Setting Constraints For Asset Classes And Individual Securities

by: Lowell Herr

In a recent blog, I mentioned the importance of setting constraints on particular parts of the portfolio. In this blog, I'll go into more depth as to what I do when it comes to setting asset class and individual security constraints. The reason for setting any constraints is to keep the optimizer in check so it does not run wild and create a nonsense portfolio. The general idea is to provide some asset allocation guidance while allowing some flexibility for the optimizer to do its work.

The Hoadley software is designed to first hone in the asset class constraints and then to examine the constraints set up for each security. More on this later.

Asset Class Constraints: HedgeHunter added several asset classes to the default number offered by Peter Hoadley, developer of this software. These additional asset classes such as International Bonds and Metals provides additional flexibility in controlling portfolio diversity. Examine the minimum and maximum percentages I set up as constraints in this example. Constraint percentages are personal and they vary from portfolio to portfolio. For example, I classify the ultra-short ETF, SDS as miscellaneous. If I am absolutely sure I will never use this ETF, and I have no other securities classified as miscellaneous, I will set the maximum to 0%.

When it comes to U.S. Equities, I provide the optimizer the opportunity to place as much as 50% of the portfolio in this large asset class. Commodities, on the other hand, can never exceed 10% of the portfolio and it can be as low as 0%. Some investors will not have any securities designated as Dividend, so this asset class may not be used. If I have VIG, DVY, or IDV in the portfolio, then I will use the Dividend asset class.

Once more, the Hoadley software (what I call the optimizer) will first examine the constraints placed on the asset classes. Now we move on to the constraints placed on the individual securities.

Security Constraints - Section One: I broke the individual securities into two sections since there are about 30 and this saves a bit of scrolling right and left. GTU is the first ETF and the constraints vary from a minimum of 0% to a maximum of 10%. This screen is subservient to the constraints placed on the asset classes. One could eliminate the asset classes and concentrate only on the security constraints. I prefer to use both as I like to first lay out the broad picture and then fine tune the constraints as you see in the following two screenshots.

Pay attention to the Volatility percentages as that may impact your maximum and minimum settings.

Securities Constraints - Section Two: Here we have another 15 ETFs we might use to populate a portfolio. There are three sector ETFs in this group and they are: VCR, VHT, and VFH. Depending on performance, sector ETFs may or may not be part of the choices. Note that I set a 5% minimum for VTI and a maximum of 30%. I want to make sure I always have an investment in the broad U.S. Equities market. To provide a value tilt I place a 1% minimum on VOE and a 0% minimum on VOT, a growth ETF. I've done something similar with VBR and VBK, value and growth ETFs. If I want to tilt the portfolio even more toward value, I will up the 1% minimum to 2% or even 3%. The constraints one places on the individual securities is a way to fine tune the portfolio whereas the constraints on the asset classes sets up the broad picture of how the portfolio is to be diversified.