Expert insight

Portfolio construction: Principles inform possibilities

August 11, 2022

Roger Aliaga-Díaz, Ph.D.

Global Head of Portfolio Construction and Chief Economist, Americas

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Portfolio solutions depend on an investor’s goals and preferences. Inputs include goals, preferences and beliefs, and the asset-class universe. Those inputs point to four investment methodologies, which include market-cap weighted, model-based strategic asset allocation (SAA), time-varying asset allocation (TVAA), and active-passive. Those methodologies lead to custom portfolio solutions.
Four investment methodologies are shown: market-cap weighted, time-varying asset allocation or TVAA, model-based strategic asset allocation or SAA, and active-passive. Market-cap-weighted investment vehicles are equity and fixed income asset class betas or indexes. TVAA investment vehicles are sub-asset classes for fixed income factors, equity factors, and equity styles and other fixed income for TIPS, high-yield, and emerging-market bonds denominated in local currencies. SAA investment vehicles are other asset classes for liquid alternatives and commodities. Active-passive investment vehicles are active investments: diversified, concentrated, private investments, ESG, and direct index.
Inflation-hedging portfolios meet the primary objective but there are trade-offs. Figure A shows the model-based inflation-hedging portfolio’s makeup, while Figure B shows the 30/70 market-cap-weighted portfolio composition. Figure C shows how the two portfolios differ. The inflation-hedging portfolio displays a greater annualized total return, greater annualized volatility, greater excess return, greater probability of excess return of less than 0, greater tracking error, and a greater maximum drawdown. It also displays a lower Sharpe ratio and a lower inflation beta.
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