3 Best Portfolio Construction Techniques you need to know in 2023

2022 was an unprecedented year in the investing landscape, with record losses across stocks and bonds. US equities posted a loss of 19.4%, the most significant decline since 2008, when the market posted a loss of 38.4%.

Investors had traditionally fled to bonds when stocks dropped, but fixed-income investors also saw years of gains being wiped away, with the corporate bond market posting a 12.9% loss, the largest since 1999, according to Morningstar. In fact, this was the first year where both bonds and stocks posted broad-based declines since 1969.

Worst Performing Stocks of 2022. Source: www.morningstar.com

Despite the challenging investing conditions, as per Reuters, hedge funds posted an average gain of 14.2% by diversifying risk and making intelligent bets through advanced portfolio construction techniques. Let’s take a look at a few advanced portfolio techniques used by the most visionary investors to reduce risk, maximize returns, and beat the market.

Understanding Advanced Portfolio Construction Techniques

Portfolio Defined

The definition for portfolio is simple: it is a collection of securities held by an investor, such as stocks, bonds, and commodities.Advanced portfolio construction techniques refer to the methods used to optimize the composition and diversification of a portfolio (what is a diversification?) in order to achieve specific investment objectives. These techniques involve the use of quantitative analysis (quantitative analysis in finance) and mathematical portfolio modeling to identify and select the most appropriate assets for inclusion in the portfolio. There are several advantages, including:

Improved Trade off Between Risk and Return

– Advanced Portfolio Construction Techniques use mathematical models to optimize the risk & return, enabling investors to achieve the desired gains based on their targets.

Diversification and Asset Allocation

– Advanced Techniques use various sophisticated methods to help identify assets that are less correlated with each other, helping reduce the risk in Investors’ Portfolios and improving overall diversification.

Transparency

– Advanced portfolio construction techniques offer better transparency and control for investors by providing detailed and actionable information on the portfolio’s composition and performance. This allows investors to have a clear understanding of the investments they hold, their characteristics, and how they contribute to the overall portfolio performance. There are several advanced techniques based on the different risk and return measures required by investors. Below, we cover a few examples of portfolio construction techniques.

1. Risk Budgeting Portfolio Construction

Risk budgeting can best be described as the one that focuses on allocating risk budget to different asset classes and investment strategies, rather than the traditional approach of allocating capital. The first step in this technique involves determining the overall risk tolerance based on the investors’ own risk appetites. Once the general risk tolerance is selected, the investor would then allocate a risk budget to each asset class.

Let’s look at this with a portfolio example

An investor determines that the overall risk of the portfolio is 10% and that he wants to allocate 50% of the risk budget to stocks, 25% to bonds, and 25% to real estate. Based on this, the investor would allocate a risk budget of 5% to stocks, 2.5% to bonds, and 2.5% to real estate. The investor would then select specific investments within each asset class or investment strategy that align with their risk tolerance and risk budget. For example, the investor might choose stocks that have a volatility of 4%, bonds that have a volatility of 1.5%, and real estate that have a volatility of 2%.

2. Smart Beta Investment

The Definition of Smart Beta is a rules-based portfolio construction technique that aims to capture risk premiums and improve risk-adjusted returns. The approach assumes that traditional index construction, such as the composition of the S&P 500, may not be the most effective way to construct a portfolio (this is true since Apple, Amazon, Microsoft, Google, and Berkshire Hathaway make up 20% of the index since they have the highest market capitalization compared to other companies in the S&P). So rather than use the traditional market-capitalization weighting, the Smart Beta approach relies on factors such as value, momentum, and volatility. By using these factors, investors can either achieve higher returns or lower volatility compared to traditionally constructed indexes.

Examples of a portfolio to understand the Smart Beta approach

For instance, an investor looking to invest purely in value stocks in their portfolio of stocks will use the Value-weighted strategy, where measures such as the Price/Earnings multiple and Price/Book select stocks for the portfolio. To implement this strategy, an investor would identify several stocks and rank them based on their value – either Price/Earnings, Price/Book ratio. In our case, let’s just use three stocks: Amazon (P/E – 82), Apple (P/E – 21), and Meta Platforms (P/E – 12). Based on the value ranking, the investor would assign a certain weight to each stock. In this case, Meta would get a 55% weightage in the portfolio, Apple would get a 35% weightage, and Amazon would get a 10% weightage.

This portfolio needs to be rebalanced periodically to keep it consistent with the value strategy. For instance, if Amazon stock falls and Meta stock rises, the investor will need to sell Meta stock to buy Amazon stock.

3. Risk Parity Portfolios

Risk Parity is a Technique used to allocate asset classes in the portfolio in a way where the risk is distributed equally. Essentially, this approach suggests that diversifying by asset classes won’t reduce risk; instead, they should also focus on the source of trouble in the portfolio. For example, an investor might allocate 60% of their portfolio to stocks and 40% to bonds, but if stocks are riskier than bonds, the overall portfolio will be riskier than desired. Suppose the investor finds out that the stocks have a volatility (volatility is a measure of risk in finance management) of 20% and bonds have a volatility of 5%; then the investor would need to invest more capital in bonds and less in stocks to ensure that the overall risk is evenly divided between the two asset classes. In this case, the investor would need to allocate 60% of the portfolio to bonds (which have 5% volatility) and 40% to stocks (which have 20% volatility) to achieve the goal of equalizing the risk between the two assets.

Backtest a Portfolio

In order to backtest a portfolio, I am using Portfoliovisualizer, which is available also for free. I am going to show you a rather interesting example. Here is the result for a simple 3 funds portfolio started back in April 1999, composed of 55% QQQ, 28% XLV, and 17% GLD:

As you can see, the CAGR of the resulting portfolio is higher than those of XLV and GLD, but on the other hand, it has the lowest risk (Stdev = Standard Deviation = Volatility). This means that for a unit of risk, we were able to get an increased return. The ratio shall not be exactly as in the example, but it shall be in that range.

This kind of portfolio optimization is part of the process of risk management and minimization of the standard deviation of the portfolio. Feel free to experiment with PortfolioVisualizer and use it to calculate portfolio standard deviation.

Bottom Line

In conclusion, advanced portfolio construction techniques are essential in today’s ever-changing financial landscape. By using risk budgeting, smart beta, and risk parity, investors can maximize returns and minimize risk in their portfolios. This not only helps to achieve their financial goals but also provides peace of mind in the face of market volatility.