Current market environment performance of dynamic, risk-managed investment solutions.
By Jerry Wagner
The “core” portion of an investment portfolio is often underappreciated, but it is the central portion of the portfolio. Like the core of an apple—which contains the seeds for future harvests—it provides the foundation for growth.
Fall is the season for apples here in Michigan. The cider mills near my house have opened for the year, temperatures are cooling, and apples are everywhere—right alongside the state’s cherries, grapes, and blueberries. Yet when most of us eat an apple, we toss the core without giving it much thought, forgetting it’s not just the center but the part that keeps apples on our tables year after year.
In much the same way, the core of an investment portfolio can seem ordinary compared to the “satellite” strategies around it—but it’s what keeps the portfolio strong and aligned with long-term goals.
Why is the core so central to an investment portfolio?
It goes back to the basics of a portfolio.
Portfolio returns are said to be made up of “beta” and “alpha.” Beta returns are those derived from simply investing in a market—in a bond index or a stock index, for example. Alpha returns are the extra juice that comes from trading, holding alternative investments, or applying tactical expertise. Alpha can enhance the portfolio returns or provide a measure of risk protection.
If you are pursuing a portfolio strategy that includes both beta and alpha, often referred to as a “core and satellite approach” (see illustration below), the core must be allocated the lion’s share of the portfolio. The core portion of the portfolio is the portfolio’s source of beta returns. It is difficult to keep up with a market benchmark if you don’t have a large portion of your portfolio invested in asset classes represented in the benchmark.
A bond portfolio may do as well or better than a stock portfolio at times, but in the long run you are not likely to get stock-like returns from a bond-only portfolio. And the same goes for getting bond-like risk management from a stock-only portfolio.
Therefore, it is important to invest a sufficient amount into the core strategy to make a difference. It has to be enough of an investment to allow the portfolio to keep up with the benchmarks.
In my opinion, 20% to 50% of the portfolio is not enough for a core position. I would prefer to see at least 60% to 70% allocated to the core to increase the probability of achieving the desired amount of beta or market returns for our clients.
Core strategies are pre-allocated to stocks, bonds, and (in some cases) alternatives. They come in various combinations to achieve a level of risk consistent with a number of preselected suitability or risk levels. As a result, three or five combinations ranging from conservative to aggressive mixes are usually offered.
How should a core portfolio be managed?
Conventional wisdom is to simply diversify among a selection of different passive index funds. The percentage invested in each is determined by both the suitability level and the interaction of either past or expected returns, volatility, and correlation of the various asset classes.
Unfortunately, this method is subject to a number of flaws. Studies show that the mean-variance methodology used by most of the industry is not robust. It explains the past with the precision that only hindsight can deliver but fails to deal well with an uncertain future in which we all invest.
It cannot respond to new market environments. It remains fully invested no matter how dire the present is or the future looks. Adjustments (so-called quarterly rebalancing) are determined by the calendar instead of market changes.
A better way would be to adopt the time-proven advantages of diversification—creating stock and bond portfolios based on investor suitability but overlaying these portfolios with risk-management methodologies. This is the approach of our dynamic, risk-managed core strategies.
The advantage of this approach is that you seek to capture the index betas—for bonds, stocks, and alternatives—while building in risk protection beyond what simple diversification can accomplish. The approach is responsive to market changes and is meant to be robust for future market conditions and risk environments.
Find the core strategy that’s right for you
We have several risk-managed core strategies. Each takes a different approach to capturing market beta in a suitability-based wrapper while employing disciplined risk-management systems. Whether you are looking to put trend following or leverage to work for you, or you’re looking for faith-based or socially responsible approaches to reflect your personal values, there is a core strategy for you.
And with our Quantified Fund Credit (QFC) strategies, multiple core strategies are available at a very low cost.
What I especially like about the QFC strategies is that they employ two distinct levels of risk management. First, each mutual fund invested in uses multiple risk-management strategies within the funds. Then, an extra layer of protection is added through the allocation method used among the funds. Two levels of risk management for one low cost.
Finally, with so many core strategies available at Flexible Plan Investments, it is possible to double down on risk management by dividing one’s core portfolio into multiple dynamically risk-managed core strategies.
In our tests here at the office, I’ve seen better results using a number of core strategies in a single portfolio than in placing all assets in one, albeit risk-managed, basket. For example, you can create a portfolio with four different core strategies of 20% each at the investor’s suitability level, and then invest the final 20% in some alpha-producing strategies. Our testing shows this approach often produces a smoother growth line, as the added diversification of multiple core strategies can further reduce volatility.
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For more information on how a multi-strategy core approach can address the drawbacks of a passive portfolio, download our white paper “A passive core is not enough” here (for financial professionals only).