Adam, glad you have enjoyed my work and found helpful
The problem with doing what you ask is there is no right portfolio and each portfolio should be tailored to the individual need, ability and willingness to take risk as well as each person's ability to deal with tracking variance risk and illiquidity risk.
I can suggest that the right way to address portfolio construction is to base the construction on the following principles.
An investment strategy should be based on these three core principles
First, markets are highly, though not perfectly, Efficient. That leads to the conclusion that active management is the loser’s game.
Second, if markets are efficient than you should also believe that all unique sources of risk have similar risk-adjusted returns, not similar returns, but similar risk-adjusted returns.
Third, If all unique sources of risk have similar risk-adjusted returns than Portfolios should be diversified across as many unique/independent sources of risk and return as you can identify that meet the criteria of persistence, pervasiveness, robustness to various definitions, implementability (meaning survives transactions costs) and have intuitive risk- or behavioral-based explanations that provide reasons for believing that the premium should persist in the future. We prefer risk-based explanations because risk cannot be arbitraged away, although popularity, and the resulting cash flows can reduce premiums. However, we are willing to accept behavioral explanations because there are what are called limits to arbitrage. The cost of shorting can be high and the losses are unlimited. In addition, The charters of many institutions prohibit shorting. These limits, as well as the tendency for Human Behavior to remain unchanged, allow anomalies, such as the poor performance of small growth stocks with high investment and low profitability, to persist
The problem is that most people don't understand that a 60/40 traditional portfolio has not 60% of the risk but closer to 90% and there is no logic to that if you believe in the principles I laid out, and especially if don't need liquidity, then one should load up on illiquid assets to earn the very significant illiquidity premium. IMO this is the most underutilized factor.
In recent posts, you've invited readers to suggest topics they'd like to see covered. One thing I'd find particularly valuable is a stylized taxable investment portfolio (or a few variations) constructed from the interval and other funds you've recommended. Seeing how you might combine these products in practice would be incredibly helpful.
Thanks, as always, for the consistently excellent content, Larry.
One topic that is always on my mind is the role of currency fluctuation in a portfolio. As I understand it, currency is an uncompensated risk. If one is seeking exposure a systematic risk in a foreign market, how should the allocator account for the added risk of currency fluctuation? I see a few options, here. Option 1: accept the uncompensated currency risk and move on with life (example: buy and hold AVDV, VXUS, etc.). Option 2: hedge the currency risk and accept the higher fees to do so (example: buy and hold HAWX). Option 3: hold a trend following fund that trades in currencies (by the way, is there a difference between trend following, managed futures, and "macro"?). I'm not entirely sure, myself, but if managed futures/trend is itself a compensated, systematic risk, then perhaps this is the optimal way to offset the uncompensated risk of holding foreign assets.
Option 3.5: I see that AQR has AQGIX, a long-only developed-world fund that seems to try to deviate from the MSCI World index's country weightings based on currency trends relative to USD. I'm not truly familiar with the fund, but I think that's what they are doing.
How do you suggest allocators think about this topic?
If you do hedge currency risk then you increase the correlation between US and foreign assets, losing some of the diversification benefits, and incurring the expense of the hedging. Thus, to me it doesn't make sense to do so and it is why most funds are unhedged. I do own AQR's long/short multi factor funds QSPRX and QRPRX which provides exposure to four asset classes and four factors (including momentum). To me that is all you need. Hope that helps
When it comes to topics to tackle it depends on who you want your audience to be. The questions that keep me up at night are that your advice is in many European countries (including mine) not implementable (yes, I am looking at you AQR!!).
I wish some posts would include funds that are at least "good enough" and are implementable in Europe, because you often repeat funds that are undoubtedly state-of-art of what is out there, but also for Europeans it's not actionable advice.
This makes your posts for ppl in my region of the world interesting titbits, but actually many posts are not that useful from practical perspective.
Pavel, while the basic research and investment strategy advice I write about applies to all investors it is true that my recommendations which are applicable to US investors are not often available to non US investors. And as US resident I admit I don't follow what is available outside the US in terms of implementation thus cannot make recommendations without having done the due diligence on them.
Adam, glad you have enjoyed my work and found helpful
The problem with doing what you ask is there is no right portfolio and each portfolio should be tailored to the individual need, ability and willingness to take risk as well as each person's ability to deal with tracking variance risk and illiquidity risk.
I can suggest that the right way to address portfolio construction is to base the construction on the following principles.
An investment strategy should be based on these three core principles
First, markets are highly, though not perfectly, Efficient. That leads to the conclusion that active management is the loser’s game.
Second, if markets are efficient than you should also believe that all unique sources of risk have similar risk-adjusted returns, not similar returns, but similar risk-adjusted returns.
Third, If all unique sources of risk have similar risk-adjusted returns than Portfolios should be diversified across as many unique/independent sources of risk and return as you can identify that meet the criteria of persistence, pervasiveness, robustness to various definitions, implementability (meaning survives transactions costs) and have intuitive risk- or behavioral-based explanations that provide reasons for believing that the premium should persist in the future. We prefer risk-based explanations because risk cannot be arbitraged away, although popularity, and the resulting cash flows can reduce premiums. However, we are willing to accept behavioral explanations because there are what are called limits to arbitrage. The cost of shorting can be high and the losses are unlimited. In addition, The charters of many institutions prohibit shorting. These limits, as well as the tendency for Human Behavior to remain unchanged, allow anomalies, such as the poor performance of small growth stocks with high investment and low profitability, to persist
The problem is that most people don't understand that a 60/40 traditional portfolio has not 60% of the risk but closer to 90% and there is no logic to that if you believe in the principles I laid out, and especially if don't need liquidity, then one should load up on illiquid assets to earn the very significant illiquidity premium. IMO this is the most underutilized factor.
I hope that is helpful
Larry
Hi Larry,
Thank you for all the great content!
In recent posts, you've invited readers to suggest topics they'd like to see covered. One thing I'd find particularly valuable is a stylized taxable investment portfolio (or a few variations) constructed from the interval and other funds you've recommended. Seeing how you might combine these products in practice would be incredibly helpful.
Thanks again for everything you share!
Thanks, as always, for the consistently excellent content, Larry.
One topic that is always on my mind is the role of currency fluctuation in a portfolio. As I understand it, currency is an uncompensated risk. If one is seeking exposure a systematic risk in a foreign market, how should the allocator account for the added risk of currency fluctuation? I see a few options, here. Option 1: accept the uncompensated currency risk and move on with life (example: buy and hold AVDV, VXUS, etc.). Option 2: hedge the currency risk and accept the higher fees to do so (example: buy and hold HAWX). Option 3: hold a trend following fund that trades in currencies (by the way, is there a difference between trend following, managed futures, and "macro"?). I'm not entirely sure, myself, but if managed futures/trend is itself a compensated, systematic risk, then perhaps this is the optimal way to offset the uncompensated risk of holding foreign assets.
Option 3.5: I see that AQR has AQGIX, a long-only developed-world fund that seems to try to deviate from the MSCI World index's country weightings based on currency trends relative to USD. I'm not truly familiar with the fund, but I think that's what they are doing.
How do you suggest allocators think about this topic?
If you do hedge currency risk then you increase the correlation between US and foreign assets, losing some of the diversification benefits, and incurring the expense of the hedging. Thus, to me it doesn't make sense to do so and it is why most funds are unhedged. I do own AQR's long/short multi factor funds QSPRX and QRPRX which provides exposure to four asset classes and four factors (including momentum). To me that is all you need. Hope that helps
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When it comes to topics to tackle it depends on who you want your audience to be. The questions that keep me up at night are that your advice is in many European countries (including mine) not implementable (yes, I am looking at you AQR!!).
I wish some posts would include funds that are at least "good enough" and are implementable in Europe, because you often repeat funds that are undoubtedly state-of-art of what is out there, but also for Europeans it's not actionable advice.
This makes your posts for ppl in my region of the world interesting titbits, but actually many posts are not that useful from practical perspective.
Pavel, while the basic research and investment strategy advice I write about applies to all investors it is true that my recommendations which are applicable to US investors are not often available to non US investors. And as US resident I admit I don't follow what is available outside the US in terms of implementation thus cannot make recommendations without having done the due diligence on them.
Best wishes
Larry