Expert insight
Portfolio construction: Principles inform possibilities
August 11, 2022
Millions of investors grow wealth and generate income with a low-cost, market-capitalization-weighted investment methodology. But what about those with different objectives, such as market outperformance, inflation hedging, or environmental, social, and governance (ESG) investing? Vanguard’s portfolio construction framework encompasses all those options.
Almost 50 years ago, Vanguard forged a path for low-cost, index investing. Passive indexes gave rise to the idea of investing in broad asset classes, and the need for a recommendation on how to allocate among asset classes resulted in the practice of portfolio construction. While many chose a do-it-yourself approach to portfolios, the market-cap-weighted portfolio quickly emerged as a go-to solution for millions of wealth accumulators who wanted a professionally managed option while preserving the simplicity and low-cost features of the underlying indexes.
Today, as Vanguard has embraced a broader universe of non-market-cap investing options, such as low-cost active, factors, private investments, and ESG, our portfolio construction expertise has evolved and adapted to align with our mission of giving investors the best chance of investment success.
Thinking beyond the market cap
Market-cap-weighted portfolios are designed to support general investor needs, often primarily wealth accumulation goals—but those common aims don’t cover all investor objectives. All investors have unique situations, defined in part by goals, risk tolerance, preferences, and beliefs. Along with an expanding universe of more complex investment options, these factors can result in a wide spectrum of portfolio solutions. It can be daunting for many to decide how to balance the numerous facets involved.
We believe the investor’s path to a sound portfolio solution starts with one of four primary investment methodologies—market-cap weighted, model-based strategic asset allocation (SAA), active-passive, and time-varying asset allocation (TVAA).
These methodologies act as goal-specific scaffolding to help investors reach particular objectives, and they can be mapped to different investment vehicles. (An in-depth explanation of each methodology can be found in our recent white paper, Vanguard’s Portfolio Construction Framework: From Investing Principles to Custom Portfolio Solutions.)
Portfolio solutions depend on an investor’s goals and preferences
Source: Vanguard.
Collectively, this portfolio construction framework puts into practice Vanguard’s four Principles for Investment Success: set clear, appropriate investment goals; develop a suitable asset allocation using broadly diversified funds; minimize costs; and maintain perspective and long-term discipline.
Models and goals: Considering TVAA, SAA, and active-passive
The market-cap-weighted investment methodology and its standard stock/bond allocations remain the bedrock recommendation for investors seeking market performance while minimizing cost and risk. But TVAA, SAA, and active-passive investment methodologies—and their associated portfolio solutions—enable investors to aim at different objectives. These objectives can include a focus on socially conscious investing, tax efficiency, different forms of active market outperformance, or a hedge against specific investment risks such as inflation.
There’s a method to the portfolio: The architecture behind Vanguard’s portfolio construction framework
Notes: The Vanguard Capital Markets Model® (VCMM) is a proprietary financial simulation tool that forecasts distributions of future returns for a wide array of broad asset classes.
Source: Vanguard.
For example, a model-based SAA methodology uses financial simulation engines, such as Vanguard’s proprietary models, to project the long-term returns of certain asset allocations and may add sub-asset-class tilts, such as value equities, long-term government bonds, commodity futures, or high-yield bonds. Our proprietary optimization engine gives a systematic foundation to portfolio recommendations and sheds light on the decisions an investor would otherwise make in a subconscious or implicit way when choosing portfolio allocations on an ad hoc basis.
Models reduce the guesswork of portfolio construction by establishing a process that ensures maximum diversification of investment risks. Such a systematic portfolio construction process can be helpful in times of market flux, such as when unexpected inflation crops up.
The inflation-averse investor
To get a better understanding of the logic behind the model, let’s look at the fictional Joan Investor, who wants her portfolio to withstand the capital-eroding effects of inflation. An inflation-hedging portfolio seeks to meet that goal: The asset mix is chosen to fully hedge against inflation relative to its market-cap-weighted portfolio counterpart.
When compared with a traditional market-cap-weighted model (30% stocks, 70% bonds), Joan’s portfolio relies more heavily on global equities, commodities, and Treasury Inflation-Protected Securities (TIPS) while discounting both U.S. and global bond allocations. While the resulting allocation may lower Joan’s inflation risk, it also increases portfolio volatility, resulting in an increased potential for underperformance in any given year.
Inflation-hedging portfolios and their risk–return trade-offs
Notes: The inflation-hedging portfolio allocations were determined by the Vanguard Asset Allocation Model (VAAM). The assets under consideration were U.S. and non-U.S. equities and fixed income securities, in addition to commodity futures and TIPS, because of their inflation-hedging properties. The VCMM 10-year steady-state projections as of September 2021 were used.
Source: Vanguard.
The takeaway? No one model portfolio is superior across all metrics; instead, each is built to align with the goal for which it was designed—protection against inflation, in Joan’s case.
Other investors may want to pursue outperformance through active investments and risk factor exposures, or they may have more complex strategies such as using private equity; incorporating environmental, social, and governance (ESG) preferences; or allocation to a personalized index.
Custom portfolio solutions may also include those designed to generate total return, target a particular duration in fixed income, incorporate active management, or invest using a tax-efficient strategy.
The full range of options is what makes a models-based approach a viable solution to investors considering a strategy beyond market-cap weighting.
Notes:
All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss. Past performance is no guarantee of future returns.
Investments in bonds are subject to interest rate, credit, and inflation risk.
Investments in stocks and bonds issued by non-U.S. companies and foreign governments are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.
Vanguard does not, and will not, make any representations about whether a model portfolio is in the best interest of any investor, is not, and will not be, responsible for the determination of whether a model portfolio is in the best interests of any investor, and is not acting as an investment advisor to any investor.
IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
