The ultimate goal of investing is the growth and preservation of capital. This requires us to have a long-term focus and to invest in diversified portfolios that seek optimal combinations of capital appreciation and preservation.
We believe asset allocation is the main determinant of portfolio returns. The centrality of asset allocation stems from its role in determining the optimal portfolio allocations to distinct asset classes based on investors’ time horizon and risk tolerance. We employ strategic asset allocation: determining an asset mix appropriate for a targeted level of risk tolerance. We systematically rebalance the portfolio to the pre-determined long-term asset allocation target and review the asset policy mix in conjunction with investors' changing needs, expected returns and type and availability of investment instruments. We partition asset classes according to their portfolio role. We see equity as the engine of growth and fixed income as preserving capital and generating income. Alternative investments have the potential to enhance portfolio diversification due to their low correlation to traditional asset classes such as equities and fixed income.
The Role of Asset Classes
We believe that the equity markets are inefficient. According to behavioral finance, most people tend to make decisions based on emotions rather than rationality. This causes stock prices to deviate from their intrinsic value thus creating opportunities for disciplined investors. Another contributor to market inefficiencies is the institutional model that is followed by large firms. An active manager can only add value by deviating from the benchmark index. However, the evidence shows that managers, on average, build portfolios not significantly different from their benchmarks due to institutional factors that encourage them to over-diversify. We believe that both investors’ behavioral biases as well as the dominance of large institutions are structural phenomena that can be exploited systematically to earn excess returns over the long term.
Contrary to the equity markets, the degree of opportunity for active management in fixed income is less promising due to the high price efficiency of these markets. For specialized areas such as mortgage backed securities or leveraged loans that require deep asset class expertise and strong risk management, we seek active managers with a proven track record. To gain exposure to other more efficient areas of fixed income we employ highly diversified, low-cost investment vehicles such as exchange traded funds.
Traditional alternative investments such as commodities, real estate and high yield fixed income provide a positive but limited benefit to overall portfolio efficiency due to their positive correlation to equities. Non-traditional absolute alternatives such as event-driven and value-driven strategies tend to exhibit low correlation with equities and bonds and therefore provide powerful diversification benefits.