PORTFOLIO CONSTRUCTION

I hope to provide some code and examples soon. Here are some of my current thoughts.

Rebalancing and diversification go hand in hand. Some think gains from rebalancing are just a gains from diversification. Similar or identical concepts go by names like Volatility Pumping and Stochastic Portfolio Theory. I have some ideas on how to clarify these ideas—hopefully they turn out nicely and I will put them here.

I like to work on rebalancing methodologies. I have a few ideas I am looking forward to exploring. There is one simple strategy I gave a talk on a couple of years ago. Essentially, it was a form of diversification that allowed for rebalancing gains in 2008 when others forms of diversification failed. Unfortunately, a lot of work and or infrastructure is required for meager gains—lets’s say, 20bps. But many institutions already have the infrastructure or should for other reasons; and 20bps here, 20 bps there and soon enough it becomes worthwhile even at smaller institutions.

Asset Allocation / Risk Budgeting

An old idea that is easy to understand, but difficult to implement: Investors with a long enough time frame should seek unpopular investments. Unpopularity, obviously, can be the result of any number of factors. Assets which are unpopular because they are relatively unknown and also happen to be scarce are a really nice find. I had one in mind that was unpopular because it is so hard to invest in. It is also unpopular because few have considered it, in part because it is difficult to invest in and few have tried to build an institutional size offering.

The other nice thing about unpopular assets is the liquidity premium. Sure you get paid for this, but the special excess returns come when the unpopular investments get popular. The risk premium (liquidity premium or other) is then compressed and that, in and of itself, is a source of returns. This is the advantage of being an early adopter, the drawback is that there is little history to use as input to the estimation of risk in these investments.

How does anyone avoid popular investments? Fortunately while the El Farol Bar problem is analogous to investing, communication is relatively unrestricted and investing decisions are often asynchronous. Strangely, I have not read much about competitive intelligence as it applies to investing. But the idea is that it pays to keep an eye on what products are being sold even if you never intend on being a buyer.