WiseBanyan strives to maximize after-tax, real investment returns tailored to each client's tolerance for risk. We construct portfolios across different asset classes, customized to each of our client's risk tolerances. For investment purposes, we use a portfolio of passively managed exchange-traded funds ("ETFs") selected from a database of over 1,400 different ETFs based on their investment focus, tracking error, historical performance, and operational efficiency.
Our strategy focuses on Modern Portfolio Theory ("MPT"), which provides the framework for targeting the highest portfolio returns possible given a certain level of portfolio risk. MPT focuses on diversification, or the idea that asset classes and securities should move independently of each other. Correlations among asset classes are calculated: the higher the correlation between two securities or asset classes, the more similar their future performance. Following this, holding correlation constant, uncorrelated asset classes will not suffer similar price shocks at the same time (unless by chance); thus the inclusion of two or more uncorrelated securities will dramatically reduce the portfolio's risk. MPT combines securities in a single portfolio such that the return is maximized for any given level of risk.
To get nerdy, MPT relies on Mean Variance Optimization ("MVO") which constructs portfolios designed to capture the highest level of returns for a given target variance or volatility. We do however modify MVO somewhat and constrain allocations within the broad asset classes of equities and fixed income. (For the purposes of this constraint and due to the fixed payment schedule and interest rate exposure we include real estate in the fixed income portion of the portfolio). Whereas unconstrained MVO can yield lopsided portfolios, our method ensures proper diversification among sub-asset classes. Further, it also helps to account ahead of time for the increased correlations that we observe during times of market stress: international equities can be a poor diversifier for US equities during a severe market downturn, which is why it is beneficial to consider the risks of the equity bucket as a whole. Indeed, while many risks are at a macro level – interest rates, inflation, GDP growth, etc. – the most important consideration is the risks of an equity allocation as a whole rather than the consideration of sectors within that asset class relative to one another.
One of the key concepts in MPT is the concept of the efficient frontier. The efficient frontier can be graphed to display the highest level of expected return based on the set preference of risk. The example graph below plots the optimal portfolio to maximize returns for a given level of risk, based on the theory of the efficient frontier:
Any portfolio lying on the line is optimal, meaning that a higher return cannot be achieved without taking on more risk. Thus, the constructed portfolio is deemed efficient. Many casually constructed portfolios reside below the efficient frontier meaning they are not optimized to maximize returns for the given levels of risk. WiseBanyan constructs portfolios that start along the efficient frontier, and remain there through automated rebalancing. This keeps our clients' investments working as efficiently as possible. The framework for MPT was first introduced by Harry Markowitz in 1952 and later expanded upon in his book Portfolio Selection: Efficient Diversification of Investments published in 1959. Markowitz was awarded the Nobel Prize in 1990 for his work on Modern Portfolio Theory (www.nobelprize.org).
Figure 1.1: Efficient Frontier, The power of diversification