At Rain, we start with the premise that risk considerations should drive capital allocation, rather than letting capital allocation drive portfolio risk. This means that the building blocks of our portfolio construction are the direct risk factors that drive asset valuation like inflation, economic growth, interest rates, liquidity, volatility, and so on. The logic is simple: correlations are significantly lower and more stable over time between risk factors than they are between asset classes. For instance, most asset classes contain primary or secondary exposure to equity risk. Rather than just using rough proxies of exposure, Rain uses primary risk factors as building blocks in portfolio construction. Not only does this approach limit unintended portfolio risks, it also allows us to evaluate strategies based on the merits and characteristics they bring to a portfolio, rather than the typical check-the-asset-class-box first cut of diligence required by traditional asset allocation. The result is truer diversification and materially less risk for a similar level of return (or, in industry terms, more efficient portfolios).
This directly addresses modern portfolio theory, but corrects for many of its shortcomings. Research strongly supports this approach as a better way of diversifying portfolios. . .We believe this ultimately translates into better investment performance over time; higher quality growth and stability with less of the merry-go-round of asset allocation.
This is an excerpt from our article “The Asset Allocation Merry-Go-Round” published December 16, 2011