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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Thinking beyond the market cap
Portfolio solutions depend on an investor’s goals and preferences
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.
Models and goals: Considering TVAA, SAA, and active-passive
There’s a method to the portfolio: The architecture behind Vanguard’s portfolio construction framework
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.
The inflation-averse investor
Inflation-hedging portfolios and their risk–return trade-offs
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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