The Brown Brothers Harriman (BBH) Investment Research Group (IRG) has written at length in the pages of InvestorView about the many facets of our investment philosophy and process. With all that we have written, however, we believe it is beneficial to step back and illustrate how the various aspects of our asset allocation process work together to create value for clients.
“Asset allocation” has different meanings across the investment industry, but it most commonly refers to the setting of sub-asset class weights based on top-down macroeconomic and financial market variables utilizing techniques such as mean-variance optimization. At BBH, we define asset allocation as the process of selecting a portfolio that balances a client’s desire for return with his or her ability and willingness to accept risk. As seen in the nearby chart, IRG employs a three-step process for asset allocation that starts with setting broad equity and fixed income targets for our portfolios. With these targets as our guideposts, we then seek out the best managers to partner with for the long term, which results in preliminary manager and sub-asset class weights. To marry these two steps – establishing the appropriate equity and fixed income levels and letting the bottom-up manager work provide the framework for sub-asset class targets – we consider how the portfolio comes together as a whole. We refer to this process as “portfolio construction.” What follows is an explanation of these three processes.
The first step in the process is to select a portfolio that balances a client’s desire for return with his or her ability and willingness to accept risk. A client’s return objective is met with growth- or equity-oriented investments, while risk is largely controlled by investing in high-quality fixed income investments or cash. Equities also serve as an inflation hedge, which is important because even modest inflation can erode the purchasing power of a portfolio over time.
At its core, asset allocation is an exercise in balance sheet management. Individuals and families have assets and liabilities, just like companies. Family liabilities might include future tuition payments or the desire to retire at a certain age, engage in philanthropy or leave wealth to future generations. Setting the appropriate asset allocation is both an art and a science, and clients will naturally have diverse circumstances and risk tolerances that require different portfolios of equities and fixed income. For example, an investor with a limited time horizon and a short-term need for both income and liquidity may be appropriately invested in a portfolio comprising solely fixed income, whereas an all-equity portfolio may be optimal for a long-term-oriented client who is not sensitive to temporary portfolio drawdowns,1 has limited spending needs from his portfolio and has a job that produces a dependable income stream. Just as important is the client’s willingness to take risk. In fact, two clients with similar assets and liabilities may choose different portfolios simply due to differences in their attitudes toward risk.
To help inform this decision, IRG performs capital markets research to understand the risk-return trade-offs of various equity and fixed income combinations. Taking all of these factors into account, BBH offers a range of portfolios that are differentiated across the risk-return spectrum that can be used as a starting point in client asset allocation decisions. Just as these portfolios may only be a starting point for discussions between relationship managers and clients in setting the appropriate asset allocation, they are also just the beginning for IRG in the creation of more granular policy portfolios, which include sub-asset class and manager-level allocations.
Capital Allocation/Manager Selection
Because BBH utilizes a fundamental, bottom-up investment approach, we do not set targets for sub-asset classes based on macroeconomic views and predictions about price movements and asset class correlations. Instead, we search for talented managers to partner with for the long term. We refer to this process of selecting and sizing managers as “capital allocation,” which forms the foundation for our policy portfolios.
In seeking talented managers, we look across sub-asset classes. In equities, we look for managers that invest in U.S., international developed and emerging markets equities across the capitalization spectrum. We also search for managers that invest in privately owned and distressed companies as well as real estate. Within fixed income, we invest across a range of securities, including Treasuries, corporates and asset-backed and other structured products, as well as loans to private companies (direct lending). What differentiates our approach from many other wealth managers is that we determine sub-asset class weights largely based on our ability to identify talented managers to partner with that have an opportunity to generate attractive long-term returns. Importantly, we would rather forego investing in a specific sub-asset class than invest with a manager that does not meet our standards.
Perhaps the most differentiated part of BBH’s process is the strict investment criteria with which we evaluate and underwrite new managers for client portfolios. Our article “BBH’s Approach to Manager Selection” discusses IRG’s approach to selecting and partnering with external managers. Once a manager is approved, the sizing of the position is based on a separate set of criteria, a selection of which we describe next.
Among the most important pieces of criteria we consider in sizing a position are the expected risk, return and diversification benefits a manager provides. To gain a good understanding of these factors, we look at a manager’s specific opportunity set and conduct deep due diligence to understand its strategy on a granular level. This deep research allows us to ascertain how a manager’s strategy will affect the risk and return of client portfolios. As an example, IRG’s decision a few years ago to allocate capital to a manager that originates loans to lower middle-market companies was based on the quality of the manager, its experience investing in private debt and its ability to provide attractive expected returns with strong downside protection. While IRG considered general characteristics of the sub-asset class (direct lending), these favorable characteristics of the manager drove the capital allocation decision.
Another factor that we analyze closely before allocating capital is concentration of holdings. Before assigning a portfolio weight to a manager, we consider what that weight implies for the position sizes of individual equity holdings in the portfolio on a look-through basis. For example, a manager with an 8% weight and an average position size of 10% and a manager with a 5% weight and an average position size of 15% would both have positions that are roughly 0.80% on a look-through basis.
Along with the consideration of other factors, including the manager’s capacity, liquidity profile of the underlying investments, level of transparency into the manager’s holdings and fees and fund structure, IRG will establish weights to the various managers, which then roll up to sub-asset classes and, ultimately, to equity and fixed income targets.
The process by which we finalize portfolios, marrying both the bottom-up and top-down elements of our asset allocation and capital allocation processes, is referred to as “portfolio construction.” In this part of the process, we utilize top-down risk management tools to determine whether our bottom-up decision-making process has resulted in unintended concentrations in key risk exposures. Accordingly, any key risks identified in the portfolio construction process may prompt us to reconsider our initial manager/sub-asset class weights. In describing BBH’s asset allocation process, we say, “We invest bottom-up and worry top-down.”
We perform several analyses in the portfolio construction process, but arguably the most important is what we refer to as portfolio “guardrails.” With guardrails, we regularly monitor key portfolio exposures at the underlying security level2 on factors such as individual holding concentration, manager concentrations, liquidity, leverage, currency, geography or more nuanced exposures like credit sensitivity or commodity risk. Because we put so much emphasis on individual managers, this process is a key risk control that allows IRG to measure portfolio-level risk exposures.
Geographic concentration, for example, is a risk that we measure by looking at the country of domicile for each security in each manager’s portfolio. By looking at the security level as opposed to the asset class level, we can gain a more nuanced picture of our exposures, since not all managers invest 100% of their assets in their “assigned” asset class. We classify BBH Core Select, for example, as U.S. large-cap equity, but the strategy holds American depositary receipts (ADRs) of companies domiciled outside of the U.S. Similarly, some of our non-U.S. developed equity managers hold positions in companies domiciled in emerging markets, and our global equity managers have exposure in several world equity markets.
Some numbers help to illustrate the different picture that emerges of our portfolios when looking at the asset class vs. the security level. At the BBH asset class level, we can only distinguish between U.S., non-U.S. developed, emerging markets and global equity. At the security level, however, we can analyze the portfolio at a more granular level. For example, at the end of February 2019, the largest exposure within the public equity portion of a BBH Growth Model Portfolio3 was the U.S. at 54%, followed by the U.K. (9.0%), Switzerland (5.6%) and 10 other countries that each had over a 1% weight. Our largest two emerging country exposures were India (1.9%) and Brazil (1.3%). Looking at some of the other measures, BBH’s largest industry exposure was software and services (14.8%), our largest currency exposures were the U.S. dollar (70.9%) and euro (9.6%), and our largest equity holding was Berkshire Hathaway (2.5%).4 Having up-to-date analyses of these exposures is crucial to understanding the real risks in our portfolio and allows us to make changes to manager allocations if these exposures are out of acceptable ranges.
In addition to guardrails, we utilize various quantitative modeling techniques, such as stress testing, that help us understand how clients’ portfolios might behave in different market environments. Stress testing is important because it allows us to compare potential long-term investment returns with an estimate of what each portfolio might have returned in some of the worst historical market environments. This exercise is one of many that help us understand the risk-return trade-offs of various portfolio combinations. Because this is backward looking, it only changes when our portfolios change meaningfully, and thus is an analysis that we update only when making meaningful allocation changes or if a new market downturn occurs.
No asset allocation and portfolio construction process would be complete without considering rebalancing. Rebalancing is primarily an exercise in risk control – that is, one that keeps a client’s portfolio characteristics in line with his desired target asset allocation. Rebalancing is especially important for clients who have chosen a portfolio that includes a fixed income allocation. If a client desires high returns, has no risk constraints and does not have an aversion to large drawdowns, she could simply invest 100% in equities, and rebalancing would be constrained to occasional realignment of equity allocations, as there would be no equity/fixed income balance to maintain. Because most investors have lower risk tolerances, they will have a blend of higher-returning equity investments and lower-returning, less correlated fixed income investments. These portfolio weights will drift based on the relative performance of the various asset classes, and as a result, the portfolio will gradually take on materially different risk characteristics over time. Rebalancing is the process that realigns the portfolio’s risk relative to the target allocation that the client specified.
Just like asset allocation, rebalancing involves various trade-offs. Adherence to policy targets would suggest more frequent rebalancing, for example, but the cost of portfolio turnover (taxes and transaction costs) would suggest less frequent rebalancing. To mitigate these trade-offs, clients can consider several “low-cost” rebalancing methods (that is, those that do not involve paying taxes), including rebalancing with new money (either inflows or various distributions or interest and dividends or distributions from private funds), gifting securities or establishing tax-advantaged accounts (for example, IRAs that reduce the cost of rebalancing). A discussion of best practices around rebalancing, as well as other portfolio considerations, such as how a new client should stage into the market, are multifaceted issues that we will focus on in a future InvestorView article.
At BBH, we believe our investment process allows us to have the best of both worlds in that it provides us with flexibility to seek out the best managers for our clients while ensuring that we understand the key risk exposures at a portfolio level. Our approach to asset allocation is designed to ensure that our capital allocation and manager selection efforts position us as we seek to protect and grow clients’ assets over time.
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1 A drawdown refers to the peak-to-trough decline in a market, usually expressed in percentage terms.
2 For example, if a manager has a 5% allocation in our policy portfolio and holds a certain security at a 6% weight, then on a look-through basis, that security has a 0.30% weight (0.30% = 5% * 6%).
3 BBH Domestic, Taxable, Qualified Growth Model Portfolio based on most recent holdings as of February 28, 2019.
4 Within our equity model portfolios, the largest holding is our aggregate cash position, which is currently 4.5%.