Some fun stuff today with a look at GMO's Benchmark Free Allocation Fund/Strategy and Meketa's thoughts on risk parity.
GMO's paper talks about a "total portfolio mindset;"
Because Benchmark-Free focuses on generating real returns instead of beating a particular benchmark, it naturally has a different view of risk than most traditional portfolios.
The paper chronicles the various changes under the hood of the fund/strategy and the result of the fund seems to walk the walk it has looked much different quite frequently, painfully different to be blunt about it.
That is a very rough 13 years in the middle of the fund's existence. The paper makes many references to real returns. Adjusting for inflation, the 4.18% comes down to 1.62% in the period charted. There's a balance between building a portfolio targeted to the outcome you need irrespective of what the broad market is doing but still giving yourself a reasonable shot at a decent growth rate.
A similar sentiment from Meketa regarding risk parity;
...since these strategies are not widely implemented, institutional investors that adopt this allocation methodology need to be comfortable being “different” from peers, that is, having high tracking error relative to broad peer portfolios.
A big pillar to what the ReturnStacked guys offer with their funds is ability to add alternatives without introducing tracking error into the portfolio. It is ok to have tracking error. Certainly for you, managing your own portfolio, who cares? Again, are you giving yourself a reasonable shot at a decent growth rate if that is what you need?
We have a lot of fun here with all sorts of crazy allocation ideas but if you need something beyond a T-bill rate or CPI plus 2%, then you probably need some sort of close to normal allocation to equities. Even just 35-40% can serve as a reasonable growth engine inside a portfolio for people who do not want the ups and downs of having 60-70% in equities.
Yes some sophisticated combo of different asset classes with very light exposure to equities could get it done but anyone pursuing that kind strategy will probably have to work a lot harder for their return versus just having a close to normal allocation to equities.
Finominal has a portfolio optimizer tool that we've used before. It can optimize for several things including risk parity. Depending on what inputs are used, the result might be interesting or not very helpful. If you include a T-bill or short term bond fund, the output will be to have a huge weighting to the T-bill or short term bond fund. A 15/85 portfolio won't be the answer for too many people.
The following study starts with 35% in SCHD, 30% in IMTM, 15% in KMLMsim and the rest in SHRIX for Portfolio 1. Portfolio 2 allocates those four at 19%, 16%, 19% and 44% respectively (rounded off) inline with Finominal's risk parity optimization.
Portfolio 1 at 65% in equities is pretty typical while the managed futures and cat bonds could cause tracking error which is fine with me, I probably want that, you probably know whether that is ok for whatever money you are managing (just your own or for clients). Portfolio 2 is a tracking error palooza. The 35% in equities is at the lower end of what we talked about above as being a reasonable growth engine inside of lower volatility portfolio. It obviously has not kept up with VBAIX but nine years is a reasonably long time and it's not that far behind but with much less volatility and much shallower drawdowns.
If someone was interested in something close to this version of risk parity but wanted more traditional bond exposure, instead of building that into the Finominal portfolio optimizer, it would make more sense to figure out how much they want in more traditional bonds like 20% or 25%, whatever, then plug the rest of what they want for the portfolio into an optimizer (Finominal or someone else), get those weightings, reduce accordingly to account for the allocation to more traditional bonds.
Long time readers probably know, there is no scenario where I am putting 44% into a cat bond fund. More realistically, I would split that 44% sleeve between five or six disparate strategies to avoid loading up on the same risks. Those five or six different strategies could themselves be risk weighted and then slotted into the more diversified version of Portfolio 2. Nineteen percent in managed futures is probably more than I'd ever want too but at a minimum, I would split that large of a percentage across two or three funds, not just one.
I think the underlying premise of Portfolio 2 is valid, gives a reasonable chance of a decent growth rate while still differentiating effectively versus VBAIX's volatility.
The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.
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