"Engineering Targeted Returns and Risks"
A "look under the hood” for constructing RP portfolios. Seems written for other industry professionals, but isn’t overly technical for the average investor. The whole paper is worth reading, but especially pages 4 through 7.
Read the original:
Important Points for the RP Investor:
*The 2011 is a reprint. Dalio originally wrote the piece in 2004 (link to 2004 version).
Page 2: Dalio writes that his ideas on portfolio construction are best described as Post Modern Portfolio Theory (PMPT), which extends Markowtiz’s MPT. Dalio says that PMPT differs from MPT in three key ways: 1) returns from alpha and beta are separated (more on this below); 2) sizes of alphas and betas are altered to more desirable levels; 3) resulting portfolios are much more diversified. One side note: PMPT is an interesting phrase, but seems like other people beat Dalio to it. They are not too distantly related, but the other (more common) PMPT was developed in the mid-1990s to correct what it saw as MPT’s incorrect understanding of risk. Whereas in MPT, standard deviation is used to describe an asset’s risk, the founders of PMPT (Rom and Ferguson) argued that what matters is downside risk. The Sortino Ratio comes out of this perspective.
Page 2: Dalio's description of the the “three building blocks” of all returns
- The Risk-Free Return - the return on cash
- Returns from Beta - the excess returns of asset classes over the risk-free rate
- Returns from Alpha - the value added by managers, who make strategic selections of assets.
Total returns equal the sum of these three building blocks.
Page 4: New section here on “Optimal Beta” portfolios. There is a useful chart comparing expected risk and expected total return for 16 asset classes:
With this chart in mind, the trick for Risk Parity is to equalize the allocations of risk. Dalio argues that different assets “can be made competitive with each other … through the use of leverage.” For bonds, for example, different ways to increase exposure to them (direct borrowing, futures and options contracts, and now, ETFs with embedded leverage) can increase the risk and returns from this asset class to balance out the risk and return usually found with an equity-heavy portfolio.
Page 4: Dalio also makes an interesting point about leverage. Most people hear the word and think of it as a scary thing, but he notes that many types of investing already depend on it, such as real estate, venture capital, and normal, everyday equities. As I write this, for example, two solid, no-frills large companies, Home Depot and Delta Airlines, are about 16 and 20 times leveraged, respectively.
Page 5: with the use of leverage, you can have access to many more asset classes that can expect a 10% return, and can then construct a portfolio of assets that have low, zero, or negative correlation with each other to produce a portfolio that has equity-like returns but with less risk (or, if you wish, equity-like risk but higher returns). This chart illustrates the point:
Page 5: A point that deserves quotation at length:
Page 6: As this section on optimal beta portfolios wraps-up, Dalio addresses a downside. Whereas the typical portfolio has a high concentration on the risk from equities, a leveraged RP portfolio is vulnerable to its constituent asset classes underperforming cash, or more simply, that leverage will backfire. In a sense, any investor at all is betting that whatever they are investing in will beat cash (otherwise, why invest?); this is a place for RP to fail. Dalio goes on to say, though, that “If investors can get used to looking at leverage in a less prejudicial, black-and-white way … I believe that they will understand that a moderately leveraged, highly diversified portfolio is less risky than an underleveraged, non-diversified one.”
Page 8 and 9: Dalio addresses the Optimal Alpha portfolio, which is a counterpart to the Optimal Beta portfolio above. The target audience seems to be other institutional investment professionals.
Pages 10 and 11: Enlightening section where Dalio “stress tests” the All Weather portfolio by seeing how it performed during the Financial Crisis of 2008-9. The All Weather outperformed a conventional portfolio by almost 42%, and an all equity portfolio by 60% (!). Dalio then discusses the reasons why on page 11, noting that “risk decreased more from better diversification than increased from the use of leverage.”