EXECUTIVE SUMMARY
Investors have a tendency to focus on the characteristics of their portfolios almost to the exclusion of other factors that will lead to success or failure for the larger objective that the portfolio is intended to serve. By taking into account the characteristics of the assets and liabilities that exist outside of their investment portfolios, they could build portfolios that are a better match for the true problem they should be solving. Because the liabilities and assets outside of the portfolios do not generally have quantitatively well-estimated characteristics the way that traditional investment assets do, this type of analysis necessarily involves a certain amount of judgment rather than simpler historical return analysis. But this effort seems well worth the attempt, because most apparently rigorous attempts to build “optimal” investment portfolios are solving the wrong problem for most .

Investors have a tendency to obsess about their investment portfolios. On the surface, this is a perfectly reasonable focus given results in the portfolio are a crucial determinant of success for whatever purpose the portfolio is there to serve. But performance of one’s investment portfolio is not the only determinant of success, and it is almost certain that investors would achieve better overall outcomes if they recognized the risks outside of their portfolios that really matter and invested accordingly. Such a shift in mindset, while theoretically almost unarguable, does run into a couple of practical hurdles. The first is that the investment portfolio is the piece of the problem that is easiest to measure, and investment professionals are generally judged on measured outcomes. While a particular portfolio might be the right one for the specific assets and liabilities of a given investor, if that portfolio underperforms those of the investor’s peers, it is not clear whether an investment committee will care much about the theoretical superiority. The second issue is that once we move beyond the investment portfolio, estimates of risk and correlation are necessarily judgment calls and investors or risk managers cannot simply rely on a historical returns-based covariance matrix to estimate overall risk. That said, just because solving a particular problem is hard doesn’t mean the right thing to do is come up with an easier problem to solve that is less relevant. I’m going to make the argument as to why traditional ways of thinking about portfolios are flawed and can lead investors to make bad decisions.

The risks that matter
No investment portfolio exists in a vacuum. Every portfolio exists within a larger framework that includes both the purpose the portfolio serves – the liability – as well as any additional assets that will come into the portfolio over time. Risk is not merely a function of the volatility of the investment portfolio but also of the relationships between the investment portfolio, the liability, and the non-portfolio assets. Defined benefit pension fund managers are used to thinking about at least part of this conception of risk because accounting standards force them to recognize the way the pension liability varies with interest rates. In worrying about the funding ratio of the pension rather than simply the volatility of the portfolio, they are moving in the right direction. But most pension fund managers tend to stop there, failing to fully take into account the assets outside of the portfolio that are relevant to the overall problem – the potential of the fund sponsor to make additional contributions to the pension portfolio when needed. Because the sponsor’s ability to make these contributions varies depending on economic circumstances, all deteriorations in the funding ratio of the pension fund are not equal. A deterioration that occurs when the cash flow position of the sponsor is worse than average is significantly worse than one that occurs when sponsor cash flow is strong. Defining how much worse is a bit tricky, as it involves estimating the covariance between the sponsor’s cash flow and the investment portfolio as well as coming up with some estimate of the amount of disutility that stems from having to top up the pension fund at a time of stress. But the fact that it is tricky to estimate the parameters of the true problem doesn’t mean that ignoring it is the right answer. And the difference between looking at the true problem and an oversimplified version can be a big deal, which I hope to demonstrate with a few examples. I’m going to be using mean variance optimization (MVO) for my examples, because it’s a widely used tool and most professional investors are familiar with it. But the basic concepts in no way depend on MVO, or indeed quantitative portfolio construction methods in general, to be relevant.