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Posted by on Nov 7, 2017 in ETF Strategist, Featured

What Is Risk Allocation & Should You Invest In It?

What Is Risk Allocation & Should You Invest In It?

By Roger Nusbaum, AdvisorShares ETF Strategist

Institutional Investor (II) had an interesting article on a different of portfolio construction called risk allocation as opposed to asset allocation. Assets are weighted based on risk, although I might argue assets are weighted by volatility as well as forward looking fundamental factors. This sure sounds a lot like risk parity to me but from few things I looked at, risk allocation doesn’t necessarily, automatically leverage up the fixed income exposure. Actually, what I looked at (more on that in a moment) seems to have less fixed income exposure.

This topic is always interesting to ponder and fun to write about. As I have said many times before my introduction to the idea that allocations can go beyond 70/60/50 equity, the rest in fixed income goes back to the 90’s when I first read about Jack Meyer who was running the Harvard Management Company, the endowment, and he was talking about timberland as an alternative investment. This has long influenced how I manage portfolios, dynamically increasing or decreasing to alternatives or as I have called them before, diversifiers, based on where I thought we were in the market cycle.

II didn’t really get into details of portfolio constructions but cited one riskier application of the concept put on by the Princeton Endowment in “dogged pursuit of alpha” by allocating 4% of the Endowment, which works out to 40% of the US equity allocation, to a manager (presumably a hedge fund but the article doesn’t say) who invests in fallen angel biotech stocks. Fallen angel as related to biotech includes companies that had a drug fail a trial.

Putnam has a traditional mutual fund that uses risk allocation. It doesn’t fare well in Morningstar’s rating system but that isn’t always an accurate barometer, especially for something that is not plain vanilla. As I have no interest in buying the fund I am not going to try to assess the merits of it so much as take an interest in the allocation to see what could be learned.

Based on the latest which is from September 30th it had 29.68% in US TIPS as its largest allocation followed by 24.58% in International Bonds, 19.72% in Commodities and 19.40% in US Equity. Total equity exposure is about 37% not including a small allocation to REITs and the fund appears to be levered as the weighting to cash is -36.21%. According to the literature the fund has four buckets it invests in; equity risk (domestic, foreign developed, emerging), interest rate risk (US investment grade, international bonds), inflation risk (TIPS, commodities, REITS) and credit risk (high yield, emerging market debt). I did not see any sort of commentary to explain why the big bet on inflation, but it is clearly an active decision.

I looked at a report on risk allocation from Cambridge Associates that gave another example of what a risk allocation strategy could look like. It broke down as 20% domestic equity, 20% foreign equity, 10% “private growth” which I presume is private equity, 25% hedge funds (which is vague…by design?), 15% fixed income and 10% real assets.

At any given time that mix or something similar could be great or terrible…choose the right hedge fund or the wrong ones or choosing good or bad managers for anything else or choosing passive at a time it underperforms like during the 2000’s, the variables are countless which is to say trying to follow someone else may not work well as opposed to taking bits of their process to hone your own process.

If any of this interests you, you can build a portfolio that is similar or a portfolio that is merely influenced by this sort of strategy pretty easily with ETFs and/or traditional mutual funds. Easy in that there are plenty of funds that target various hedge strategies for example but not all of them can do it well. There are no short cuts to this in terms of deciding from the top down what to own in this regard like commodities for example, and then how to own them or hedge fund replicators. I am not aware of any exchange traded hedge fund replicators that would target something so narrowly like fallen angel biotech but if that really appeals to you, then you could do the research to find individual stocks and then allocate accordingly if you think you have an aptitude.

Not all of the exposures in risk allocation are that alternative really; commodities, REITs and TIPS are pretty mainstream and easily accessed with exchange traded products. Some of the more exotic strategies can be difficult to implement under the hood of an ETF depending on the constraints of the prospectus. There is at least one event driven hedge fund replication ETF out there (naming names is difficult for compliance reasons) for example. It’s three largest holdings target short term corporate bonds, convertibles and senior loans. Those three funds account for 75% of the ETF. I have no doubt that the fund provider can explain the allocation in compelling fashion like maybe it is worried about an event having to do with rising interest rates, but event driven as I understand it tends to target narrower events. The fund could absolutely deliver a low correlation, low volatility result and while I think those are desirable attributes it is not clear that the fund actually offers event driven hedge fund exposure.

For years I have been saying that more alternative (diversifiers) strategies would be available to retail sized accounts (obvious conclusion), that has happened and is continuing to happen. Rob Ivanhoff reported that a fund company in the UK will be listing ETPs that offer 2x exposure to individual stocks. Bank of New York is working on ADRs that will hedge out currency exposure as just two examples.

You may or may not want risk allocation, risk parity, managed futures, global macro or do some sort of pair trade with currency hedged and unhedged ADRs but these kinds of tools, and other ones I’ve written about can help smooth out the ride when the ride needs smoothing, but the key here as always is sizing. Equities go up the most, most of the time. If you believe that will continue (I do) then this is about managing equity volatility not replacing equity exposure. Too much exposure to alternatives and you have a portfolio of alternatives hedged with a little equity and would then be likely to lag behind the equity market. In the last five years, Google Finance shows the S&P 500 up about 80%. Being up 60% during that period in the name of a conservative approach that includes some exposure to diversifiers is a manageable situation but being up 10% in that time when you were expecting to participate in a bull market for equities may not be.

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