop’s fable does such a great job of illustrating. The concept we are discussing is “compound returns.” The power of compound returns is that we earn money on the profits of previous time periods. However, returns only compound if we made money in the previous period. If we did not make money or if we lost money in the previous period, there are no profits to compound. Thus, if returns vary from period to period, there is a cost associated with the possibility of failing to compound the previous period.

Aesop’s fable chronicles the great race between the tortoise and the hare. Although the hare is much faster than the tortoise, he loses the race because of his propensity to stop and nap. Whereas, the tortoise just keeps putting one foot in front of the other. Thus, slow and steady (modern portfolio theory) beats fast and variable!

Picture of the tortoise from Aesop's fable of the tortoise and the hare and the modern portfolio theory.

Let’s look at an example to show how this concept specifically applies to investing. In this scenario we have two investment options:

Portfolio 1 – a portfolio of a single investment:

Investment A returns 20% and 0%, alternating every other year.

Portfolio 2 – a 50/50 portfolio of two investments:

Investment A returns 20% and 0%, alternating every other year; and Investment B returns 19% and 0%, alternating every other year, and it earns 19% when Investment A earns 0%.

The results of investing $1,000,000 in each of these portfolios are:

Portfolio ACumulative Portfolio ValueAsset AAsset BPortfolio BCumulative Portfolio Value
Year 120.00%$1,200,00020.00%0.00%10.00%$1,100,000
Year 20.00%$1,200,0000.00%19.00%9.50%$1,204,500
Year 320.00%$1,440,00020.00%0.00%10.00%$1,324,950
Year 40.00%$1,440,0000.00%19.00%9.50%$1,450,820
Year 520.00%$1,728,00020.00%0.00%10.00%$1,595,902
Year 60.00%$1,728,0000.00%19.00%9.50%$1,747,513
Year 720.00%$2,073,60020.00%0.00%10.00%$1,922,264
Year 80.00%$2,073,6000.00%19.00%9.50%$2,104,879
Year 920.00%$2,488,32020.00%0.00%10.00%$2,315,367
Year 100.00%$2,488,3200.00%19.00%9.50%$2,535,327
Year 1120.00%$2,985,98420.00%0.00%10.00%$2,788,860
Year 120.00%$2,985,9840.00%19.00%9.50%$3,053,802
Year 1320.00%$3,583,18120.00%0.00%10.00%$3,359,182
Year 140.00%$3,583,1810.00%19.00%9.50%$3,678,304
Year 1520.00%$4,299,81720.00%0.00%10.00%$4,046,135
Year 160.00%$4,299,8170.00%19.00%9.50%$4,430,517
Year 1720.00%$5,159,78020.00%0.00%10.00%$4,873,569
Year 180.00%$5,159,7800.00%19.00%9.50%$5,336,558
Year 1920.00%$6,191,73620.00%0.00%10.00%$5,870,214
Year 200.00%$6,191,7360.00%19.00%9.50%$6,427,884
Average Annual Return10.00%9.80%
Standard Deviation10.00%0%
Compounded Rate of Return9.50%9.70%
Future Value at Year 20$6,191,736$6,427,884

The interesting thing about this simplified example is that although Portfolio 1 has a higher average return, it earns $236,148 less than Portfolio 2 over the 20 year period. This may seem counterintuitive. However, it is just like the hare losing  to the tortoise. Portfolio 1 can clearly run faster, but its variability has a cost. The cost of variability is the periodic lack of compounding. Portfolio 1 only compounds its profits every other year. Whereas, Portfolio 2 compounds every year. Slow and steady, while it may appear mundane, wins the investing race too!

The goal of modern portfolio theory is to maximize the expected rate of return for a given level of risk. Risk is measured by the variance in returns from what we expect (commonly we use standard deviation for this measure). We showed in  our example above that if we have two negatively correlated investments (i.e. whose returns move in the opposite directions), we can lower the volatility of the whole portfolio. By maximizing the return/risk dynamic, we decrease our portfolio’s return variance, and we increase our compounded return.

This is one of the key reasons that led me to start Autumn Lane Partners. Throughout my career I have built and managed many investment portfolios, and I noticed my larger portfolios typically outperformed the smaller portfolios on a risk- adjusted basis. I believe the explanation for this is two-fold:

  1. Larger portfolios can negotiate lower fees; and
  2. Larger portfolios have a wider selection of investment choices.

The first point’s effect is obvious. The second point deserves more discussion. One rarely builds a two asset portfolio like the one I used in my example. Instead, we build portfolios with multiple investments. Our goal is to find investments that are uncorrelated (i.e. whose returns are not dependent upon one another). By combining these uncorrelated investments, the resulting “diversified portfolio” has  a much lower variance. The key though is that each investment needs to be independent from the other (at least as much as possible).

The issue with smaller portfolios is that they have fewer investments from which to choose. Many potential investments are not available due to minimum investment requirements. For example, most of the hedge funds in which Autumn Lane  Partners invests have a $5 million minimum investment threshold. Thus, to  recreate the Autumn Lane Partners portfolio literally requires $100 million.

Wall Street’s solution to this problem is to settle. Rather than trying to build the optimal portfolio, Wall Street “customizes” the client’s portfolio to each investor’s limitations. In other words, after excluding all the investments one cannot invest in, Wall Street provides the optimal solution with what’s left…

I never liked this answer, and the sub-optimal solutions definitely played a role in explaining why our larger portfolios outperformed the smaller portfolios. It also explains why many wealthy families create investment partnerships to combine assets across entities and generations. The combined assets in these family investment partnerships can access more investments, as well as negotiate better fees. This is exactly what we built with Autumn Lane Partners. With a $100 million seed investor, we were able to strive for the optimal portfolio and use modern portfolio theory. And with our partnership structure, smaller portfolios can now get their pro rata share of this solution. The result is better diversification, a more consistent rate of return, and the resulting compounding effect. Slow and steady wins again.

Disclosures:
This information is provided, on a confidential basis, for informational purposes only and does not constitute an offer or solicitation to buy or sell any security. It is intended solely for the named recipient, who, by accepting it, agrees to keep this information confidential. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents. There can be no guarantee that a client will achieve the intended investment returns or objectives. There are associated risks with all investments and those risks are described in the investment advisory agreement. The information contained in this material does not purport to be complete, is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Past performance is no guarantee of future results. Autumn Lane Advisors, LLC is not a law firm, CPA firm or insurance agency and does not provide legal advice, tax advice or insurance products.

© 2020 Autumn Lane Advisors, LLC. All rights reserved. This material may not be reproduced, displayed, modified or distributed without the express prior written permission of the copyright holder. Send email requests to info@autumnlanellc.com.

Hank’s TAW and the Two Goal Allocation

The 2008 drawdown in the valuation of all risk-bearing assets highlighted a significant problem with the use of Markowitz’s efficient frontier to “optimize” a private client’s portfolio. The issue is that a private client’s risk tolerance is not constant. Not only does it adjust throughout life as cash flow needs and life expectancy change, private clients also tend to increase or decrease their risk tolerances when market conditions change. Unfortunately, this latter adjustment tends to happen in the wrong direction at the wrong time. If only people could follow Warren Buffett’s suggestion to “be fearful when others are greedy and greedy when others are fearful.” Let’s dive in further to the two goal allocation.

This paper’s goal is to combine behavioral finance and modern portfolio theory to improve a private client’s investment returns over a full investment cycle. The idea is to use a common behavioral bias, mental accounting, to enable the maintenance of a constant risk profile. Simply put, private clients should manage separate portfolios to meet two independent goals: 1) lifestyle spending needs and 2) long- term or dynastic wealth creation. With two constant risk profiles, the portfolios are easier to maintain, resulting in superior returns and higher utility to the private client investor.

Most people approach investing and portfolio management like a roll of the dice or a game of marbles.

Introduction

In the game of marbles, the shooter marble is also referred to as the “TAW.” During  a discussion with one of my clients, he mentioned he was creating a new  partnership called “TAW.” He went on to lay out a conservative investment policy for this partnership. He explained the peculiar name by quoting a piece of advice from his father, “never lose your ‘TAW’ when playing marbles, that way you can always play another game.” So, this new partnership was my client’s investment “TAW,” and I was told to never lose it because he wanted to keep playing.

The TAW partnership provided a specific benefit. It allowed us, his financial advisors, to design a long-term and growth-oriented portfolio for the surplus assets. These surplus assets were not managed for our client per se, but for his children, grandchildren, and the family foundation. He had effectively subdivided his assets into a lower risk portfolio and a long-term growth portfolio.

The above story helped clarify an idea that had been bouncing around in my head; an idea that would facilitate a positive investment outcome via a common behavioral bias – mental accounting. A clear example of mental accounting is that of a person who walks into a casino and says “as long as I leave with the cash in my left pocket, I am ok.” He then goes on to gamble with the cash from his right pocket. What is the difference between the cash in the two pockets? Nothing is different except for the way the gambler feels.

This bias becomes more evident with winnings. When a person wins in a casino, he will often gamble more aggressively with his winnings, which he refers to as “the house’s money.” However, it is not the “house’s money;” it is his money. He could safely walk out of the casino without security tackling him. So why is he more comfortable to lose his winnings? All this person has done is mentally separated the money into buckets.

The drawdown in the valuation of all risk-bearing assets during the winter of 2008/2009 highlighted a significant problem with the use of Markowitz’s efficient frontier to “optimize” a private client’s overall portfolio. The issue is that a private client’s risk tolerance is not constant. Not only does it adjust throughout life as cash flow needs and life expectancy change, private clients also tend to increase or decrease their risk tolerances when market conditions change. The dynamic nature of a private client’s risk tolerance in relation to market conditions can be linked to the bias of mental accounting.

When markets are good and investors are making money, they say “let it ride!” In their minds, they are only playing with the gains of the past… Unfortunately, this increase in risk tolerance tends to happen at the wrong time, just as many assets are becoming overvalued. If only people could follow Warren Buffett’s suggestion to “be fearful when others are greedy and greedy when others are fearful.”

Through the combination of behavioral finance and modern portfolio theory, we can improve a private client’s investment returns over an investment cycle. The crux of the idea is to use the common bias of mental accounting to facilitate the maintenance of a constant risk profile. With a constant risk profile, the private client’s portfolio is easier to maintain and would ultimately deliver better returns and a more satisfying investment experience.

Behavioral Bias – The Good, the Bad, and the Ugly

Richard Thaler use to write a column in the Journal of Economic Perspective entitled “Anomalies” in which he began each article with the following statement:

Economics can be distinguished from other social sciences by the belief that most (all?) behavior can be explained by assuming that agents have stable, well-defined preferences and make rational choices consistent with those preferences in markets that (eventually) clear. An empirical result qualifies as an anomaly if it is difficult to “rationalize,” or if implausible assumptions are necessary to explain it within the paradigm…

In the most recent market downturn, we are all reminded of the fact that private client investors suffer from loss aversion; private client investors are more sensitive to losses than they are to gains of equal magnitude. I have heard economists say this is irrational and suggest that private clients should be able to stare down losses and rebalance their portfolios when asset classes underperform. However, for those private clients who will likely use this wealth for future consumption, the risk of

additional losses is likely more important than equal future gains. Such losses could affect their lifestyle. In my mind, loss aversion is not irrational but rather a rational fear based on the well-defined preference to maintain a specific lifestyle.

Thus, in this world of loss aversion, how can financial advisors convince private clients to hold the line? How can we convince them that the efficient portfolio created by mean-variance optimization will deliver the best results over an investment cycle? This is an extremely difficult argument for any financial advisor  to convincingly make. For instance, what if the investment cycle’s duration is longer than the period in which a private client can hold their risk tolerance constant. Financial advisors are taught to use time horizon as a factor in determining a client’s ability to take risk. However, this time horizon shrinks with age (assuming the assets are used by the client and not left for future generations or charity).

This leads us to the question of how long is the investment cycle? Although this paper does not cover this topic in detail, I should point out there is much debate as to the actual length of an investment cycle. Many people point to data from the National Bureau of Economic Research showing there have been 10 cycles from 1945-2001, with an average duration of 67 months between peaks. However, an investment cycle may span multiple economic expansions and contractions. If we cannot define exactly how long an investment cycle is, how can a financial advisor possibly recommend a single efficient portfolio to meet his/her client’s future goals?

The answer is that most private clients should not utilize a single portfolio. Instead, they should create a lower risk portfolio (“TAW” or “Lifestyle” portfolio) and a higher risk portfolio for the remaining assets (“Legacy” or “Dynastic” portfolio).

The Lifestyle Portfolio

One benefit of dividing the goals of the private client into two distinct buckets is the simplification of risk profile discovery. Private clients may not know how much “volatility” they can stand, but they will likely know how much money they spend now and wish to spend in the future. Thus, with an assumption for expected inflation, we can quickly identify the amount needed to meet this goal. If there is a “capital preservation” goal in addition to the cash flow goal, we can account for this by adding a terminal value greater than zero.  Either way, a simple annuity formula is used to calculate the present value of the necessary portfolio:

PV = (C / i) x (1 / (1+i)n) + FV/(1+i)n

Where “PV” is the present value of the required capital, “C” is the annual cash flow requirement, “i” is expected inflation, “n” is the number of periods, and “FV” is the capital preserved until time n.

Now that we have the size, we can focus on the asset allocation and implementation of the Lifestyle portfolio. This portfolio will obviously lie on the left side of the efficient frontier (i.e. conservative side). Its main purpose is to:

  1. Meet the real income needs of the client; and
  2. Preserve capital.

The three main risks with which this portfolio is concerned are market risk, credit risk, and purchasing power risk due to inflation. Since the lifestyle portfolio will produce income, taxes will also affect the allocation of the portfolio. Thus, I will make three general recommendations for taxable investors:

  1. The majority of the portfolio should consist of high-quality fixed income securities;
  2. The fixed income portfolio should have a short to intermediate duration (2.0-4.0 years); and
  3. Some allocation to US equities, real estate investments trusts, and other risky assets may be suitable to hedge against unexpected inflation and to produce income.

Optimal versus Suboptimal Allocation

The most obvious argument against the creation of two distinct portfolios is that the average of the two portfolios would lie below the efficient frontier. This is easily illustrated with a graph. Figure 1 shows that a combined portfolio of a low-risk lifestyle portfolio with a more aggressive dynastic portfolio would fall somewhere along a linear line connecting the two portfolios, thus creating a suboptimal total portfolio.

Figure 1.

This chart show the optimal versus suboptimal allocation of two different types of portfolios. A lifestyle portfolio and a dynastic portfolio.

The simplest defense against the claims of inefficiency is whether or not the comparison frontier is actually efficient itself. There are many assumptions that could adjust the location of the curve, most notably return and covariance.

We could also set about trying to appease the MPT disciples by creating two portfolios as described above, identifying the volatility of the aggregate portfolio, reallocating to the efficient frontier assuming that specific volatility, and then splitting the portfolio into two separate buckets again. In other words, we back into the average risk profile of the client and then split the allocation back up again into a conservative and more aggressive bucket. The problem with this idea  is determining which assets move to the Lifestyle Portfolio versus the Dynastic Portfolio. If we set the aggregate portfolio on the efficient frontier, the Lifestyle and Dynastic portfolios are now off the curve and cannot be easily modeled utilizing a mean variance optimizer. Thus, this strategy creates more questions in order to solve a problem that may or may not truly exist.

A final argument for the two-portfolio allocation or two goal allocation goes back to the behavioral biases of private client investors. Assuming that the average portfolio created by the two- portfolio allocation is inefficient, would one rather have an inefficient portfolio that remained fully invested or an efficient one (at least originally efficient) that changed risk profiles mid-investment cycle due to fear or euphoria? It may just come down to selecting the best of two imperfect choices. For a more complete discussion of goal-based asset allocation and its relative efficiency, I would refer you to Jean L.P. Brunel’s paper entitled, “How Sub-optimal – If at All – Is Goal-Based Asset Allocation?” (Journal of Wealth Management, Fall 2006, Vol. 9, No. 2: pp. 19-34).

Conclusion

The Markowitz efficient frontier does provide the optimal portfolio for long-term assets. However, the optimal outcome requires investors to retain their portfolio’s risk level throughout an entire investment cycle. Since private client  investors suffer from loss aversion and other behavioral influences, the theoretical outcome is rarely attained.

Using goal-based asset allocation, private client investors can take advantage of behavioral bias, mental accounting, to facilitate the maintenance of a constant risk profile throughout the investment cycle. Specifically, the two-portfolio or two goal allocation provides several other key benefits:

  1. A simpler way to define one’s risk profile;
  2. A lower level of anxiety during market drawdowns; and
  3. A more capital appreciation focus for the Dynastic portfolio.

Disclosures:
This information is provided, on a confidential basis, for informational purposes only  and does not constitute an offer or solicitation to buy or sell any security. It is intended solely for the named recipient, who, by accepting it, agrees to keep this information confidential. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents. There can be no guarantee that a client will achieve the intended investment returns or objectives. There are associated risks with all investments and those risks are described in the investment advisory agreement. The information contained in this material does not purport to be complete, is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Past performance is no guarantee of future results. Autumn Lane Advisors, LLC is not a law firm, CPA  firm or insurance agency and does not provide legal advice, tax advice or insurance products.

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