Cedars Hill Group has a unique portfolio construction philosophy which has been informed over an institutional portfolio management career that began in 1996 and continues to be refined today. The construction process has two common primary goals: the growth and protection of wealth but we take a unique approach to achieve these goals. ## Compound Wealth, but for what Purpose? Popular Markowitz portfolio theory is a single period concept however wealth is created over multiple periods and therefore compounding wealth is a multiplicative process. This means that is occurs over a period of time and takes a unique path for each investor. This necessitates an ongoing decision-making process over the life of a portfolio and trusted principals to execute that process. Like most advisors we start with setting goals and determining what sort of compounding of wealth is required to achieve those goals. Typical client goals are saving for college, weddings, retirement, charitable giving, and "keeping up with inflation." These exist along a spectrum of specificity and the more wealth one has the harder it is to have specific goals. The more abstract goals are the less likely you will achieve them. This is where applying the institutional discipline of specificity can unlock many benefits for non-institutional clients. If goals are too aspirational, based on available risk-adjusted market returns, we will push back on those goals or encourage more risk tolerance to achieve those stretch goals. We believe that goals should be informed by the available market capacity to underwrite those goals and that capacity depends on the investor's risk tolerance. Risk tolerance is widely misunderstood and risk management is mostly about running away from risk. We encourage [[Jerry Colonna TKP Interview|running towards something instead of running away from something]] in general and when it comes to constructing a portfolio. We take a layered approach to attain desired wealth outcomes. We start with the returns available to the lowest risk asset, cash, and then determine what marginal risks are most attractive to achieve marginal returns which stack up to provide the required wealth growth and volatility. We consider the risk of both the goals and the investment returns and seek to immunize these as much as possible. For example, an individual planning for retirement has an inherent short inflation position since their post-retirement expenses are greatly impacted by inflation and lower retirement expenses require less savings today. This observation alone demonstrates how unique our philosophy is because it would encourage investing in assets which are positively exposed to inflation which bonds are not. This philosophy implicitly raises the bar for an investment in bonds which are a core component of the widely accepted 60/40 portfolio. The output of the goal setting process is a decision-making process. ### Decision Making The decision making process is the most important part of the portfolio construction process. Employing a consistent process allows us to learn from outcomes and adjust strategy accordingly which increases the probability of achieving our goals. To measure the quality of our decisions we must start with the most basic and layer on the decisions from there. Any decision to add a layer can be tracked and measured to see if it is achieving the expected outcomes. Performance is an important output of portfolio construction and we must measure performance to understand how our construction decisions impact the portfolio returns. Performance can be absolute or measured relative to something else. When targeting an absolute rate of return we should strive to take as little risk as possible to achieve that rate of return. Cash becomes the natural benchmark to measure performance against because cash carries very little, to no [[Risk|risk]]. The vast majority of investors are targeting an absolute rate of return, because their goals are based on achieving a certain terminal wealth. In that case if you can fully lock-in the required rate of return to achieve your desired terminal wealth with little, to no risk, then you should just buy the "risk-free" asset that delivers that return and call it a day. Unfortunately, the required rates of returns to meet our goals tend to be much higher than what risk-free assets offer. Therefore when deciding how to construct our portfolio we employ this layering approach and we consider the impact that returns and volatility have on the path dependency and ultimate outcome of terminal wealth. When we set our terminal wealth goals we pair that with a risk tolerance based on how far off path we are comfortable deviating. **There is a fundamental truth that marginal returns come with marginal risk and marginal risk increases volatility which lowers the odds of achieving our terminal wealth goals.** When targeting relative performance we must start with the thing we are trying to beat and layer on decisions from there. First, we can decide to own the thing or not. This decision is all about tracking error. When you choose the benchmark index you get its return and risk. If you want the return with less risk you can choose to buy things that are less risky and not included in the index, but this will likely lower your return and increase tracking error. Second, we can choose to rebalance the index at different intervals or we can choose to own it for different periods of time. This is commonly called tactical asset allocation or market timing. The idea that you should be starting to realize is that returns can be generated in many different ways. So much focus is on security selection but that is just a small part of the overall construction process. ## Protecting Wealth, from what or whom? Protecting wealth is not about avoiding risk, it is about taking risk intentionally and putting yourself in a position to first not be hurt by uncertainty and second to profit from uncertainty. **The biggest risk to your portfolio is you.** You can 100x your money over ten-years but you must be willing and able to withstand massive deviations from that goal in the path to realizing that outcome. This is not a quantitative process, it is philosophical and requires radical self-reflection. ### Required or Desired Terminal Wealth The realized compound annual growth rate of our wealth will be the mean arithmetic return we earn less one half the volatility, $\sigma$, of those returns: $ realizedCAGR = arithmeticReturn - \frac {\sigma^{2}}{2} $ The required CAGR to achieve our terminal wealth goals is dependent on the time horizon $T$: $ requiredCAGR = \sqrt[T]{\frac{endingWealth}{startingWealth}} -1 $ Because of the fundamental truth that as our required CAGR increases the volatility we will experience increases there is a tradeoff between risk and reward that we must make. The Sharpe Ratio measures return per unit of risk and provides a useful construct for making this tradeoff. We can target a desired Sharpe which will give us a required volatility: $ \sigma = \frac{CAGR}{Sharpe}$ When we seek return we must take risk to achieve a return above the risk-free rate. Based on the return and risk objectives our next task is to construct a portfolio that delivers these desired outcomes and characteristics. This is where we start to consider how the different risks combine together. If our objectives are impacted by certain risk factors that we can hedge in our investment portfolio that is an opportunity to increase return, lower volatility, and increase the certainty of achieving our desired outcomes. If we are seeking a single return objective then the challenge is to find the right combination of assets that achieve that return objective but also minimize the volatility of the different possible path's to that outcome. ### Risk Identification & Selection Corey Hoffstein suggests selecting risks across three dimensions: how, what, and when. This is based on the fact that returns can be harvested by more than just security selection: 1. Rebalancing Timing 2. Strategy Selection: L/S, CTA, HF, PE, etc. 3. [[Asset Class Index|Asset Class]] Selection 4. Style Selection: Value, Growth, etc. 5. Factor Selection: Momentum, Quality, etc. 6. Security Selection 7. Cash Allocation: can we achieve a similar Sharpe with a combination of cash and risky asset? The process of risk selection is best viewed as a negative art; meaning that we start by trying to exclude things from our universe of possible selections. We can do this based on the unique environment at selection time. For example, currently (August 2023) the high yield bond market is trading at historically tight spreads (rich valuations) while the probability of a recession is high (negative fundamentals). While valuations alone are never a reason to short something, they can be a good reason to exclude something from our universe because they lower the potential reward from the risk in that thing. So today, it is fairly easy to exclude high yield bonds from our selection universe. However, whether we choose to short high yield is another, separate decision. This method of exclusion is how we are able to match the returns on offer in the market against our goals. ### Covariance We also consider the covariance amongst the portfolio holdings as well as amongst the factors that may change our goals. Take inflation for example, if our goal is to return inflation plus some margin then our portfolio should be constructed to highly correlation with inflation and then take idiosyncratic risks that are uncorrelated to inflation to generate the margin above the rate of inflation. While correlation and covariance are statistical concepts, the measure themselves are less stable than the causal forces which create them. ## Differentiated Outcomes By following this philosophy you will find that you do things very differently than traditional wealth management practices prescribe. One example is that this process is intensive and requires a lot of ongoing work. Most non-professional clients do not want to do this work so they choose to outsource it to a manager or managers. If you go through this process and come to this decision the next step you take in manager selection is something very different than what a traditional manager selection process is. You will search for a partner that shares your philosophy and aligns with your values instead of a product that meets your superficial needs. This process is designed to meet your core needs of financial safety and prosperity. Below are some of the different ways we think about common features of modern day portfolio construction. ### Benchmarking Benchmarks are useful for determining how to pay investment managers, other than that we find they provide little value in the portfolio construction process. Tracking error against a benchmark is widely used as a risk measure today but it has little relevance to the investor. Sometimes tracking error is desired against a sub-optimal benchmark. Sometimes benchmarks are viewed as optimal portfolios because they have recently delivered attractive performance and Sharpe ratios, however many times the same Sharpe can be achieved by a less risky combination of cash and a risky asset. ### Asset Allocation [[ReSolve's 12 Days of Investment Wisdom-Day 1|The alpha from asset allocation is more sustainable than the alpha from security selection.]] Modern portfolio construction methodologies generally fall into three categories: 1. Mean-Variance Optimal (Markowitz, Efficient Frontier, etc.) Portfolios 2. Growth Optimal Portfolios 3. Risk Parity Portfolios The mean-variance approach taken under the Markowitz methodology is the easiest to implement and by far the most prominent asset allocation model used by practitioners. We take a different route altogether by borrowing different aspects of all approaches to build growth optimal portfolios which can also be a subset of of Markowitz optimal portfolios, also utilizing a risk-based framework to minimize uncompensated portfolio risk and diversifying among compensated risks. ### Factors **Case Studies:** - [[CHG Issue 188 Cinco de Mayo]] - [[CHG Issue 164 Real Estate in a Rising Rate Environment]] - [[CHG Issue 163 Reframing the Bond Market]] - [[CHG Issue 148 Unpacking Investment Vehicles]] - [[CHG Issue 142 What's the Frequency, Kenneth]] Explore Further: [[CHG Risk Factors]] | [[Sizing]] | [Corey Hoffstein's 15 Ideas, Frameworks, and Lessons](https://blog.thinknewfound.com/2023/08/15-ideas-frameworks-and-lessons-from-15-years/) | [[Ergodicity]] | [The Kelly Criterion, Capital Market Parabola & The Almighty Sharpe Ratio](https://outcastbeta.com/the-kelly-criterion-capital-market-parabola-the-almighty-sharpe-ratio/) | [ReSolve Asset Management](https://investresolve.com/research/) Tags: #portfolio-management Your support for Cedars Hill Group is greatly appreciated <form action="https://www.paypal.com/donate" method="post" target="_top"> <input type="hidden" name="hosted_button_id" value="74PGN8ZXHQVHS" /> <input type="image" src="https://www.paypalobjects.com/en_US/i/btn/btn_donate_LG.gif" border="0" name="submit" title="PayPal - The safer, easier way to pay online!" alt="Donate with PayPal button" /> <img alt="" border="0" src="https://www.paypal.com/en_US/i/scr/pixel.gif" width="1" height="1" /> </form>