Miccolis, Bengen and Evensky on the New Challenges in Portfolio Construction

Conventional wisdom about the best way to construct a portfolio has been discredited, according to three industry thought leaders – Jerry Miccolis, Bill Bengen and Harold Evensky. Each has distinct visions of the ways in which advisors should build portfolios in the wake of the financial crisis of 2008, but all three agree that traditional methods must be scrutinized.

The financial crisis of 2008 was a rare event jarring enough to make people remember where they were when they first learned what was going on. At the very least, advisors surely remember where their clients’ portfolios were positioned when crisis struck – most likely in a range of supposedly well diversified assets whose values, all of a sudden, were plunging in unison.

Since then, advisors have been forced to ask themselves – what could I have done differently?

Miccolis, Bengen, and Evensky got together last week to explain how they are tackling that very question. Appearing for a panel discussion at the Business & Wealth Management Forum in Chicago on October 15th, the three industry leaders explained how they have changed their approaches to portfolio construction since 2008.

A tail risk hedge diamond in the rough

For Miccolis, recovering from 2008 was a matter of shedding the seductive simplicity of conventional wisdom – identifying the core benefits he most sought from his portfolio allocations and working methodically backwards to the sophisticated tools that would reap the proper dividends. Miccolis is Principal and Chief Investment Officer at Brinton Eaton Wealth Advisors, a New Jersey-based advisory firm.

“The modern portfolio theory that most of us are used to using and dealing with doesn’t really correspond to the real world,” Miccolis told the audience. “One of the things that we’ve been doing is taking modern portfolio theory and making it real.”

The standard measure of correlation, for example, “is not up to the job in the real world,” Miccolis said. He said he now favors the use of a statistical application known as copulas, which allows him to capture more dynamically the probabilities of how asset classes may interact. However tempting the simpler calculation of basic correlation might be, Miccolis no longer believes he can afford to eschew tools that will improve his understanding of his portfolio.

To approach portfolio construction systematically, Miccolis said, his firm focuses on four central features that define a good portfolio: strategic focus, natural hedging, risk exploitation, and – especially important since 2008 – catastrophe protection.

To achieve better natural hedging, for instance, Miccolis outlined a more active, responsive approach than traditional rebalancing, which Miccolis called “pretty naïve.” In its place, Miccolis uses a sector rotation approach that takes into account the momentum of various assets.

Miccolis explained his approach as follows: He starts by dividing the S&P 500 into 10 distinct sectors by industry. Employing a simple algorithm to obtain a moving average for each sector, Miccolis then compares each sector’s current index price to its moving average and applies a simple rule: If the index exceeds the moving average, it’s a sign to get in; when it dips below, that’s a sign to get out.

Miccolis said this strategy would have consistently surpassed the S&P 500 index over the last two decades.

The part of Miccolis’ presentation that most piqued the audience’s curiosity was his unconventional strategy, developed since 2008, for most effectively managing the risk of economic catastrophe. 

Tail risk protection, Miccolis noted, has been in high demand since the havoc that the fall of 2008 wreaked on investors’ portfolios. “It’s a seller’s market out there right now for tail risk protection,” Miccolis said, adding that many of the solutions being pitched are either very expensive or ineffective.

Miccolis’ three exacting criteria for the tail risk hedge he sought were (1) that it should not give back the value it accrues after a crisis passes, but rather it should lock those gains in; (2) that it must be inexpensive; and (3) that it cannot disrupt the overall makeup of his portfolio.

“Very, very, very few things … satisfy all these criteria,” Miccolis said, noting that #1 is an especially tricky goal to achieve – common tail risk hedges, such as VIX, fail this test and were consequently rejected by Miccolis.