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What to Own is Important, Where to Fund is Just as Critical

Keel Point
September 30, 2018

What to Own is Important, Where to Fund is Just as Critical

Our clients and friends have read our thoughts on risk from a few angles by now in these Investment Bulletins. It is a frequent topic because we view it as the most important. Previous discussions have usually centered around the risk of the overall portfolio; this month we wish to go a layer or two deeper. We want to relay how we think about funding and benchmarking asset classes and strategies, especially alternative strategies, with a risk driven process. The flow of the piece begins with a recap on how we think about high level portfolio construction and then pivots to discuss asset classes and strategies, with the Keel Point Tactical program providing an interesting case study in this regard.

For us, portfolio construction starts with risk. If we can collectively decide on the appropriate amount of risk that your portfolio should take, we can translate that into a risk-equivalent benchmark portfolio. “Risk-equivalent” solves for the combination of two highly diversified and easily investable assets – global stocks and US investment grade bonds – that have historically experienced your selected level of risk. The combination serves as the portfolio benchmark.

Our objective is to improve on the results of the benchmark over the long-term. To do so we must reweight the stocks and bonds in the benchmark and/or add assets or strategies outside of the benchmark. Whenever we overweight or include non-benchmark strategies, we must decide what to underweight (what to sell) to fund our tilt. For example, we may decide to overweight emerging market stocks. This decision requires us to own less of another category within, or sell a pro-rata slice of, the benchmark MSCI All Country World Index (“ACWI”). Or we may decide to own high yield bonds, which are not a component of the Barclays Aggregate Bond Index (“Agg”); to do so we must decide where to free up the capital to execute this tilt.

For those with finance backgrounds, this exercise may strike you as similar to your process to identify the cost of capital for a project. To break ground, you needed an expectation of a positive net present value. Discounted cash flows from the project must exceed your cost of the capital locked up in the project. So it goes for portfolio management – we add asset classes and strategies that we expect will outstrip our cost of capital (the expected return of the corresponding benchmark asset). Those with an economics background might recognize this in “opportunity cost” terms. Our term of art is “risk funding”. It relates to both how we fund an asset class or strategy and how we benchmark its results.

Perhaps the most challenging risk funding decisions are posed by alternative strategies. The same cost of capital concept applies, but the math often demands a blended funding of stocks and bonds to properly account for the characteristics of the new strategy. This is because many alternatives contribute partial equity risk to the portfolio. Not quite enough to fund from global stocks, but too much to fund from bonds. Further complicating the math, these properties can vary through time. The secret sauce is selecting the right combination of stocks and bonds.

To understand why, revert back to the portfolio benchmark. If we add an alternative strategy with a poor understanding of the amount of equity and/or bond risk it exhibits, we are likely knocking the total portfolio off the risk level you chose. Let’s say you started with a growth portfolio (75% ACWI and 25% Agg) to which we added 10% in a new strategy by selling 10% in equity. However, it turned out that the new strategy had risk characteristics more like a 60% ACWI, 40% Agg blend. The result is an under-risked total portfolio – we end up with a 71% ACWI, 29% Agg blend. (The math is 65% left in the ACWI plus 6% more coming through the new 10% strategy equals the 71% at the portfolio level.) Avoiding these errors requires a high degree of confidence that whenever we deviate from benchmark we do so in a risk neutral way.

Risk neutrality is easiest when it comes to pure stock or bond replacements. This category includes assets in our equity, fixed income, and defensive alternatives. Risk funding and benchmarking tie to the ACWI or the Agg. This may be counterintuitive for defensive alternatives as they have little to do with bonds, but they share the same goal of diversifying equity and thus take their risk funding from bonds. These strategies include many equity market neutral hedge funds, global macro funds, managed futures, reinsurance, and precious metals.


Case Study: KP Tactical

Let’s go into more detail on cases requiring a risk funding blend of stocks and bonds by studying the Keel Point Tactical program. Tactical combines a risk lever, which increases portfolio risk in environments scored as favorable for risk assets or decreases risk in unfavorable environments, and a relative strength methodology for selecting sector and regional ETFs. When deciding on funding we have both challenges previously mentioned – partial equity risk and properties that change through time. We have applied multiple analytical techniques to the problem and arrive at a view that 60% ACWI, 40% Agg is the right blend.

Figure 1 shows how Tactical has performed against its 60/40 funding source. Since the beginning of 2016, tactical (the blue line) has earned $124 for each $100 invested. This compares favorably to the $122 generated by the 60/40 portfolio (green line). The comparison (as well as the one made in Figure 2) is net of a 1% annual management fee. Importantly, the chart shows visually that risk has been about the same. If it were much different we would see one line bouncing around more wildly than the other. Statistics also confirm the risk near-equivalence – Tactical has a 5.8% standard deviation of returns while the 60/40 is at 5.3%.

We pause for a moment to discuss what this means. If you embarked in the Tactical program at the beginning of 2016 with proper risk funding, you would have swapped $60 of stocks and $40 of bonds for your new Tactical strategy. The result since then is a portfolio that experienced about the same risk as if you had not made the swap. A bad result could have been swapping $100 of bonds for Tactical – this would have added risk to the portfolio, which wouldn’t have been a problem in this particular period, but certainly held the potential for a nasty surprise if we had experienced an equity drawdown. At the other end of the spectrum, a $100 stocks for Tactical swap would have decreased portfolio risk. Over this period that would have left real money on the table as less upside was captured.

Getting the risk funding correct is critical. Understanding whether out- or under-performance to the risk funding benchmark is normal or concerning is also important. We illustrate this concept with rolling twelve month returns for both Tactical and its 60/40 funding in Figure 2. In the course of outperforming by 2% since 2016, the strategy has gone through periods of better and worse performance versus the 60/40 blend. The weakest period ended in June 2017 – Tactical underperformed by 4%. You can see its blue line meaningfully below the green line in that period. Conversely, the strategy has led by as much as 5% in the twelve months ending in June and August of this year.

We think this is about right for the strategy: plus or minus 5% relative performance over twelve month periods is normal. Other assets or strategies may see wider dispersion around their funding source. Knowing the range helps when a strategy struggles (and they all do at some point). It may have been difficult to stick with Tactical in June 2017 when it had earned $110 versus $113 for the 60/40 blend. Capitulating then would have forfeited a further $14 in gains to date versus just $9 in the blend.

The principles at work here – calibrating portfolios to risk target, deviating from benchmark with thoughtful risk funding decisions, and formulating a view on reasonable deviations from the risk benchmark – are all part of a process which gives us confidence in portfolio construction. We hope this information gives you a better understanding of the thought process that goes into portfolios and welcome any questions these thoughts may have triggered.□


This material is distributed for informational purposes only.

The investment ideas and expressions of opinion may contain certain forward-looking statements and should not be viewed as recommendations, personal investment advice or considered an offer to buy or sell specific securities. Data and statistics contained in this re-port are obtained from what we believe to be reliable sources including Bloomberg, but their accuracy, completeness or reliability cannot be guaranteed. An index is an unmanaged weighted basket of securities generally representative of a certain market or asset class. An investment cannot be made directly in an index. Our statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. No conclusion should be drawn from any chart, graph or table that such illustration can, in and of itself, predict future outcomes. You may request a free copy of Keel Point’s Form ADV Part 2, which describes, among other items, risk factors, strategies, affiliations, services offered and fees charged.


Past performance is not an indication of future returns.

Securities offered through Keel Point Capital, LLC, Member FINRA and SIPC. Investment Advisory Services are offered by Keel Point, LLC an affiliate of Keel Point Capital. Keel Point does not give tax, accounting, regulatory, or legal advice to its clients.  The effectiveness of any of the strategies described will depend on your individual situation and on a number of complex factors.  You should consult with your other advisors on the tax, accounting, and legal implications of these proposed strategies before any strategy is implemented.


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