Implementing "Efficient Core" Portfolios

This article is relevant to financial professionals who are considering offering Model Portfolios to their clients. If you are an individual investor interested in WisdomTree ETF Model Portfolios, please inquire with your financial professional. Not all financial professionals have access to these Model Portfolios.

WisdomTree introduced the idea of “efficient core” portfolios last fall. Given today’s rapidly changing market regime, it is time for an update.

First, a quick reminder of the structure behind our capital efficient suite of individual products (using NTSX as the example). Put simply, if you have $100 to invest, you can invest $67 of it into NTSX and have the equivalent exposure to $100 worth of an S&P 500/Treasury portfolio, leaving you with $33 left to explore more alpha-seeking, yield-seeking or diversifying exposures within your overall portfolio.

How the Capital Efficient Strategies Are Constructed

• Equity component: For every $100 invested in the ETF, $90 is invested in equity exposure via the WisdomTree U.S. Efficient Core Fund (NTSX). The equity component is a portfolio of 500 large-cap U.S. stocks, weighted by market capitalization to provide broad exposure to U.S. equities. 
• Cash component: For every $100 invested in the ETF, $10 is held in short-term collateral that earns returns comparable to U.S. Treasury bills. 
• Bond futures ladder: To help magnify the potential benefits of the asset allocation, $60 of bond futures are overlaid on top of the $90 of equity exposure and $10 of cash collateral.
  • Treasury futures are laddered (equal-weighted) across the 2-, 5-, 10- and 30-year segments of the yield curve to diversify interest rate risk.
  • The average effective duration for the fixed income portion of NTSX is typically 7–7.5 years and is meant to offer the duration profile of traditional aggregate bond indexes. 

In addition to NTSX, the other strategies currently available in our Efficient Core suite include NTSI (the EAFE version of NTSX), NTSE (the EM version), GDE (a gold plus equity version) and GDMN (a gold plus gold miners version).

In that introductory blog post from last fall, we provided some hypothetical examples of how advisors might allocate the freed-up capital.

1. Uncorrelated alternative assets to reduce volatility and/or add in additional potential sources of return.
2. Income-enhancing strategies to boost incremental yield on top of a 100% portfolio.
3. Maximum growth satellites to allocate to longer-term thematic and high-growth industries, sectors and firms.
4. Private investments for longer-term growth allocations.

Why Now for Efficient Core Portfolios?

We seem to be at the beginning of a market regime that is different than most advisors have experienced in a long time—where it is not enough to simply allocate to long stocks and bonds to deliver the appropriate investment experience. U.S. and global stocks, as well as bonds, are down sharply year-to-date, so using just bonds to hedge equity risk is not working.

Given our view on rates (they will continue to rise), inflation (higher for longer than the consensus view) and what we believe will be consistently higher volatility in equity markets, we think this regime may be with us for quite some time.

From a longer-term perspective, meeting defined investor objectives with specific asset allocations has changed dramatically. Consider this chart, which is updated annually by investment consultant Callan Associates, based on their own capital market assumptions. 

Assume the investment objective was an annualized 7% return. According to Callan’s analysis, that objective could have been met in 1992 with a simple allocation to cash and bonds, resulting in an annualized standard deviation of 3.2%.

In 2007, 15 years later, the same return target would have required an allocation to global equities and bonds, resulting in a standard deviation of 9.4% (three times that in 1992).

Roll forward to 2022 and that same 7% return target requires an allocation to global equities, private investments and real estate, resulting in a standard deviation of 16.8% (roughly five times that in 1992).

In other words, it might benefit advisors to consider additional portfolio allocations to meet long-term client objectives. We certainly are receiving more inbound enquiries asking some variation of the question, “What else might I put into client portfolios, beside stocks and bonds?”

But how to fund them? Let’s consider one simple hypothetical example, where the investment objectives are to hedge inflation and increase diversification within the portfolio.

Take a look at the YTD performances of (a) U.S. large-cap equities (as measured by the S&P 500), (b) large-cap non-U.S. equities (as measured by the MSCI ACWI ex-U.S.), (c) U.S. bonds (as measured by the Bloomberg Aggregate), (d) a global commodities strategy (using our own GCC at NAV), (d) a managed futures strategy (using our own WTMF at NAV) and (e) a variation of a hedged equity strategy that capitalizes on higher volatility (our own PUTW at NAV).¹

For the most recent standardized performance, click the respective ticker: GCC, WTMF, PUTW.  

The YTD performance differential between the core equity and bond exposures and the diversifying strategies is stark. Using the capital efficient strategies (NTSX and/or NTSI and NTSE) and using the freed-up capital to allocate to these diversifying strategies may have dramatically improved both overall performance and the inflation-hedging profile of the portfolio.²

This is just a simple hypothetical example. The opportunities to “explore” appropriate allocations for the freed-up capital are almost limitless and completely dependent on the investment objectives for the overall portfolio.

A final thought is this—many advisors have been hesitant to make reallocations within their clients’ portfolios because of unrealized capital gains, the result of a remarkable multi-year bull rally in both stocks and bonds.

As bad as this year has been for most allocations, the result is the ability to make portfolio reallocations while minimizing realized gains, or perhaps even capturing tax losses that can offset gains elsewhere in the portfolio (i.e., “tax alpha,” which is real money back into the end clients’ pockets).

Conclusions

We think the time has come to explore the possibilities of building efficient core portfolios. The market regime has changed and both advisors and clients are investigating innovative ideas.

One of the age-old questions we have always received as advisors is, “I like the idea of including non-core stocks and bonds into my portfolio, but how do I fund them?” We believe the efficient core portfolios can—well—efficiently address that question. You can still implement the core portfolio without having to pick and choose how to fund the portfolio satellite positions.

The primary point is the use of the WisdomTree Efficient Core suite of portfolios opens possibilities for advisors and investors to build truly customized portfolios in a highly capital-efficient manner, without sacrificing an underlying allocation to a traditional stock/bond portfolio.

¹ We use all WisdomTree strategies in this example for simplicity purposes. In actuality, all actual WisdomTree Model Portfolios are “open architecture” and contain both WisdomTree and third-party strategies.

² This is a hypothetical example for illustration purposes only and does not represent actual investment advice. Past performance does not guarantee future results.