• Martyn Wild

COVID-19 & taking portfolio construction one step further

Updated: Jul 25, 2021

By Martyn Wild.

Chicken Little in financial markets?

Is the sky is falling in?

Like many (if not all) investment advisors out there, we're really busy at the moment. How will COVID-19 affect markets? Will there be a recession? What do I do differently (if anything)? These are some of the common questions we're hearing. So what to do?

Remember your training

Well, at the risk of sounding like a broken record, our general advice is to spend an appropriate time determining your strategy and then stick to that plan. In times like these, there is an understandable human desire to just do something. We get that. Nevertheless, in our experience, good-intentions (even logically derived ones) often undermine a good strategic plan. As such, only in rare cases do we adjust our strategic positioning once set; because doing so tacitly means we didn't (or couldn't) fully consider the future pattern of market returns.

Remind me again - what's the goal?

When you construct a standard efficient frontier, you kinda get what you are given when it comes to the likelihood any given portfolio delivers the average return or better (regular readers of our materials know that we call this likelihood the 'Success Factor'). What we really want to do when constructing portfolios is maximise the Success Factor. Sure, our ongoing research has enabled us to materially improve the Success Factor for any given risk efficient portfolio, but it's fair to say that the marginal rate of improvement will diminish.

What we need is a different way of looking at things...

Ask better questions

In the chart below, we illustrate a return/risk frontier derived using our proprietary optimisation techniques (orange line).

Return v Risk Frontier

To calculate this curve, we are essentially solving the following objective function:

"Derive the most risk-efficient frontier"

The second chart (below) shows the native Success Factor of the efficient frontier derived above. Notice how the Success Factor is less than 50% for the least risky portfolios? That's just the way it is when you focus on minimisation of volatility for a given level of return.

Return v Success Factor Frontier

Can we do any better? We think so but it means we have to ask a slightly different question. In the chart below, we apply precisely the same approach as before, but this time define a more complete objective function:

"Derive the most risk-efficient frontier and ensure that the Success Factor is at least 60% (where possible)"

When you do that, you get this...

Return v Risk Frontier - including target probability frontier

In this chart, the red line illustrates all risk-efficient portfolios that also have a Success Factor of at least 60%. In this case, a 60% Success Factor means that the portfolio delivers the target return or greater at least 60% of the time, i.e. way better than a coin toss and materially better than the standard efficient frontier. At first blush, the red line is still a risk-efficient frontier but clearly inferior to the orange line in return-risk space. Does that matter?

Return v Success Factor Frontier - including target probability frontier

Whether this approach is superior ultimately comes down to whether you feel that a little bit of extra volatility is worth a comparatively large improvement in Success? If yes, you optimise based on the red line. If not, the orange.

From our perspective, portfolio construction should be about maximising the risk-adjusted Success Factor of achieving your target return and not simply be an exercise in minimising volatility. We like red.

Getting a piece of the action

If you are wondering precisely how we build portfolios like these, the answer is that we have built a proprietary model backed by decades of research. Traditionally, we have constructed portfolios for clients by operating this tool on their behalf. However, recognising that some advisors would like to construct client-portfolios by themselves, we are now offering the tool in a form that enables suitably trained users to do it for themselves! Some of the key aspects are:

Core Model

  • Microsoft Excel-based

  • 1-year time-horizon portfolios

  • Includes 9 key asset-classes

  • Data updated quarterly

  • Users can apply minimum and maximum constraints by asset class and by overall growth assets

  • Users can specify which assets are considered 'growth' or 'defensive' and in what proportion

  • Users can derive standard efficient frontiers and MARQAM frontiers with all key graphs and statistics by portfolio

  • Users can also derive individual portfolios with specific target returns

Advanced Model - same as Core Model plus...

  • 1 & 5-year time-horizon portfolios

  • Users can add up to 5 additional asset classes of their own including third-party manager portfolios (subject to those assets having a long enough return history)

  • Users can also derive Success Factor-targeted MARQAM frontiers with all key graphs and statistics by portfolio

  • Users can also derive individual portfolios with specific target returns and minimum Success Factor targets

So if you think it is time to take your portfolio construction to the next level, let us help you take the next big step upward.

For more information or to talk to a member of the MARQAM team, please click here.

MARQAM is a privately-owned, boutique consulting company focused on providing superior investment outcomes for clients and greater profitability for businesses. We are not affiliated with any other financial institution

Disclaimer: The information provided here is for interest purposes only and does not constitute investment advice or a recommendation of any kind.

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