Portfolio construction: Principles inform possibilities

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.

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.)

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.

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.

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. 

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.

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.