In the world of investing, understanding the different asset classes and the roles they play within the portfolio construction process is crucial. From stocks and bonds to cash and alternatives, each plays a unique role in a portfolio that is not always clearly defined. Recently, there has been a shift towards simplifying investment strategies. Institutional investment consultants have begun using a three-sleeve approach: growth (or high expected return), defensive, and other (variously, diversifiers, income, or stabilizers). However, Verum Partners has taken a different approach on how to build an investment portfolio, inspired by Ellen Ellison, the former Chief Investment Officer of the University of Illinois Foundation. We have adopted a straightforward Offense/Defense investment schema. This simplified approach aligns with our belief that there are two general purposes for allocating to an investment: (1) to help achieve the investor’s long‐term return target, and (2) to protect the portfolio against permanent losses.
For decades, investments were categorized simply by security type, such as stocks or bonds. Then, in the 1990s, Morningstar’s creation of the style box led to a more detailed categorization of stocks into nine boxes based on market capitalization and valuation. In addition to the style box, one also can categorize by country, region, and sector. Further, fixed income portfolios are now being dissected into various sectors and risk profiles. Despite these advancements, categorizing assets solely by security type (stock, bond, alternative) has its limitations. For example, within fixed income portfolios, there are significant differences in risk, with some securities posing far greater risk than others. High yield bonds or emerging markets debt, while categorized under fixed income, have risk profiles that differ greatly from U.S. Treasuries. We believe this can be misleading to clients, as investors allocate to high yield for return potential and core fixed income for safety, yet these various securities are often lumped together for performance reporting. To provide greater transparency, we believe these securities should be categorized based on the purpose of the investment, not the name.
The categorization of alternative investments also poses challenges. Alternatives can include assets that trade like stocks, such as REITs or MLPs, as well as assets with no correlation to stocks, such as managed futures or market neutral strategies. Precious metals like gold and silver are often included in the alternatives category as well. Additionally, illiquid investments like real estate, private equity, and private debt are all classified together as alternatives despite their different risk profiles. This broad categorization of “alternatives” can be confusing for clients and is very often the section of the portfolio that contains the highest fees, which can be dangerous.
This is what ultimately led us to take the Offense/Defense approach to our investment schema. We feel this provides the most transparency for clients and sets clear expectations for investments based on their inherent risk and return profiles.
The Offense sleeve is set up to consist of strategies that tend to produce reasonable expected returns in exchange for the investor taking some sort of default risk. Within this sleeve, there are five sub‐categories:
- Stocks – public market equities from across the globe. We have created a sub‐category inside stocks to break out U.S. stocks, international developed stocks, emerging markets stocks, and global stocks.
- Diversifying Offense – investment strategies which have traditionally been categorized as alternatives or asset rotation. These are strategies which have a mandate to deliver stock‐like performance over a full market cycle but deliver this performance with lower volatility and lower correlation to stocks. Hedge funds often fall in this category but must be fairly highly correlated to the stock market.
- Higher Yielding Bonds – in general, risks from fixed income investing can be classified in two ways – credit risk or interest rate risk. In our view, many advisors and consultants use credit risk to increase the return profile of the fixed income sleeve of a portfolio. There is nothing inherently wrong with this strategy; however, it is misleading to cast fixed income as “safe” or “defensive” if the fixed income portfolio is taking additional credit risk that exposes that part of the portfolio to significant drawdowns.
- Public Real Assets – REITs, MLPs, infrastructure investments, energy, and agriculture commodities fit in this category. These tend to be inflation‐oriented or yield‐oriented assets that are tied to real property.
- Private Capital – this category includes illiquid alternative investments such as private equity, private debt, and private real estate. We believe the illiquid nature of the assets and their investment vehicles warrant their own category.
The Defense sleeve is set up to consist of securities or strategies intended to lower the overall drawdown of the portfolio during a bear market for stocks. Within this sleeve there are three sub‐categories:
- Bonds – as discussed under “Higher Yielding Bonds,” bonds in the Defense sleeve consist of investment grade bonds. This includes short‐term, intermediate‐term, and long‐term fixed income. It also includes Treasuries, investment grade corporate, investment grade ABS/MBS/CMBS, and municipal bonds.
- Diversifying Defense – uncorrelated alternative strategies that tend to do well during a market drawdowns sit inside this category. Verum Partners will primarily use managed futures, which tend to do well during prolonged market downtrends, and possibly certain long/short strategies that fit within the market neutral category.
- Hedging Strategies – hedging strategies tend to be strategies with a negative long‐term expected return. Verum Partners does not expect to use these strategies on a strategic, long-term basis. However, there could be times in which Verum Partners recommends investing in strategies that ultimately hedge out some of the equity risk in the portfolio. These strategies include short-biased strategies and put-buying strategies.
When comparing Offense vs. Defense, asset classes in the Defense sleeve typically exhibit relatively low standard deviations, indicating lower volatility. Conversely, assets in the Offense sleeve tend to have higher standard deviations, reflecting higher volatility. However, it’s important to note that some Defense asset classes, such as managed futures, may have higher standard deviations than certain Offense assets; but they often have a low correlation to other asset classes, offering valuable diversification benefits.In conclusion, the investment consulting and advisory industry currently employs inconsistent methodologies for asset classification. Verum Partners advocates for a straightforward, purpose-driven approach to an investment schema. We believe this simplifies the classification system by grouping investments into two clear categories, Offense and Defense. Such a method helps to avoid the confusion associated with broad categorizations, offering a more transparent, outcome-oriented process when it comes to building and maintaining an efficient portfolio.
