Secular declines in interest and inflation rates have given the investing masses license to stretch Markowitz’s modern portfolio theory (MPT) beyond its contextual foundations and to extrapolate investment practices bearing little relation.

It is time we broaden our core notions regarding portfolio theory and related practical applications. A great starting point for the next leg of forward progress in the realm of portfolio theory is with disaggregated capital at risk (DCaR)—an important extension of MPT encompassing the heretofore lacking dimension of market participation.

Serial autocorrelation in prices (i.e., that prices tend to trend), and rather widely and sloppily imposed (yet rarely discussed) assumptions regarding perpetually “full-in” capital deployment, carry deeply profound and underappreciated implications for the very foundations of portfolio theory and, more importantly, for the construction of practical applications.

Forest For The Trees

One major problem with the majority of the discussion regarding how to manage portfolios is that it starts with the proverbial “trees,” rather than stepping back to gaze at the big-picture “forest.”

The “active vs. passive” investing debate that has raged in financial media circles over the last decade, for example, is relevant and important, but it is far from the first order of “strategy” business that investors and risk managers should undertake. Likewise for ongoing debates regarding the asset allocation format du jour and the casting of opinions regarding the relative importance, prospectively, of individual asset classes or subclasses.

Indeed, starting with the “active vs. passive” debate, irrespective of which of the two strategies (or both) is adopted, or with the asset class allocation matter, can lead to patently wrong conclusions regarding where investors need to look first in order to manage risk.

By focusing on these debates first, many investors erroneously conclude that simply engineering a particular active or passive asset allocation strategy will enable customization of risk and return attributes with precision, thereby ensuring (or so they believe) risk characteristics that they both understand and can live with.

But along the way they’ve missed the first and, really, most critical question: To what extent is capital placed at risk?

Just what does this question mean?

Reduced to their most basic level, any and all investment strategies can be viewed as residing in one, and only one, of three discrete risk buckets:

Risk Bucket 1: Fully principal-protected

 

Risk Bucket 2: Conditional market participation and capital at risk, with explicit exit protocols

 

Risk Bucket 3: Open-ended, uncapped risk to invested capital

In reviewing an existing portfolio of strategies and holdings, investors and risk managers first need to determine the distribution of investment capital across the three macro-level risk buckets. This is also the first level at which an investment strategy prescription must be defined. Starting anywhere else can cause important sources of risk to be underappreciated or entirely overlooked.

Let’s take a closer look at the three capital-at-risk classifications to see what each includes and what it does not include.

Risk Bucket 1: Fully principal-protected

This includes FDIC-insured money market holdings, FDIC-insured certificates of deposit and short-term Treasury securities. All other “cash” vehicles lack explicit protocols that would definitively limit risk to invested capital.

Risk Bucket 2: Conditional market participation and capital at risk, with explicit exit protocols

 

This includes trend-following strategies, and others, that place definitive and explicit exit protocols on holdings in a manner designed to limit participation in negatively trending markets.

 

Risk Bucket 3: Open-ended, uncapped risk to invested capital

 

This includes buy-and-hold strategies of any flavor, whether they employ actively managed and/or passively managed components.

The common denominator is found neither in the instruments used nor in the distribution of holdings across asset classes but, rather, in whether definitive and explicit exit protocols are attached to holdings by the investor or investment manager.

Risk to invested capital that lacks definitive and explicit exit protocols is, de facto, open-ended.

So in which risk bucket would an asset allocation covering equities, fixed income and alternatives fall if it is using actively managed mutual funds to cover each of the asset classes? Such an approach would reside squarely in the third risk bucket if capital allocated to the strategy lacks explicit exit protocols on each of the funds (or if the individual managers, alternatively, lack explicit exit protocols on holdings residing within their respective strategies).

What about the same asset class allocation strategy (across equities, fixed income and alternatives) if index-based ETFs are used instead of active managers? Classification in the third risk bucket still applies since there are no explicit exit protocols in place to limit damage during market declines. For what it’s worth, a mountain of academic and industry research suggests that the strategy using index-based ETFs is highly likely to outperform the same strategy employing active managers. But that topic, a quite important one, would naturally follow the discussion in this paper.

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