The Alpha cautious portfolio framework

If you describe yourself as a cautious investor, you might not equate that with a worst-case drop in portfolio value of 15 per cent. That’s the most severe peak-to-trough drawdown our cautious strategy suffered over 40 years of back-testing. That drawdown occurred during the bear market after the dotcom bust, and the time until recovering the prior peak was a miserable four years and two months.

That’s hardly selling it, but you must set that against the risk of investing in just shares, something most people drastically underestimate. The cautious strategic asset allocation (SAA)’s dotcom losses pale by comparison with those of the MSCI World index of global shares, which (on the end-of-month basis we judge the SAA by) had a maximum drawdown of 48 per cent in the same bear market and took more than two years longer to fully recover. Then, in the global financial crisis, the MSCI World tumbled 55 per cent versus 9.7 per cent for our cautious strategy.  

No two crises are exactly the same, but the point of a strategic asset allocation is to effectively give investors a personalised benchmark to help them achieve investment targets, maximise the ratio of returns to risk taken and limit downside in absolute terms. On its own, the SAA is a good way to passively invest, dilute the worst risks and keep stress down to rebalancing to target allocations once or twice a year.

Even doing this, investors making regular contributions would do better than the risk-adjusted returns of our static weights due to the pound- or value-cost-averaging effect of spreading new cash inputs over different valuation levels over time. It is possible to do better, however.

These asset weights are high level and there are adjustments within asset classes that would make a huge difference. Changes like these are known as tactical asset allocation (TAA). For example, in 2022, investing the bond allocations in funds with a shorter average duration (which would lower the risk of capital loss from rising interest rates) would have made the portfolio performance much more robust.

Hindsight is a wonderful thing, of course, but often a good strategic asset allocation cushions the early stages of volatile markets and buys investors time to make tactical adjustments to lessen downside. There are also times when some of the riskier allocations in the portfolio can be changed to focus on tactical assets such as commodities. In short, although it could be followed as an effective passive strategy, the SAA provides a management framework based around a realistic approximation of the most uncomfortable portfolio falls you can expect.

How we decided on our Cautious asset allocation

The Alpha ‘Cautious’ strategic asset allocation was developed using indices tracking the total returns of seven core asset classes back to the beginning of 1978. These were UK shares, developed market international shares (hedged to sterling to eliminate currency effects), UK government bonds (gilts), US government treasury bonds (but unhedged to give the US dollar exposure), UK real estate, diversified commodities (with a sterling hedge) and gold (also hedged).

We applied a model that worked out the risk/reward ratio of owning each asset. This didn’t just focus on volatility (measured using standard deviation of asset returns from their mean value), it also adjusted for what are known as skewness and kurtosis.

Unlike data that follows a normal distribution, which displays as a symmetrical bell curve on a histogram, asset returns are often negatively ‘skewed’, ie there are frequent small gains, and the losses, although fewer, are larger. Kurtosis refers to the fatness of tails in a frequency distribution, with the high magnitude losses that occur resulting in fatter tails on the negative (left) side – known as leptokurtic distributions.

Next, we used a coefficient – ‘theta’ – to estimate the level of utility investors with different levels of risk tolerance gained from owning each asset given its risk-to-reward profile. Investors with the lowest risk tolerance get the least utility from owning an asset with high left-tail risk, even if it might also achieve a high rate of return smoothed out over time. These conservative investors are assigned a greater theta for the utility calculation.

In our four strategic asset allocation models the theta coefficients in ascending order are: Adventurous (2.5), Moderate Risk (3.5), Balanced (4.5) and Cautious (6).

Finally, we used an optimisation solver to calculate which combination of our seven assets gave the highest utility given the theta we had assigned to different risk groups. In the case of all our strategies, the optimal risk-to-reward portfolio eschewed diversified commodities and UK real estate as long-run strategic assets although the cautious strategy has a strategic allocation to gold.

Below is the long-run strategic asset allocation for a cautious investor, based on the opportunity set of investments that we surveyed:

How we made the long-run Cautious SAA contemporary

Going back to 1978, it is realistic that there would have been a big home bias for investors in shares, with even the largest overseas stocks more difficult and costly to acquire. The reason UK shares feature so prominently in our asset allocation models is that the All-UK market index, although naturally concentrated to large-cap shares, has more exposure to smaller companies than the MSCI World index that we use for international shares. Although in the recent past, big companies especially in the US have made spectacular gains, over the 45-year period surveyed the UK index has benefited more from size and momentum premiums.

While a slight domestic bias makes some sense – especially for income investors wanting to benefit from the UK plc dividend culture and to receive those payments in pounds – the modern equity investor needs to think globally. This is now much easier to do thanks to low-cost exchange traded funds (ETFs), which are the tools we use to create a contemporary and easily investable version of our strategic asset allocation.

We keep true to our risk management principles in two ways. The first is to not alter the levels of bonds from our long-run SAA model and to set an upper limit for the gold allocation of 5 per cent. This means any changes are made by altering the balance between the riskiest assets (shares and gold within its additional constraint).

Secondly, we calculate the risk budget for the long-run strategic asset allocation and stipulate that the adjusted strategic asset allocation cannot exceed this. The measure used for the risk budget is related to Modified Value at Risk (MVaR), which also takes account of skewness and kurtosis.

Using daily returns for ETFs tracking the five asset classes that made it into our strategic asset allocations (UK shares, global shares, UK gilts, US treasuries and gold), we applied the weights of our long-run cautious asset allocation and calculated that we would expect to lose a minimum of -1.70 per cent in portfolio value on the worst 1 per cent of days. (We could also estimate the average extreme loss on those days but for our purposes we are concerned with the risk threshold).

Then, we look to optimise the level of returns we can achieve, subject to the MVaR threshold being no worse than -1.70 per cent and the constraints set around keeping to our bond weightings. We do this by running a query to solve for the highest MVaR Sharpe Ratio.

This ratio (designed by Favre & Galeano) is a variation of the famous Sharpe Ratio. The numerator of the original is the excess return of a security or portfolio over and above the ‘risk-free’ rate of return (the yield on a safe sovereign bond) and the denominator is standard deviation of the security/portfolio returns.

The MVaR Sharpe Ratio has the same numerator but the denominator is the risk-free rate minus the risk threshold we calculated. Running a query to achieve the highest ratio subject to the outlined constraints, the weights suggested are used for our contemporary strategic asset allocation for cautious investors. For all of these models, we owe a mention of gratitude to NEDL – the channel focused on teaching coding solutions for investors. 

Remember, portfolio management isn’t about eliminating risk, it’s about managing it and that’s what the SAA helps us to do. The opportunity cost of not investing at all is the guaranteed loss of inflation outrunning returns on cash. Although the worst drawdowns might exceed expectations anchored in the era of quantitative easing inflating share prices, being realistic about them is vital. This is an important step in getting comfortable and becoming systematic in making active decisions that can help improve your portfolio.