SITFO used equal weights, then shifted small caps to private equity

Transcript

From the transcript How I Invest publishes with the episode.

1. 7:46

   Yep. We actually did that. So we're earlier on, we were I think one of the ways of thinking about asset allocation is yeah. I had the good fortune of hearing, Harry Markowitz present at a really small conference when he was presenting on something about the four zero one k, how to, like, optimally use your company stock in your four zero one k, but he started out his presentation by saying, I don't want any of you young whippersnappers here to ask me about mean variance optimization and why, you know, it's so naive or whatever.

2. 8:14

   He's like, I did that fifty years ago. It's how you guys are the ones who are supposed to be improving on it. And he said, in fact, the best, you know, the the best diversifying portfolio or the best diversification is just to go fifty fifty. And that's the naive approach, and it tends to be, like, from an academic perspective, the best, diversification, if you will. And the so we you know, I I thought about that, and then I read another author put together something kinda similar, but and then you look at risk parity and what Bridgewater's done, and it it's kind of the same concept of, you know, the naive portfolio is to not, you know, be concentrated in one thing if diversification is the goal.

3. 8:48

   So when we started our asset asset allocation, we kinda started from an equal weight perspective, and, you know, we used optimization techniques and, you know, made sure that we were being quite quantitative in the end to stress test our decisions. But we started with, what if we were equal weighted? What would our expected returns be? And then what dials should we turn to get our expected return up based on, you know, the size of the portfolio, the size of our resources, the fact that we have money coming in from, you know, land based revenues, you can call it, mostly oil and gas and real estate development.

4. 9:20

   So we thought we put all that together and we were we were more or less an equal weighted portfolio. Like it was pretty close and it was, you know, a terrible experience for the first few years. And as we kind of lived with that and tweak with it and evolve, one of the decisions we made was to take down the small cap exposure and move it into private equity. That's been about five years or so in the making.

5. 9:42

   It it finally was and being newer, you know, we didn't have enough private equity to have a 20% target when you're, you know, just pacing in your first dollars. It's kind of ridiculous. So it made sense as we evolved over time to pull down our small cap exposure and direct it towards private equity. The truly diversified portfolio, to me, is a very interesting thought experiment, which is if you worship at this altar of diversification, this is your model portfolio.

6. 10:05

   You start with that, and then you kind of tweak it from that. But you guys literally did that. Yep. Yeah. That's how we started the conversation. Yeah. And are you not just trying to and and why not just optimize on Sharpe ratio and come up with this super efficient portfolio that is optimized on this one variable of Sharpe ratio? I like to say things that are kind of controversial, and maybe I end up just putting my foot in my mouth most of the times when I do.

7. 10:30

   But one of the things I like one of the the things I like to remark is that the Sharpe ratio is a perverse indicator. So I think if you're optimizing on Sharpe ratio and you're assuming distributions are normal and you're assuming your inputs are more correct than they probably are, and if there's any mean reversion, you're you're sort of top ticking, you know, with your optimizing on Sharpe or targeting the high Sharpe investment based on historical experience.

8. 10:56

   So if you really look out ex ante and by the way, like, know, as being a consultant and having working on a lot of institutions and a lot of asset allocation exercises, it's really hard to take a lot of risk when you have all the different asset classes available to us. If you have some exposure to those and you're, you know, thinking about it pretty clearly, it's pretty hard to have a really terrible experience that you can't survive even in August 2022.

9. 11:23

   I mean, those are really dark and terrible periods. I had clients that had a lot of problems to to deal with, but, you know, they in the end, it was it was fine. No one missed a benefit payment. No one had to go out of business. It is fine to have a decent amount of volatility ex ante, and it is fine to optimize on the return and not the Sharpe ratio. Like, if you need a higher return, you're not gonna have a great Sharpe ratio, and that's So