Myron Scholes on the real promise of the total portfolio approach

But important is, what are the constraints that this, uh, strategic asset allocation strategy imposes on you now, and what are the costs of those constraints? And basically, by moving to a new dimension, how do you alleviate those costs, and how they would then lead to better performance for pension funds and endowments and the like? And so you, uh, really, uh, the most important thing in all of finance and investment is trying to understand how constraints affect you and how constraints affect the performance of your fund.

So if you think about the board's drawdown budget, the first thing that has to be done is thinking about, what is the total drawdown tolerance? How much drawdown can we take? And basically, we have now the idea you have a sixty percent equity portfolio and a forty percent bond portfolio, for example, or duration portfolio.

And basically, what does that mean? You know, is it-- Will the TPA strategy allow us to get together and decide on what our drawdown budget really is? Because if you take a sixty/forty strategy at times of shock or crises we had in 2008 or 2002, the US equity markets fell about fifty, fifty-five percent, and markets around the world tended to collapse together.

So the diversification was lost, uh, basically, as you, uh, looked across the universe.

And so what that meant, if you're at a sixty percent equity portfolio and you have a fifty percent drawdown in equities, then your portfolio should expect to lose about thirty, thirty-some percent, as many portfolios did in the, uh, at the time of these drawdowns, these excessive drawdowns.

So basically, the thing is, what is the drawdown tolerance, and why do we want that drawdown tolerance? Why not a seventy/thirty? Why not a fifty/fifty? Why not an eighty/twenty? So those are questions that you have to address, because why? If you're taking this risk reduction, if you allow yourself to reduce risk by going sixty percent and forty percent, that means that you're giving up something each year because you're not a hundred percent in equity.

If the idea of risk premium on average of equities is five percent and you're sixty percent in equities, that means you're only gonna get, uh, you're gonna lose two percent of that by being in the duration portfolio in terms of excess returns.

So the point is that thinking about why you're paying these costs and what it means and what the drawdown b- tolerance is, very important.

So the CIO, the chief investment officer in the team, they build themselves a base portfolio, which may be like an expanded strategic asset allocation portfolio, which includes equities, private equities, ver- uh, venture capital, et cetera.

And so that's selectivity.

So part of the way a TPA is more dynamic selectivity, but it's not static selectivity.

Why are you gonna move from more PE or less PE or more hedge funds or more equities or less equities? So you should see there's more dynamics.

Right now, the strategic asset allocation has silos and tracking error within silos, but very concentrated in its position and very slow to adjust over time.

Going back to the board, discussing with the board, taking months to decide potentially how to reallocate.

So the CIO has more flexibility.

We can judge whether the TPA strategy is being used efficiently if you see more flexibility, more use of this flexibility that the CIO can move and his team can move for various of the, uh, the, the different, uh, groupings or, or, or allocations.

And this next allocation problem is not only use of the selectivity, but what about a dynamic risk budget? In other words, is a sixty-forty strat, uh, static, or what you're taking, or is it the case when risks are increasing for the downside and the opportunity set is not as great, risks are reduced, so you keep using less of your risk budget.

You know, so you go more into duration at that time.

Or vice versa, if the opportunity set is very rich and risks are muted, then you wanna think about increasing the risk, uh, uh, of the r- use of the risk budget.

So one thing is what is the risk budget? What is our maximum loss we can take? Two is how to use the risk budget dynamically given changes in the opportunity set that we see.

So I think basically what we're gonna see is a state contingent risk budget framework where tracking error is not the thing, saying you have a ten percent tracking error, a five percent tracking error, but it is based on an outcome of a chosen exposures that the, uh, CIO and team are gonna take.

So it's the reference portfolio is a guidepost.

If you say a sixty-forty portfolio is our guidepost, why is that the guidepost? Because you're trying to define what the tracking, what the risk budget is, how much drawdown you can take before it's the case that actions have to be taken.

If you define the risk budget as a, um, maximum loss that you can take approximately before you have to liquidate your portfolio, et cetera, then we have to realize that you wanna try to reduce the natural negative convexity that pension funds and endowments have.

The idea that when you take losses occur, actions are taken which are really not possible to recover from in a compound return space because you're liquidating assets, you're reducing risk, you're re-re-responding as opposed to not being proactive.