Risk Adjusted Vs. Capitalization Asset Allocation Portfolio Construction

 |  Includes: DBC, PCY, RWX, TIP, TLT, VB, VEA, VNQ, VTI, VWO
by: Lowell Herr

Is it better to construct a portfolio based on allocating assets around capitalization divisions or is one better off using a risk adjusted platform? The following two screen shots show the details of these two approaches to portfolio construction. In each case, I am using ten ETFs that provide worldwide diversity. Four years of historical data goes into the following Quantext Portfolio Planner (QPP) analysis. In the first example, I will use the familiar capitalization model or the approach we use with the ITA portfolios tracked on this blog.

Capitalization Model: The following capitalization asset allocation model mirrors the "Swensen Six" portfolio in that 30% of the assets are allocated to U.S. Equities (VTI and VB), 20% to international markets (VEA and VWO), 20% to real estate (VNQ and RWX), and the remainder to treasury instruments and commodities.

The projected return is 8.6% or 1.6% above that projected for the S&P 500. This meets goal number one. The second goal is to bring the projected standard deviation in under 15%. The asset allocation plan fails this standard. The Diversification Metric is under 40% so goal three is missed. We prefer DM to top 40%. Portfolio Autocorrelation (PA) is a respectable 18.2%. We strive to keep PA under 20%. Two of the four goals are met and we can control the standard deviation.

If the ITA Risk Reduction model is put into place, the 15.7% standard deviation is not of the same concern vs. using this asset allocation plan as a buy-and-hold model. Over the last four years, this portfolio had a volatility of +/- 20%. Fortunately, most of that was a + 20%. Nevertheless, 15% is sort of a warning point as one could lose 30% of the capital in a two sigma market draw-down. That is what we want to avoid.

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Risk-Adjusted Model: In the following model, each asset or ticker is set up to carry equal risk in the portfolio. The greater the variability the investment, the smaller the percentage allocated to that asset. Since TIP has the lowest variance it receives the highest allocation.

The projected return matches that projected for the S&P 500. We gain an advantage with this portfolio by lowering overall risk. It is down to 12.6% or a very acceptable number. Keep in mind that we would likely not invoke the ITARR model since this portfolio is already set up to reduce risk. We don't gain any significant advantages with the DM and PA metrics. One could set up this portfolio and then rebalance it once a year.

Readers will note how difficult it is to increase the projected return and still hold down the projected volatility.

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