In this edition of the Model Portfolio Masterclass Series, we provide a high level overview of how MVO can help construct a Model Portfolio that aligns with a client’s risk tolerance and return objectives. In subsequent editions, the Masterclass Series will dig deeper into the topic and work through several ‘How To’ exercises to explain in more detail a wide range of approaches that a hands-on practitioner can follow.
What is a Model Portfolio?
A model portfolio is a pre-designed collection of investments, such as stocks, bonds, Mutual Funds and Exchange Traded Funds (ETFs) created to meet a specific investment goal or risk level. It serves as a template or guide that investors can follow to build their own portfolios, making it easier to align with objectives like growth, income, or capital preservation.
When it comes to designing Model Portfolios that include Structured Notes, though, such an inclusion makes the task of backtesting a strategy very difficult for those who do not have access to complex risk management systems. For that reason, while there is quite a broad range of investment products that are used to build Model Portfolios, for today’s discussion we shall restrict our attention to just using funds, revisiting this topic in later editions of the Masterclass Series.
Model Portfolio Lifecycle
A model portfolio is a pre-designed collection of investments, such as stocks, bonds, Mutual Before jumping in, it’s worth placing the crucial step of portfolio construction in context by first looking at the full lifecycle and key topics to address when running a Model Portfolio Service.
Defining Investment Objectives and Client Needs
- Identify Client Segments: Start by analysing the target client base. Consider demographic factors, risk tolerance levels, financial goals, and investment horizons.
- Set Clear Investment Objectives: Determine the core objectives for each portfolio, focusing on factors like growth, income, and capital preservation. This will inform the level of risk each portfolio will assume.
- Risk Targeting Framework: Define specific risk targets and tolerances for each portfolio, using standardized measures (e.g., volatility, maximum drawdown, Value-at-Risk) tailored to client needs.
Asset Allocation Strategy
- Design Strategic Asset Allocation (SAA): Develop a long-term asset mix based on the defined risk objectives. This could include equities, bonds, commodities, and alternatives depending on market expectations and risk tolerance.
- Incorporate Tactical Adjustments (TAA): Implement tactical shifts around the SAA to exploit shorter-term market opportunities, adhering to the portfolio's risk budget. Potentially add themes and sub-asset classes as tactical tilts.
- Factor Integration: For more precision, consider incorporating factors (e.g., value, momentum, quality) aligned with the portfolio’s objectives.
Investment Vehicle Selection
- Select Suitable Instruments: Choose between ETFs, Mutual Funds, and other investment vehicles that fit the portfolio's needs.
- Evaluate Cost and Liquidity: Balance expense ratios, bid-ask spreads, and other transaction costs with liquidity to ensure efficient access and scalability.
- Ensure Diversification: Use a diversified mix within each asset class to manage risk and achieve the targeted exposure across sectors and regions.
Portfolio Construction and Optimization
- Optimize Weightings: Use portfolio optimization techniques, such as mean-variance optimization or risk parity, to assign weights that align with the portfolio’s risk-return goals.
- Backtesting and Stress Testing: Assess historical performance and stress test the portfolio under various scenarios (e.g., interest rate shocks, market downturns).
- Implement Risk Controls: Define and apply risk controls, including maximum asset and sector exposures, to protect against concentration risks.
Platform Selection
- Portfolio Management Tools: Ensure the platform supports advanced tools for rebalancing, performance tracking, risk assessment, and reporting to meet your model portfolio needs.
- Platform Fees: Review the fee structure, including administrative, transaction, and custody fees, and consider how they will impact portfolio performance and client fees.
- Distribution Opportunities: Some platforms have extensive networks of financial advisors, which can help expand your reach. Assess the platform’s network size and type of advisors (e.g., wealth managers, IFAs) to ensure it aligns with your target audience.
Portfolio Implementation
- Execution of Trades: Implement the initial portfolio design, carefully managing transaction costs, slippage, and timing.
- Monitor for Drifts: Track any deviations from the target asset allocation due to market fluctuations or asset price movements.
- Rebalancing Protocols: Set periodic or threshold-based rebalancing protocols to maintain the portfolio’s allocation within the set risk bands.
Ongoing Monitoring and Rebalancing
- Regular Performance Review: Continuously review portfolio performance against benchmarks and reassess alignment with client objectives.
- Tactical Adjustments: Make tactical adjustments as necessary to adapt to changing market conditions without deviating from the portfolio’s risk profile.
- Rebalance as Needed: Conduct rebalancing in accordance with either time-based (e.g., quarterly) or drift-based (e.g., asset allocation deviation) protocols.
Implementing a Framework for Testing Model Portfolio Strategies
- If you want to become a hands-on practitioner, it will become apparent that while the theory of fund selection is easy to grasp, the vast number of available funds very quickly presents its own problems.
- When thinking about testing how a particular asset allocation model performs, one needs to differentiate between the model that determines the weight of the allocation to each asset class and sub-asset class, from the individual investments that you will allocate to those buckets?
The framework that we have developed at Algo-Chain is to take an ‘ETF first’ approach. Many ETFs are index trackers providing end investors with access to sections of the market, and in that sense, act as good proxies for parts of the market. ETFs are well suited for testing an asset allocation model as there invariably is an ETF that provides the exposure you are looking for. Once you have a good handle on what your allocation model looks like, it’s your choice if you allocate using an index tracker or instead prefer to allocate to a tried and tested active manager.
There will be many sceptics who frown when you show them your latest backtested portfolio, ignore them, investing is a science, and it is not feasible to launch an investment service without having first tested one’s strategy. How you interpret your test results is a different matter altogether, and is best left for another discussion, but test you must and for that you need data.