Exploring The Total Portfolio Approach

It's time to stop missing the forest for the trees

This is the second post in what I think is going to be a three post series. You can read the first here.

I became a CAIA (Chartered Alternative Investment Analyst) Charterholder 10 years ago. At the time, it had nothing to do with my day job, but I thought the material was interesting so I took all the exams and paid the fees to join. Over these past 10 years, I’ve been to some good events and met some good people, but it was never really that central to what I was trying to do in my career. Recently, though, that has all changed, as the CAIA Association is at the forefront of the two biggest trends in the investment management industry:

1. Retail Alternatives — this is not the focus of this post, and I’m sure I’ll revisit this again in the future, so I’m just going to mention it here and then not elaborate. If you really want to know more now, I found this podcast series informative.

2. Total Portfolio Approach — Total Portfolio Approach (TPA) allows for opportunism – investing with a mindset of what is the best investment right now for the overall portfolio, while maintaining allegiance to the portfolio risk budget. The most sophisticated institutional investors are on board with this approach and are pushing the thinking forward.

I bring all this up because understanding the Total Portfolio Approach is key to building the convex portfolio I talked about in the first piece in this series. If you recall, the author of the Convex Strategies is seeking to build a portfolio that gains more when the market goes up than it loses when the market goes down.

In a traditional institutional-style portfolio, the investment team would determine a strategic allocation across a number of buckets (categories of investment) and then seek to maximize the return within each bucket.

So, in the Hedge Funds bucket, the investment team would try to construct a portfolio of hedge funds with the highest possible risk-adjusted returns. What the Total Portfolio Approach says is that it might make more sense to maximize risk-adjusted returns at the portfolio level, and that might mean trying to achieve different goals within the buckets.

So, rather than maximizing risk-adjusted hedge fund returns, it might make more sense to invest in a hedge fund strategy that provides a diversifying alpha stream — something that performs best when equity markets go down — even if its overall expected returns are lower than a strategy that tracks equity markets more closely.

Convex Strategies references a joint JPMorgan Asset Management and GIC (one of Singapore’s sovereign wealth funds) piece that looks at this question in more detail. They find that the portfolio of hedge funds you would construct if you were trying to maximize the return of your hedge fund bucket is different than the one you’d build if you were trying to maximize the return of your overall portfolio.

They go on to say

the key takeaway from this case study is the difference between the two approaches – the hedge fund Standalone optimal mix and the Integrated optimal mix. Comparing the two, we observe that a standalone-designed hedge fund mix tends to have more exposure to high beta types of managers (Equity Complement and Equity Substitute), to reach a desired absolute return. The total portfolio optimised, or Integrated hedge fund mix, on the other hand, tends to have more exposure to diversifying hedge funds (Loss Mitigation) and gain equity beta exposure directly from global equity investment. Intuitively, this illustrates the simple concept that the cheapest and most direct way to obtain equity beta is via investing in global equities. Accessing it via embedded equity beta from hedge fund managers is only desirable if these managers provide bigger alpha. However, as shown in the earlier section, alpha tends to be higher for low beta hedge fund groups and lower for high beta groups.

Looking at the overall portfolios you’d construct when using the two approaches, it becomes clear that the Total Portfolio Approach gives a better overall portfolio, even if the Hedge Funds bucket is not risk-return optimized.

Ok, that was a lot of pretty dry material. You’re probably wondering why I’m telling you all of this. Well, I needed to set the stage for the third part of this series — the one where I convince myself to YOLO long Bitcoin. I think I have some pretty good reasons to do this, but they’re all reliant on taking a Total Portfolio perspective, so I wanted everyone to understand where I’m coming from. There’s a lot more to the Total Portfolio Apporach than what I described here, so if you’re interested I urge you to check out the CAIA materials I linked at the top. Otherwise, I’ll see you next time, when we take the convex portfolio to velocidade cinco.