Portfolio Construction for Today's Markets: A practitioner's guide to the essentials of asset allocation

By Russ Koesterich

For most of the past 50 years the simplest asset allocation solution was often the best. A balanced portfolio of stocks and bonds provided the investor with good returns. Unfortunately, this approach is not likely to work as well in the future. Interest rates are close to historic lows, equity valuations and bond prices appear stretched, and global economic growth has slowed. Investors need a new asset allocation solution.

In Portfolio Construction for Today's Markets, BlackRock Portfolio Manager and investment expert Russ Koesterich addresses this problem by describing the step-by-step approach to building a portfolio consistent with investor goals and suited to today’s market environment.

This portfolio construction process is divided into six stages, beginning with setting objectives and moving through assessing risk tolerance, diversification, the importance of factors, generating return assumptions, and combining assets in a risk-controlled manner. In the final chapter, Mr Koesterich presents a highly useful summary of the five fundamental rules of asset allocation and a five-step checklist to follow when constructing portfolios.

For investors and their advisors constructing portfolio in today's markets, this book is an indispensable new guide.

• Language: English
• Publisher: Harriman House
• Release date: Apr 27, 2018
• ISBN: 9780857196309

Book preview

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Contents

About the author

Preface

Introduction

Chapter 1. Money for Nothing: The Challenges of a Low-Rate World

Chapter 2. Investment Therapy: Setting Objectives, Removing Constraints

Chapter 3. The Cost of a Good Night’s Sleep: Considering Risk

Chapter 4. Not Dead Yet: Why Diversification Still Matters

Chapter 5. A New Lens: How Factors Drive Performance

Chapter 6. Math and Magic: How to Forecast Returns

Chapter 7. Some Assembly Required: How to Build Portfolios

Conclusion

Index

About the author

Mr Koesterich is a financial services veteran with 22 years’ experience in the industry. Since 2005 he has worked at Barclays Global Investors and BlackRock, the world’s largest asset manager, with over $6 trillion in assets.

Mr Koesterich is currently a Portfolio Manager of the BlackRock Global Allocation Funds. In that capacity Mr Koesterich is responsible for driving asset allocation and risk management for BlackRock’s largest investment team, managing approximately $80 billion. Prior to his current role Mr Koesterich served as the Global Chief Investment Strategist for BlackRock as well as the Chief Investment Strategist for the iShares business, the world’s largest provider of exchange traded funds (ETFs). Prior to joining BlackRock (then BGI) in 2005, Mr Koesterich was the Chief North American Strategist for State Street Global Markets in Boston.

Mr Koesterich is a frequent contributor to the financial news, including CNBC, Bloomberg, and Fox Business television, the Wall Street Journal, Financial Times and MarketWatch. He is the author of two previous books.

Mr Koesterich holds a BA from Brandeis University, a JD from Boston College Law School and an MBA from Columbia Business School. He is also a Chartered Financial Analyst (CFA).

Preface

What this book covers and who this book is for

Since coming out of the financial crisis in 2009, investors have had both the best of times and the worst of times. Stock markets have soared, helping create significant wealth for those who have stayed invested. Others have struggled, sitting in cash awaiting a return to a more normal rate environment.

The financial advisor is caught in the middle. Some clients are perpetually enraged that their multi-asset class portfolio is not keeping up with hot tech stocks. Many older or more conservative clients are facing a completely different challenge: low, and sometimes negative, interest rates defy both logic and experience. For the latter group, many keep searching for that now almost mythical 5% yield, a level that many investors view as a virtual birthright.

This book will hopefully offer a solution for both sets of clients – those shooting for the moon and those just looking to fund their retirement.

My approach is to tackle the challenge of asset allocation through the lens of portfolio construction. What’s the difference? To my mind portfolio construction is to asset allocation what engineering is to physics: the practical application used to build actual things. In this case, what we’re looking to build are portfolios geared towards achieving client goals.

That is a tall order in itself. It is also a long-term goal. As such, there is little here to tell an investor whether emerging market stocks or silver futures will outperform next year. I’ve also intentionally avoided questions regarding implementation. Many investors are still struggling to decide whether to focus on actively managed mutual funds or exchange traded funds (ETFs) that simply try to mimic an index. The short answer is, you can use both. While the choice is not trivial, the first and to my mind more important question is: can you build a robust asset allocation?

Given that goal, the reader can approach this book in two ways. First, I’ve provided a relatively simple, step-by-step approach to portfolio construction. A second group will come to this book with their own predispositions and methods. That is fine as well. There are many ways to forecast returns, estimate risk and put the pieces together. For this second group I would still recommend the book, but less as a manual and more as a manifesto. Even for those who feel comfortable with their own methods, hopefully the book can serve as a reinforcement of a few key principles: the primacy of risk, the need for explicit investment goals and a healthy appreciation of why it is difficult to forecast returns.

In the end, both the advisor and end client are left with the unavoidable reality that excess return requires risk. That said, hopefully the book will provide some insight on how to minimize and manage that risk. A properly constructed portfolio should lead to fewer panicked, late-night phone calls. More importantly, it will help prevent clients from abandoning long-term plans. To the extent a better designed portfolio will help mitigate the biggest risk – the risk of giving up and hiding under the mattress – both the client and advisor benefit.

How this book is structured

I have arranged the book as seven chapters that trace the different areas someone constructing a portfolio in today’s investment climate needs to consider. These are as follows.

Chapter 1 covers setting investment goals. The next two chapters cover the implementation of those goals, with Chapter 2 devoted to constraints and Chapter 3 focused on measuring risk.

In Chapter 4, I cover the arguments for diversification. Chapter 5 offers a different perspective, introducing factor investing as a different prism through which to view your portfolio. Chapter 6 covers the various methods for forecasting returns, a key input to any portfolio construction process.

Finally, in Chapter 7 I bring everything together and cover the subject of how to build a portfolio while bearing in mind all that has gone before in the previous six chapters.

Introduction

The art of asset allocation

Most investors are drawn to stock picking. Uncovering a little known value stock or finding the next big growth company is the fun part of the job. For those with the requisite skill, successful stock picking can also help boost returns. In a few, rare instances it will make you and your clients rich.

Unfortunately, few possess the stock picking prescience of Warren Buffett. The hard truth is most investors struggle to beat the market through stock selection. In addition, an exclusive focus on finding a winning stock, or for that matter a winning mutual fund, ignores the bigger challenge.

No investor should ever live or die based on a single stock or investment idea. It is the mix of stocks, bonds, cash and other investments that drives long-term performance. Asset allocation, stock picking’s less glamorous cousin, is where investment goals are achieved or missed.

Asset allocation is the art of combining different investment assets to build a portfolio aligned with the investor’s objectives and respectful of their limitations. More than picking the right stock or owning a particular bond, it is the allocation to these assets that drives returns.

Yet, despite the importance of asset allocation, there is little agreement on how to do it most effectively.

The primacy of risk

Many investors have a tendency to start building portfolios with a view on the markets. While understandable, this skips a few, critical steps. There can be no asset allocation until you define the return you are trying to generate, the risk you are willing to tolerate and the constraints you need to impose.

The challenge, as seasoned investors have come to realize, is that most people either don’t know their risk tolerance, or tend to grossly overestimate it. At least, they overestimate until things turn bad. This results in a lot of unnecessary pain.

Not only is a less volatile portfolio conducive to a good night’s sleep, but more importantly it is a necessary prerequisite to sticking to an investment plan. If the volatility of an investor’s portfolio is outside his or her comfort zone, they are more likely to sell, probably at exactly the wrong time.

A related challenge is getting investors to define their constraints, ideally in a sensible fashion. Constraints can be thought of as financial no-fly zones. Some investors, to their detriment, won’t invest outside of their home country. Others avoid certain asset classes, such as commodities. Most of these constraints come with a cost. In an effort to avoid risk, many investors wind up with a portfolio that is actually riskier than it needs to be.

A dearth of income

Defining investor objectives and teasing out their constraints has never been easy. More recently investors have been contending with a new problem, one more directly tied to markets and the economy. Thanks to a sluggish recovery following the 2007–09 financial crisis, coupled with the creativity of central bankers, interest rates remain stuck near historic lows. Bonds, the traditional source of income, pay a fraction of what they did 20 or 30 years ago.

This is not an easy problem to fix. If the part a portfolio allocated to bonds is producing little to no return, there are only two choices: buy riskier assets or dramatically lower investment return expectations.

The net result is that the old rules of asset allocation do not apply any more. Placing your clients’ assets in a 60/40 stocks/bonds portfolio and leaving the market to do the rest is unlikely to work as well over the next few decades as it has in recent years. A refresh is needed.

Rethinking the model

This book is intended to provide some of the answers. Humans do many things well, but managing money is generally not one of them. Fear and greed get in the way, no matter how smart we may be. Managing the emotional side of investments is every bit, and arguably more, important than the analytical side. It therefore helps to have a plan.

In an effort to produce that plan, this book breaks down the asset allocation process. The aim is to turn portfolio construction into a series of steps that demystify the exercise. Starting with setting objectives, the book covers all parts of the process, including the importance of risk, generating return assumptions, and combining assets in a risk-controlled manner.

Recognizing that combining assets in a risk-controlled manner is not nearly as exciting as how to retire rich at 40, some may have already lost interest. For anyone with the more modest goal of building robust portfolios to meet client goals, please keep reading.

Chapter 1. Money for Nothing: The Challenges of a Low-Rate World

T his, time, it’s and different have been said to be the four most dangerous words in finance. In the past they’ve very often preceded an argument attempting to justify a dicey investment scheme, overvalued asset or sometimes outright fraud. With that disclaimer in hand, in one big, important respect investors are today facing a very profound this time it’s different moment.

Money managers have been following the mantra of long-term portfolios for decades now. Success may have varied depending upon the period and how well the investor stuck to their plan, but for the most part, the classic approaches worked. Simple asset allocation models were effective.

The most well-known asset allocation model was based on a simple formula: invest 60% in stocks and 40% in bonds. This simple formula – the 60/40 model – provided a reasonable balance between long-term growth, income and manageable volatility. In certain decades, notably the 1980s and 1990s, when both stocks and bond markets rallied in unison, the 60/40 model provided better returns than most had expected.

If 60/40 has worked so well in the past, why change now? The simple but uncomfortable answer is: this time it’s different.

One potential argument for why things are different this time is valuations. As of this writing, stock markets are in the ninth year of a bull market and equity valuations, particularly in the United States, are stretched. While this does not necessarily suggest stock prices are in danger of an imminent collapse, it does suggest lower returns on equities going forward. That said, these high valuations are not really a game changer. After all, stocks have been overvalued in the past, before then dropping in price, and then subsequently bouncing back.

It is also worth noting that while obvious in hindsight, bear markets are rarely obvious before the fact. Even for those lucky enough to get out in time, few are so skilled as to re-enter the market at the exact bottom. More often they miss most of the subsequent rally before re-entering the market. The prospect or even likelihood of a bear market – we know at some point in the future one will occur – is not sufficient to throw out well-established asset allocation rules.

If a creaky stock market is not the game changer, what is? In one word: bonds.

It’s bonds

It is a cornerstone of finance that there is a time value to money. People prefer their money today rather than a year from now. Accordingly, for me to lend you my money you need to pay me a rate of interest. While interest rates have fluctuated dramatically over the thousands of years humans have been lending to each other, they have almost always been comfortably above zero. That can no longer be taken for granted.

The big change that has occurred in recent years, the one that upends the whole process of building a long-term portfolio, is what has happened to interest rates. They have plunged.

This brings us to bonds. While traditionally thought of as the boring, less sexy cousin of stocks, bonds are critical to a portfolio. They play three important roles: income, stability and a hedge against equity market volatility (in other words, diversification). However, all three roles are now under threat.

Income

The most obvious change has been income, or more accurately the lack of it. Today most bonds pay practically no income, even before accounting for taxes and inflation, because yields are so low. This means that under a 60% stocks, 40% bonds arrangement, a good chunk of the portfolio is doing little to produce returns. As a result, the rest of the portfolio – the part not invested in bonds – has to contribute more to make up the shortfall.

The income challenge is further exacerbated by the fact that a prolonged period of low rates has pushed up the valuation on other types of assets that generate income. In the United States in 2017, many dividend-paying stocks trade near record valuations as investors flee the bond market in search of a reasonable yield. As bond investors migrate to dividend-paying stocks in search of income, prices have risen. Higher prices mean that the dividend yield – defined as the annual dividend divided by the price – on many of these stocks and sectors is significantly lower than in the past.

As an example, consider the utilities sector. Utility companies, which are typically valued for their high dividends, now offer a yield of closer to 2%–3% rather than 4%–5%. This suggests that even if an income-oriented investor is willing to accept the greater risk of owning a stock rather than a bond, many of those stocks are now providing a significantly lower dividend yield than was the case 20 years ago.

Stability

Low interest rates inject another complication into the mix. A side effect of low rates is that bond durations, i.e. the sensitivity of the bond to changes in rates, are elevated relative to historical norms. Higher durations translate into more interest rate risk. In more visceral terms, as duration rises, bondholders will experience greater losses when and if interest rates rise. So, as things stand today, even a small rise in rates will inflict significant losses on the bond portion of portfolios.

Diversification

Low rates and higher durations imply less income and more risk. However, up until recently investors could at least rely on bonds for the third characteristic: diversification.

Even though rates have been low, bonds have still done one thing reliably well. For most of the post-crisis period they have provided a hedge against equity risk. In other words, when stocks have gone down, bonds have typically gone up. In more quantitative terms, bonds have had a consistent negative correlation with stocks.

Negative correlation is the holy grail in building portfolios. The negative correlation between stocks and bonds has helped to cushion the blow when markets have been volatile. In the few recent instances when stocks have declined sharply – summer of 2011 or early 2016 – bonds have been there to help mitigate the damage. Going forward, if stock/bond correlations are not as consistently negative, bonds will be less effective in mitigating overall portfolio risk.

Thus, we have established that the three priority roles for bonds in a portfolio – income, stability and diversification – are challenged by the current environment. We will return to look at these three areas in more detail later in the chapter.

Low for long, very long

Before taking each of these three challenges in turn, it is worth exploring why rates are as low as they are. Equally important is how low rates are relative to historical norms.

To say that interest rates remain close to historic lows sounds a bit like hyperbole. At least in the United States, the Federal Reserve has begun the process of tightening monetary conditions by raising short-term interest rates. This process is likely to continue in the coming years, which should see short-term rates continue to rise above the 0% level that defined much of the post-crisis environment.

At the same time, long-term bond yields have also risen. US ten-year government bond yields are roughly 1% higher than they were at the lows during the summer of 2016. Is it really accurate to still talk about ultra-low rates?

Despite marginally tighter monetary policy in the United States and a modest increase in bond yields, by any historical measure interest rates remain close to levels that would have been deemed unlikely, if not impossible, ten years ago. A good example of how truly unusual this period is comes from the United Kingdom, where financial records extend further back in time.

One of the longest continuous series of interest rates is from the Bank of England (BOE). Founded in 1694, the Bank of England has been setting short-term interest rates for the United Kingdom even before there was a United Kingdom (the Act of Union with

Reviews for Portfolio Construction for Today's Markets

[Kalos Italia srl · Rating: 5 out of 5 stars]

Good and well written. A basic book but very helpful