Portfolios

How we build our portfolios

The CIO asset allocation modeling process incorporates:

  1. Estimating return, risk, and correlations between asset classes: how can we expect the asset classes we have selected to behave?
  2. Combining asset classes in one asset allocation model and stress testing: what are the optimal portfolios?
  3. Portfolio tailoring: how can portfolios best fit with investor needs?

Estimating return, risk, and correlations

Our return estimates are a combination of “equilibrium” estimates and qualitative asset class expertise. Equilibrium estimates are consistent with financial theory, which tells us that over multiple business cycles investors should receive the same return per unit of risk, regardless of which asset class they hold. However, empirical data shows this is not always the case; certain asset classes can be “cheap” or “expensive” at different times. We therefore ensure that equilibrium estimates are combined with qualitative asset class expertise, which takes into account asset class fundamentals like bond yield surfaces or equity valuation. 

To estimate volatility and correlation between asset classes, we use long-term historical time series for each asset class in order to capture their behavior over multiple business cycles. This approach allows us to account for periods when correlations and volatilities can spike, such as during the financial crisis. 

Combining asset classes

Our asset allocation modeling platform incorporates all of the above estimates, in order to find the optimal combination of assets. “Optimal” asset allocation models for us are those that balance a number of attributes: the best combination of a high return-to-risk ratio, low levels of drawdown in stress scenarios, and rapid recovery following a loss. They also need to fit with investor needs and demands.

We also acknowledge that forecasting is subject to error. We therefore make sure that our modelling process is not purely quantitative, and that portfolio risk is spread widely, across different drivers, markets, and asset classes.

Portfolio tailoring

Ultimately, portfolios are exposed to investor needs and demands. For instance, even an optimal asset allocation model could fail if its behavior fails to meet an investor’s expectations, leading them to make suboptimal changes to its composition.

We therefore emulate individual investor behavior by applying the above framework to a variety of investment concepts. These include “classic” approaches, such as those advocated by Modern Portfolio Theory – these are for investors seeking long-term capital growth or income, and who are willing to invest over a range of asset classes and are tolerant of potential drawdowns in periods of market weakness.

As we describe in Alternative Investment Concepts, other approaches emulate investors with low liquidity needs, a desire to limit exposure to equities, or with a complex mix of growth ambitions and risk-aversions.


Our asset allocation models

In the my House View section, you can try out our interactive feature to see how your portfolio is positioned compared the UBS House View.


Alternative Investment Concepts

Overview

Investors are commonly described as either “institutional” or “private.” However, if we look carefully at investors’ time horizons, requirements, and characteristics, we note that some private clients actually have more in common with certain types of institutions than with other private clients. Some alternative investment concepts, pioneered by institutions like hedge funds or endowments, can be applied by private investors to help achieve their objectives. The following guidance is applicable to non-taxable investors. Tax implications could change the allocations significantly.

Endowment Approach

The needs of some private investors have a lot in common with endowments; model portfolios of both need to provide recurring cash flow, while also preserving the purchasing power of the portfolio against inflation into perpetuity.

Many endowments have been highly successful in fulfilling this objective in recent years, the most notable being US universities. Over the past decade, the MIT endowment has risen by an average of more than 10% annually, with Stanford, Penn State, and Harvard all earning in excess of 7.5% annually (according to Bloomberg data).

These investors earn more return, with lower volatility. But it is not by magic. The key to their strategy lies in not limiting the scope of their investment universe. They take positions in asset classes worldwide, including niche and less liquid assets in private equity, real estate, hedge funds, and private debt markets. By diversifying broadly and accepting lower levels of liquidity, they are able to earn high returns. We believe some of the principles of this approach can also be successfully applied by many private investors.

An endowment-style approach, if applied by private investors, could be used as: i) a source of ongoing cash flow to fund expenses, ii) a long-term portfolio to reach goals 10 or more years into the future, or iii) an intergenerational portfolio that can secure capital growth across generations.

So, how does it work? The key building blocks, in our view, are some assets from public markets (bonds ranging from the safest government bonds to sub-investment grade bonds, and equities), and some assets from private markets (hedge funds, private equity and debt funds, and real estate). Endowment-style allocations typically have a much heavier weighting in private market investments than most traditional allocations held by private investors. This mix of assets meets the key criteria of income and purchasing power protection: income is provided by diversified streams: dividends from public equities, distributions from private equities, rents from real estate, and interest from a variety of fixed income instruments.

Meanwhile, purchasing power should be protected by cap- turing additional sources of return. In addition to the traditional “risk premiums” that can be earned by investing in public markets, the high share of private market investments means that investors can also capture returns from exposure to less liquid and less well-followed markets.

An additional benefit that may be realized by private investors is protection against behavioral biases that a largely illiquid allocation can cause. Overtrading based on emotion is a major source of underperformance for private investors – less liquid investments and a long-term time frame can help avoid temptation.

The "illiquidity premium" approach

Many successful institutional hedge funds, particularly in the “relative value” strategy, earn returns by investing in less liquid assets within fixed income. Given that many private investors do not need to access the majority of their funds regularly, and others prefer not to allocate to equities, this approach can also be successfully applied by private investors.

When employed by institutional investors, such strategies have tended to deliver consistent returns in recent years. Private investors may not have the time or capacity to conduct the kind of due diligence on specific issuers that many hedge funds undertake, so we consider ways in which private investors can earn the same illiquidity premium in a diversified way.

We believe that the full credit spectrum, including the complex universe of different credit classes within a corporate structure, provides attractive opportunities for illiquid investments that provide a high income stream. This includes assets like mezzanine loans, asset-backed securities, hybrid corporate bonds, and bank capital, including Tier 1 securities and Tier 2 bonds. These assets can form an important part of an illiquidity premium portfolio.

Of course, some more liquid assets are required for diversification purposes too: A well-constructed illiquidity premium portfolio should include some more “standard” fixed income asset classes, such as senior corporate bonds, emerging market credits, and HY credits.

We think that the diverse characteristics within this fixed income universe mean that a mix of securities should be sufficient to achieve both diversification and return, without having to turn to assets like equities to provide growth.

Interest rate shifts are of course an important concern for any fixed income focused portfolio. To try and mitigate the risk of higher rates, it is important for such an illiquidity premium model portfolio to also have exposure to floating-rate debt instruments such as senior loans.

Quantitative Approach

Studies show that most individuals feel more pain at a loss than pleasure at a gain. Therefore, many private investors seek to sharply reduce risk at times of market uncertainty, and buy back in when conditions are more stable.

The key challenge is discipline. Behavioral biases consistently work against investors, encouraging them to consistently wait for more favorable prices to sell or buy. This often leads to inertia.

One way of overcoming this is to use risk management tools, similar to those used by leading institutional investors, to provide a “buy” or “sell” signal, and using the output within a disciplined framework.

For this approach, we use a quantitative World Equity Market Indicator, incorporating a series of indicators on the health of the business cycle and market sentiment to determine periods of high market uncertainty. This can provide a signal at times when investing in equity markets is inherently more risky, and times when it is safer.

One way of using this signal would be to determine a portion of a portfolio which is “dynamic” and can be switched between a safe asset, like government bonds, and a risky asset, like equities. When the signal indicates high levels of market risk, the dynamic portion of the portfolio can be switched to the safer asset, and when the signal indicates low market risk, the dynamic portfolio can be switched to equities.

That said, it is important that investors do not make their entire portfolio dynamic. A crucial risk to consider is that a dynamic approach may leave investors uninvested in equities in the initial rebound phase following a market crash, when returns can be powerful. The principles of a well-diversified underlying portfolio still hold, despite the more dynamic nature of this approach.

Additional approaches

We continue to review the potential merits of other approaches employed by institutional investors and the ways in which private clients can employ them. These include the “risk parity” approach to investing applied by a number of major hedge funds.


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Investment Philosophy

We believe in a long-term approach to asset allocation and that diversification is the 'last free lunch in finance'. By extension, investors need to take some risk to earn a sustainable return over the long run. That said, it is equally important that investors do not overstretch and implement a well thought out investment policy.

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