DR.CHENJIAZI ZHONG

Traditional asset classes such as stocks, bonds, and cash tend to be highly correlated with each other during the down markets. The long-only investments may not meet the changing needs of investors, as a combination of equities and bonds do not provide enough diversification. In a traditional portfolio of stocks and bonds, the major sources of risks are essentially equity beta and interest rate.

Including alternative asset classes will involve several risks beyond the typical risks associated with traditional investments, such as the nature of higher fees, less liquidity, less transparency; however, in general, the benefits of such implementation outweigh its risks over the long run, and the risk/reward potential of including alternative assets into a portfolio differs depending on the strategy.

Essential Portfolio Theory vs. Modern Portfolio Theory

The Essential Portfolio Theory (EPT) was originally published in April 2005 by Professor John Mulvey, Princeton University. EPT extends Modern Portfolio Theory (MPT) by taking into account the factors that influence today’s financial markets but were not considered in the MPT. There are several problems in the implementation of MPT:

• MPT has generally used performance measures of stock and bond portfolios over single periods as long-only investments with symmetrical return patterns; however, such idea oversimplifies the market.
• One of the bases of MPT is “market efficiency,” however, as a matter of fact, markets are not fully efficient.
• MPT focuses on past performance; however, successful investors look at future expectations for corporate earnings growth, global economic conditions, and interest rate movements that drive future returns.

Seven Tenets of Essential Portfolio Theory

1. Take advantage of true diversification – true diversification is enhanced by using a variety of strategies that have the potential to perform independently of each other during periods of market volatility.
2. Using leverage with diversification to achieve a targeted risk/return
3. Offset the constraints of long-only portfolios
4. Move away from cap weighting – most benchmarks used by investors are market-cap weighted; the overweighting of the largest companies could subject investors to the potential perils of a non-rebalanced buy-and-hold approach, as most indices have built-in concentration risk
5. Incorporate current and forward-looking data – the true implementation of EPT mandates a more forward-looking methodology. It focuses on the use of current data in an attempt to generate future expectations and maximize future returns.
6. Implement multi-factor strategies – many model portfolios suffer from an over-reliance on the CAPM, under which that the expected return is equal to the risk-free rate plus the market return times expected beta; however, there are limitations in relying on single factor (beta in this case) to value a portfolio, as neither beta nor the risk-free rate is static over time, nor does beta account for other factors that impact market performance, such as investor behavior, and changes in GDP.
7. Employ rules-based rebalancing – when better-performing asset classes become too heavily weighted in a portfolio, it adds to the risk of the portfolio

Essential Frontier vs. Efficient Frontier

Essential Frontier seeks to improve information, trading systems, and enhance risk management techniques. In addition, the Essential Portfolio Theory (EPT) extends the Modern Portfolio Theory (MPT) and takes advantage of true diversification, which is enhanced by using various alternative assets that have the potential to perform independently of each other during periods of market volatility.

In this simple illustration, the Essential Frontier reallocates 25% of the traditional Efficient Frontier portfolio to alternatives and allocates equally to five asset classes: commodities, long/short equity, multi-strategy hedge funds, real estate, and private equity.

As can be seen from the chart and table, the Essential Frontier line shows the incorporation of alternative investment strategies affects the Efficient Frontier by moving it leftward, resulting in higher returns and lower standard deviation.

Below is a “Growth of a Dollar” graph comparing a traditional diversified portfolio with stocks and fixed income securities only (Portfolio A) to three scenario portfolios with different allocation of alternative investment strategies.

However, it is necessary to note that these results are not indicative of future performance.

Other Risks/Concerns

In addition to the risks that mentioned earlier, portfolios with alternative asset classes may lag in strong up markets, as investments that seek to generate absolute returns often use short selling strategies, so they may lag long-only strategies in strong up markets. Beyond that, such portfolios may not diversify risks in extreme down markets, as was the case in 2008.

Reference:

1. Essential Portfolio Theory – John Mulvey, Princeton University, 2005
2. Essential Portfolio Theory – Rydex Investments, 2005