THE BIG PICTURE

At Rockefeller Global Family Office, we help our clients – ultra-high-net-worth and high-net-worth individuals and families, family offices, endowments, and foundations – design bespoke multi-asset portfolios based on their investment objectives.

To design an appropriate, thoughtful, and efficient investment portfolio, we begin by first exploring the true meanings of risk and reward to each individual investor. Based upon this understanding, we then apply a disciplined approach to our investment process through three stages that are intended to add value incrementally:
i. Setting a strategic asset allocation, the long-term foundation of an investment portfolio,
ii. Tactically tilting the asset allocation to capitalize on short-term opportunities that arise from the ebbs and flows of each market cycle,
iii. Bringing the asset allocation strategy to life through implementation with a calibrated blend of investment solutions.

While fluidity throughout the three stages is critical to maximizing the value creation potential of the portfolio construction process, empirical research (Brinson, Hood and Beebower 1995)1 on the performance of pension portfolios has found that the risk contribution of investment policy (i.e., strategic asset allocation) dominates that of market timing and security selection, explaining roughly 95% of the total variance of portfolio performance. The return contribution of strategic asset allocation similarly dwarfs that of market timing and security selection.

The importance of strategic asset allocation is well researched and widely acknowledged. This gave rise to the practical applications of capital market assumptions.
For decades, long-term asset class return and volatility expectations have served as key inputs that inform investors’ strategic asset allocation decisions (along with other statistical estimates such as correlations, tail dependency, and higher moments of probability distribution).

That, however, is not the primary purpose of this paper.

Our Philosophy and Approach

In our view, the traditional asset-class-based framework has a critical flaw. That is, this approach obscures investors’ visibility on the underlying risk exposures of a portfolio. Subsequently, it may create the unintended outcome of under-diversification, which leads to greater portfolio vulnerability to macro risks.
As different asset classes often share common underlying return drivers, we believe that investors can improve the rigor and transparency of their portfolio construction approach by looking beyond the asset class perspective.

Specifically, we see great value in evaluating investment decisions through the lens of exposures to risk factors (e.g., growth, inflation, real yield, liquidity, volatility, etc.).

We believe that, by developing a logical understanding of the linkages between market pricing and fundamental macro forces, we can improve the quality of our probabilistic estimates of how asset classes may behave in various macro environments.

With such understanding, we are better equipped to construct high-quality, sophisticated, and resilient investment portfolios consisting of genuinely diversified collections of fundamental return sources – portfolios that utilize risk more efficiently to generate returns and are better positioned to withstand unexpected macro shocks.

We dedicate a significant portion of this paper to explaining how we develop our long-term expected returns for the various asset classes. In fact, we encourage our readers to focus on the methodology, which – in our view – is more important than the return estimates themselves. Our methodology for constructing expected returns involves decomposing each asset class into fundamental risk factors and corresponding risk premia.

In addition, we believe that a well-designed asset allocation should not only aim to deliver high quality returns but also reflect a story about the specific investor: who they are, what they hope to achieve, and the corresponding plan to work towards that objective.

At face value, asset allocation refers to assigning different weights of investable capital to various asset classes with distinct risk and return characteristics. Fundamentally, such weightings should manifest our conscious construction of various risk premia that make up the expected returns from the corresponding asset classes. A truly efficient and thoughtful strategic asset allocation should reflect a well-diversified and appropriate combination of risk factors customized for the given investor.

Compared to the conventional asset-class-based framework, our risk premium approach allows us to craft a portfolio solution that is more intuitive from the perspective of the investor and can be calibrated to align more precisely with the investor’s own interpretation of, and preferences for different risk types.
Ultimately, a strategic asset allocation is the anchor of a portfolio. It reinforces discipline during times of feast or famine and serves as a roadmap during times of uncertainty.

In order for a strategic asset allocation to accomplish what it has been designed for, we – as investors – must first believe in it. And in order to believe in a strategic asset allocation, we must first understand it: what risk exposures are we taking on and what corresponding returns should we reasonably expect?

The methodology discussed in this paper serves to translate a strategic asset allocation into an intuitive story that we hope to deliver to our clients – to ensure that it is understood, believed in, and ultimately succeeds.

I would like to thank Harry Singh, Jimmy Chang, and Dylan Bern for their insightful feedback and editing assistance.

For the complete version of the whitepaper, please download the PDF at the top of this page.