The new paradigm of portfolio construction

Today’s investment vehicles can help better deliver what clients truly seek. – By Evan Cooper @ Investment News



Current thinking about the best way to construct investment portfolios stems from seminal events in 1952, 1993 and 1605. Yes, 1605.

That was the year when perhaps the cornerstone of portfolio construction — the value of diversification — first was articulated in print. While the context had nothing to do with securities, because they didn’t yet exist, Miguel de Cervantes observed in his classic novel “Don Quixote” that “it is the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.”

A more contemporary and securities-specific perspective on diversification, and one that revolutionized portfolio construction, came in 1952 when Harry Markowitz introduced Modern Portfolio Theory. Honored for his work with the Nobel Prize in Economics, Markowitz emphasized the importance of diversification and posited that risk-averse investors can construct portfolios to maximize their expected return based on the level of market risk they wish to assume. The zone of acceptable trade-offs was termed the “efficient frontier.”

When put to use in portfolio construction, the Markowitz view of risk as directly proportional to the variability of returns bolsters the diversification argument made by Cervantes centuries earlier. An investor who owns only equities, for example, has the potential to earn considerable returns, but since stock prices are so variable, loading up on stocks is risky. Ergo, dialing down stocks and adding some bonds and real estate, whose prices tend to zig when equity prices zag, can reduce portfolio risk.*

In recent years, new developments in economic theory and in securities themselves have further widened our thinking on the value of diversification and risk management in portfolio construction. One big change has been the emergence of the body of knowledge known as behavioral finance, which contrary to the assumption in classical economic theory that investors are rational, has demonstrated that investors also are irrational. This results in them tending to buy high, sell low and misperceive risk, and also leading them to make portfolio choices and decisions that are not always in their best long-term interests. In constructing portfolios for their clients, therefore, financial advisers must take into account that an optimal portfolio based on objective criteria may not necessarily be suitable or “best” in the context of the client’s actual risk tolerance as demonstrated by their reaction to actual market declines, not questionnaire responses.

Another change has come in the form of investment vehicles themselves. The increasing popularity of mutual funds in the 1960s, 1970s and 1980s made portfolio diversification among asset classes and within asset classes much easier to achieve than when investors largely had to choose among individual stocks and bonds. The mid-1970s also saw the creation of the first passively managed index mutual fund, which enabled investors to capture the performance of the broad market at low cost.**

A major innovation leading to changes in portfolio construction came in 1993 with the launch of the first U.S. listed exchange-traded index fund — the SPDR S&P 500 ETF Trust — which built on the diversification advantages of conventional index mutual funds by lowering costs further and by providing more flexible trading choices. This was followed by the introduction of more targeted and complex exchange-traded securities, including smart-beta ETFs, in which stocks are selected based on particular factors, such as lower valuation, smaller capitalization or lower volatility. Since stocks characterized by such factors have tended to outperform other stocks over time, smart beta funds have become increasingly popular.***

Employing today’s innovative financial vehicles in addition to traditional investments, advisers now can create portfolios, or use portfolio models devised and managed by experts, that are diversified by asset class and within asset classes and better match an investor’s true risk tolerance. In fact, many advisors now use a “hub and spoke” approach to portfolio construction in which a mix of broad and narrow exchange-traded index funds serve as a core to deliver market returns at low cost, while a variety of actively managed funds, direct investments and alternative investments are used in an effort to generate above-market and non-correlated returns.

These and other portfolio construction strategies use today’s investment vehicles to attain the diversification and level of risk that advisers — working with clients — deem optimal. Using modern tools that build on the insights of earlier thinkers, today’s advisers have a new paradigm for portfolio construction.