As a portfolio manager, our mission is to help clients allocate their money to investment portfolios that provide efficient risk-adjusted returns over the long-term. Given the ever-expanding list of potential investment products, how do we determine the composition of client portfolios and select the securities to include? Our portfolio construction process – something we review each year – consists of four main steps:
- Creating long-term capital market assumptions for various asset classes.
- Developing model portfolios with varying asset allocations and a range of risk/return characteristics.
- Reviewing the universe of available investment products and determining which ones to approve for use in our model portfolios.
- Mapping approved investment products to model portfolios across various account types to minimize costs and taxes.
Similar to how our 2022 Long-Term Capital Market Assumptions article examined the first step of the portfolio construction process, this article will focus on step 2, including a discussion of the changes we’ve made to our model portfolios for 2022.
What is a Model Portfolio?
Before discussing our model portfolios, let’s first define what we mean when we use the term model portfolio. A model portfolio is a set of asset class allocations (or weightings) used to guide the investment of a client’s money at a high level, before any security-specific implementation decisions are made. Since the allocations are assigned at the broad asset class level, model portfolios are theoretical and it is not possible to invest in them directly. However, model portfolios are useful because they allow us to assess risk/return characteristics and construct portfolios using a limited number of inputs – our nine approved asset classes for example – rather than having to consider the full universe of available investment products, which number in the thousands.
Using our nine approved asset classes as building blocks and assuming the allocation for each asset class can range from 0% to 100% (in 1% increments), there are more than 350 billion possible model portfolios. It wouldn’t be practical to manually evaluate the risk and return characteristics for each of these possibilities, but thankfully mathematics and technology can assist us.
To begin, we input our long-term capital market assumptions and a set of minimum diversification constraints into portfolio optimization software. The software then analyzes all possibilities using the framework of modern portfolio theory, and eliminates any inefficient model portfolios – a portfolio is considered inefficient if any substitute portfolios exist that 1) provide a higher return for the same level of risk, or 2) provide the same return with a lower level of risk. When the optimization process has completed, the software outputs what is know as an efficient frontier: the set of model portfolios expected to provide the highest return at each possible level of risk.
We then select a sample of the model portfolios along the efficient frontier to be used when completing investment suitability assessments with our clients, allowing us to provide a broad, but manageable, range of risk/return investment options.
Our 2022 Model Portfolios
After completing the portfolio optimization process outlined above, we’ve updated our model portfolios for 2022, split into two groups: those with an allocation to gold and those without. While it is difficult to predict the future with a high degree of certainty, our model portfolios represent our best guess of the asset allocations that a Canadian investor can reasonably expect to provide the highest return for a given level of risk over the long-term:
Changes to Model Portfolio Allocations
Our model portfolio allocations for 2022 remain identical to the prior year with the exception of the fixed income allocations in our Risk Level 1 and Risk Level 2 models. As discussed more thoroughly in our Commentary on Recent Capital Markets Performance (May 12, 2022), capital markets have experienced significantly negative year-to-date performance in 2022, with the poor performance of Universe Bonds particularly out of the norm. The large performance difference between Short-Term Bonds and Universe Bonds in the first half of 2022 highlighted the potential for enhancements to our most conservative model portfolios, so we therefore reduced the allocation to Universe Bonds and increased the allocation to Short-Term Bonds in our Risk Level 1 and Risk Level 2 model portfolios.
Risk Level 1
We shifted 40% of the Risk Level 1 model portfolio allocation from Universe Bonds to Short-Term Bonds. The portfolio allocation is now 10% Global Low Volatility Equity and 90% Short-Term Bonds. Previously the allocation was 10% Global Low Volatility Equity, 50% Short-Term Bonds, and 40% Universe Bonds.
Risk Level 2
We shifted 15% of the Risk Level 2 model portfolio allocation from Universe Bonds to Short-Term Bonds. The portfolio allocation is now 20% Global Low Volatility Equity, 45% Short-Term Bonds, and 35% Universe Bonds. Previously the allocation was 20% Global Low Volatility Equity, 30% Short-Term Bonds, and 50% Universe Bonds.
Model Portfolio Return Assumptions
By combining the model portfolio asset allocations outlined above with our 2022 long-term capital market assumptions we can calculate the weighted-average expected return for each of our 2022 model portfolios. While it is difficult to predict the future with a high degree of certainty, these assumptions represent our best guess of the returns (before fees or taxes) that a Canadian investor can reasonably expect to achieve over the long-term by investing in a portfolio of securities with a similar asset allocation to each of our model portfolios:
Our model portfolio return assumptions play a key role in financial planning. Once we have completed an investment suitability assessment and allocated a model portfolio to each of our client’s investment accounts, we update the assumptions in their financial plan to reflect the expected return of their actual investments. By working with a portfolio manager that also provides financial planning, clients are ensured that there is consistency between the two.
Hopefully this article has provided insight into what a model portfolio is, how we analyze the many combinations of asset class allocations, and how we filter down the possibilities into a manageable set of model portfolios that cover a range of risk and return characteristics. If you have any questions or would like to discuss the topic in more detail, please contact your advisor. If you haven’t already done so, you can also learn more about the first step of our portfolio construction process: 2022 Long-Term Capital Market Assumptions.
Model portfolio expected returns are an average of the asset class expected return assumptions weighted by each model portfolio’s target asset allocations. Returns presented are hypothetical because it is not possible to invest in a benchmark or asset class index directly and the expected returns do not reflect the transaction costs or management fees that an investor would incur when investing in a financial product, such as an exchange-traded fund, that attempts to track the performance of a benchmark or asset class index.
Clients’ actual returns will vary based on their management fees and the timing of cash flows into and out of their respective accounts. Model portfolio expected returns also assume that asset class weightings are held constant while in practice an account’s asset allocation may deviate from targets within a reasonable range.