A Risk-On, Risk-Off ETF Income Portfolio

I'm increasingly convinced that investing for income is a robust and increasingly relevant investing theme. I also believe being a good investor, is more about the ability to manage risk than being good at selecting or timing exposure.

The portfolios is structured as a Global Absolute Return Income mandate, subject to rule-based but dynamic Risk Management guidelines.

The end result should be a portfolio constructed according to state of the art techniques, and with what I deem to be the best ETP’s in the Cranberger database.

With a focus on Risk Management, I construct the portfolio with a focus on Risk Management starting top-down by minimizing Geopolitical Risks, focusing on Countries with Strong or improving surpluses, trading at relative attractive valuations. The aim is to find several currencies with Currencies likely to increase. I hence make an explicit bet on some Currencies, by first filtering out countries that has relative high Geopolitical risk (there are indices), from this subset look at present cross-sectional valuation using fx. a CAPE methodology.

Income investing provide, the opportunity to participate in future opportunities, where best priced and from a risk perspective, the ability to port unwanted exposure. “Staying power”!

If we say we want to structure the portfolio from an ideal risk management perspective, It is important to describe what I perceive as being risk. When people talk about risk, they mainly refer to Volatility. Now standard Volatility measures like Variance does not discriminate between down-side or up-side deviation from the mean, but more importantly can we capture all dimensions of risk in a single metrics?

In the current context we are dealing with a number of risks like geopolitical risk, interest rate risk, Financial market risk, that we must mitigate through diversification and hedging

The fact that one cannot construct a portfolio of Assets Independent from liabilities is important insight. Risk is not if the market goes up or down, risk must be the evolution between the value of your unique liability and the assets you have composed to meet this liability. I have written more about this elsewhere.

So in practice im limited in my opportunity set to assets that has a high correlation with Interest Rates and Inflation.

Because the return on such liability-hedging assets tend to be relative low, and I’m under pressure to generate a return drift rate, higher than what the liabilities compound at, I’m also forced to add exposure to risky assets that generate higher returns. But I can be clever about it. I don’t need to invest in 60% fixed income and 40% in Equities.

I do all this by conceptually splitting the notional amount into a number of sub-portfolios, each with its own function.

A liability-hedging “Core” portfolio that should hedge interest rate liability and Inflation. I could create my own Core portfolio completely with a mixture of Actively Managed Aggregate Bond portfolio ETFs, Investment Grade Floating Rate loans and Real Asset ETPs, optimized to track my unique liability proxy. However there is overshadowing element of practically and cost, so what I do is to split the “Core” allocation into two Actively Managed Fixed Income ETPs with a flexible Global Mandate and that allocate capital according to a Duration band or target. And get exposure to the Inflation liability through the selection methodology, by limiting my opportunity space in the Performance seeking portfolio, to Assets and Strategies with a positive correlation to my Inflation proxy. The reason i do this is fully utilize the comparative advantage specialized Fixed Income ETP providers offer at comparative low cost in the ETP format.

A number of more risky “Satellite” portfolios diversified across several return drivers. Here i have an absolute return approach starting top-down by noticing, that even after diversifying across return driver, one is still subject to geopolitical risks and extreme events. I think a way to try mitigate such risk, is to limits the opportunity-set into assets denominated in currencies of Countries with a solid and improving credit rating. This should likely contribute to the portfolios performance both through lower risk, but also in an element of currency appreciation.

Notice how i try to diversify not across Asset Classes, but across as many different return drivers as possible. However the allocation between the Core and Satellite Portfolio is not fixed or static.

Through Risk-Budgeting techniques I can vary my exposure between the “Core” and “Satellite” portfolios Strategically depending on how far I am from having the house fully funded. Within the “Satellite” sub-portfolios Allocation can also be varied Tactically dependent of current market over-under valuations.

The key must be that the process is mechanically in order to eliminate many of the human biases we have, and with an eye for trading costs.

However one also have to accept that no matter how diversified the portfolio is, especially in this risk-on and risk-off environment with much uncertainty, I need to complement the setup with:  

3. A "Completeness" portfolio used to neutralize tactically any excess or unwanted return driver exposure and Currency risk.

4. An “Extreme-event” portfolio to hedge the Event risks that diversification, can never eliminate. Such portfolios often consist of VIX/VSTOXX-derivatives or options that unfortunately has costs and hence some "return-drag" on the portfolio.

One can view this as a insurance premium a prudent investor should be ready to pay. I know of hedge funds who opportunistically look at volatility surfaces for the best offers at any given time. Perhaps with a bit of effort one can construct such hedging at a credit, but the question remains if it is worth the time and cost. There is also the option of just buying access to a manager who specialise in Extreme-event overlays.

Options overlays

There is a couple of ways I see the portfolio benefitting from options overlays.

Risk reduction:

From a risk reduction perspective one can buy protective put on any instrument with a high correlation against the portfolio, or alternatively buy calls on VIX/VSTOXX futures.

Yield-Enhancement:

From a yield-enhancing perspective one can tactically utilize Covered-call writing. When a stock price stays near or below the strike price, investors keep their shares and option premium, enhancing the portfolio’s yield. Or one can tactically write OTM VIX/VSTOXX puts.

The main point of options overlay is the same as risk-budgeting techniques. it helps truncate and tilt the return distribution favorably.

Weighting methodology

The liability hedging "Core" portfolio should be optimized so as to minimize the tracking error vis-a-vis the liabilities. In practice it is very difficult due to lack of good liability benchmarks and variation, it is just key that there is an element of stabile correlation.

For the "Satellite" portfolio, it is more an exercise of a traditional Risk Parity framework, whereby assets are weighted such that each Return Driver contribute an equal amount of risk.

Note: Unlike the traditional mean-variance portfolio, such equal-risk portfolio does not require an assumption about the expected returns of each asset and simplify the weight optimization.

Regarding the dynamics of the Allocation between the "Core" and "Satellite" portfolios.

I'm convinced that the difference between a good or bad Portfolio Manager is in the approach to taking risk. Structuring a portfolio between on one side, a Core portfolio of liability hedging assets and on the other side, a set of Satellite portfolio of different return drivers, can only be the starting point.

As the difference between the value of Assets and Liabilities move dynamically with the markets, i'm obliged to change the allocation based on my current capacity for taking risk.

If this dynamic can be rule based, eliminating human "Bias" and clearly structured according each investor's unique and time varying capacity to take risk, then I believe the such process is much more robust and prudent vis-a-vis a strategy based on guestimating the next asset that will outperform.

Therefore the allocation between the Core and Satellite portfolio should be managed Strategically through a dynamic risk budgeting methodology like CPPI/VPPI/TIPP described elsewhere , but allocation should only change when benefits outweigh costs of course.

Additionally it may make sense to tactically rebalance the Satellite sub-portfolios for tax harvesting. ( Interesting rebalancing methodology Collar-weighted ).

To Summarize Total return can be broken-up into four components:

Targeted Return streams

1. Income in the form of Yield and Dividends from Assets

2. Return from Currency Appreciation

3. Option Premium from Option Strategies

Return Streams I dont Target per see, but are happy to see

4. Return from an increase in Price of Assets

Over the coming months, I will perform due diligence on all ETP's within the different income generating assets groups, and post them in a structured format here.

Please: If you know of any Risk Budgeting or Asset Allocation Expert, you feel may contribute with stress testing above framework, please encourage them to stop and post their comments for all of us.

Note on the role of illiquid Real Assets:

One could include illiquid Real Assets into the life-cycle of the portfolio as it evolve. My thinking is that if I can get exposure to a non-listed and hence Stale Priced asset like Forestry or Real Estate, on a sub-section of the Portfolio that is never at a liquidation risk it will provide access to:

A. An illiquidity Premium

B. Smoothing of Volatility and Drawdowns, as the Real Asset price discovery is Stale.

C. Inflation hedge because fx. Rental Income is CPI indexed

I know some Managers like Swendsen from Yale Endowments, use heavy allocation to illiquid assets, just to capture that extra illiquidity beta premium, but they have also had to sell some of these illiquid assets at precisely the wrong time and at a steep hair-cut in order to to fund liabilities.

Once the combined Core-Satellite Portfolio has performed into a state of funding surplus (Assets cover projected future Liabilities) the framework gradually migrate into more of a absolute return portfolio. For HNWI Investors, perhaps one day cleared OTC Swaps would be available, that allow one to to swap the portfolios return for a fixed return, locking in the needed returns and securing Investor completely.

For investors who wants more..

After having successfully funded Liabilities, Investor is no longer constrained to Liability correlating Assets. Investor can invest into everything he/she wants, and could introduce leverage, as a function of a portfolio yield minus funding rate.

Just to make it crystal Clear! Please note below Product does not constitute any buy recommendations from my side. Each investor has a unique Liability side and Risk aversion, so naturally the highlighted product may not fit your situation.

 

Step 1 - Core

Step 2 - Satellites

 

Fair Value Reversion

Step 2 - Satellites

 

Economic Growth/multiple Expansion

Step 2 - Satellites

 

Momentum

Step 3 - Hedges

 

Extreme Event

Step 4.

 

Tactical Completeness Portfolio

1. Fixed Income

         

RIGS

Riverfront Strategic Income Fund

US00162Q7833

Net Expense 0.22

         

BYLD

iShares Yield Optimized Bond ETF

US46434V7872

Net Expense 0.28

         

 
         

2. Equities

         

2.1 Dividend Strategies - With ETP Options Available

         

Developed Markets

 

IDV

iShares Dow Jones EPAC Select Dividend Index Fund

US4642884484

Net Expense 0.5

     

Emerging Markets

 

DEM

WisdomTree Emerging Markets Equity Income Fund

US97717W3152

Net Expense 0.63

     

US

 

SCHD

Schwab U.S. Dividend Equity ETF

US8085247976

Net Expense 0.07

(06.05.2014 US trading Rich)

     

2.2 Dividend Strategies - Quality Enhanced

         

Europe

 

EUDG

WisdomTree Europe Dividend Growth Fund

US97717X6105

Net Expense 0.58

     

Developed Markets -  & USD Hedged

 

IHDG

WisdomTree International Hedged Dividend Growth Fund

US97717X5941

Net Expense 0.58

     

2.3 Global Macro - Value

VIDI

Vident International Equity Fund

US26922A4040

Net Expense 0.75

       

3. Commodity

   

FTGC

First Trust Global Tactical Commodity Strategy Fund

US33739H1014

Net Expense 0.95

   

4. Alternatives

VXVIB.PA

US Volatility Short Balanced EasyTRACKER

FR0011176403

Net Expense 0.8

   

CVOL

C-Tracks Linked to the CVOLT Index

US17316G7271

Net Expense 1.15