Equities and interest rates: till death do us part

• Step 1: Examine the purpose of equities in the context of the portfolio;
• Step 2: Look at whether the equity portfolio is accomplishing the goal set out in the initial exercise, especially as it pertains to interest rate exposure; and
• Step 3: Determine that the interest rate exposure in the equity portfolio is not skewed such that the downside risks are more significant than potential upside appreciation.

In this article, the first in a three-part series, I’ll examine Step 1.

The first step of any asset allocation process is to determine the goal(s) of the portfolio. While we’d all like to have high returns, it may require taking on risk levels which are deemed uncomfortable. Thus, maximizing return subject to a defined acceptable risk may be a goal of the portfolio. Another goal may be to minimize the volatility of surplus/deficit of the portfolio relative to a liability stream.

One can also construct partial goals. For example, ideally the goal of the portfolio may be to minimize surplus volatility, but in the current climate the returns of adhering to such a goal may be deemed insufficient. Therefore, one may attempt to follow that goal for part of the portfolio with the intent to increase the portion of the portfolio dedicated to that goal over time or as market conditions change. For the purpose of this article, let’s assume that the goal of the portfolio is to maximize return subject to portfolio risk constraints.

Constraints that we place on the asset allocation process will also become part of our goal-setting process. Examples of constraints may be geographic constraints, currency constraints, income requirements, as well as constraints on individual asset classes.

It’s important to acknowledge the value that each asset class brings to the asset allocation process. An asset may be categorized as return seeking, liability replicating, inflation hedging or some combination thereof. We must be aware of the category or combination of categories that frame our expectations for each asset class.

Once the expectation framework for an asset class has been completed, we must ensure that our investment in that asset class adheres to the framework. If we expect equities to contribute a certain return stream based on historical performance, we must ensure that we are investing in the “right” equities. For example, we may determine our allocation to equities based on a process which includes expected standard deviation and correlations of our equity investments. If we then invest in an equity style or group of equities with specific attributes which differ from those in our original analysis, then the embedded assumptions related to our equity allocation may no longer hold true.

For example, using a risk/reward framework, we may determine that the appropriate allocation to equity investments is 40% of our portfolio. This would be based on how volatile the equity index is expected to be, as well as how equities correlate to fixed income and our other asset classes. If we then choose to invest our equity allocation in sectors that have a high interest rate exposure, then we are rendering useless the entire framework upon which our 40% allocation to equities is based. By investing in equities that have a high degree of sensitivity to interest rates, we may lower the volatility of our equity component but increase the volatility of our portfolio, since our equity investments will now exhibit high correlation to our fixed income allocation.

By articulating the purpose of our investment in equities and remaining consistent throughout the allocation process, we can ensure that our actual portfolio retains the characteristics of our allocation framework.

In the next article of the series, we will look at Step 2: whether the equity portfolio is accomplishing its goal.