Asset and Risk Allocation

Seemingly different assets can carry similar risks. Recognizing this fact can help fiduciaries gain a perspective on true diversification and better understand the risks in their portfolio. At Verus, portfolio design incorporates asset allocation and risk allocation principles and methodologies.

We begin with forward-looking capital market return assumptions driven by an established methodology—not in an attempt to predict the future, but because an asset’s returns are inextricably linked to the economic environment and its entry point valuation.

We construct policy portfolios based upon a client’s risk tolerance and anticipated liabilities, and a multifaceted process that includes stochastic modeling and scenario testing helps us determine an optimal solution. For defined benefit plans, we analyze a fund’s actuarial projections using a proven asset/liability model. For endowment and foundations, we focus on the projected spending policy and special cash-flow requirements over time.

In portfolio construction, we favor diversification by economic regime, which requires us to consider the potential impact of inflation, deflation, and periods of low economic growth. We believe in globally diversified portfolios and a carefully calculated exposure to alternatives.

It may be apparent that all these ideas can’t fit into a mean-variance optimization (MVO) framework. MVO is an elegant, Nobel Prize-winning mathematical formula, but it implies an unrealistic level of precision and is not well-suited to allocating assets in the real world. (Learn about the many imperfections of MVO here.)

Consequently we do not use MVO to estimate drawdown risk or identify the most efficient portfolios, but only to integrate our capital market assumptions and to project a policy return and a crude measurement of volatility. Instead, we also use our proprietary Scenario Analysis Model to better understand the range of possible outcomes that might be expected.

This tool assesses the key inputs into the likely behavior of each asset class, and models the possible behavior of the portfolio as those inputs vary. This approach produces a range of possible forecasts for the key capital markets based on historical behavior, and by doing so allows a much more rich understanding of the range of possible outcomes that might be achieved from a particular asset allocation under a different circumstances.

From there, we further test policy portfolios against the five prominent risk factors found in almost all asset classes: equity risk, interest rate risk, credit risk, inflation risk and currency risk. Using MSCI BarraOne and proprietary tools, we help clients better understand the true drivers of risk in their portfolios.

Once a policy portfolio is adopted, we overlay our research to see if strategic tilts are warranted and identify potential opportunities. Given our emphasis on understanding the economic environment and relative valuations, we may recommend modest tilts to enhance returns. We might suggest a capitalization tilt within the equity portfolio, for example, a heavier weighting towards credit, or an overweight to certain regions of the world. In 2009, for example, this led to opportunistic allocations to distressed debt and taking advantage of special programs like TALF. While such opportunities do not always present themselves, we are always looking for them.

Our process is rooted in reality and clear about the drivers of portfolio risk. This approach equips our clients to better understand risk, withstand volatility, and take advantage of opportunities when they arise.