Smart Portfolios 5 – Top-Down, Assets, Alternatives

Smart Portfolios 5 – Top-Down, Assets, Alternatives

Today’s post is our fifth visit to Rob Carver’s book Smart Portfolios.

Top down

Today we’re going to be looking at asset classes, and in particular, the alternatives to bonds and equities.

  • I’m hoping that the content might be a bit easier to digest than what we’ve seen from the book so far.

Like me, Rob believes in a top-down approach to portfolio construction / asset allocation.

  • You choose your asset classes first, then your countries / industries and firms (for stocks, as an example).

It’s almost impossible to predict risk-adjusted returns by using historical data, so selecting stocks or funds is a complete waste of time and effort.

Instead you should be focusing on buying the most diversified portfolio possible. And diversifying means investing in a wide range of assets across asset classes, countries and industries.

Top down counteracts home bias and “favourite industry” bias.

  • It also deal with people who are obsessed with stocks (often small caps) or with another asset (usually property, or gold).

Top-down also comes with a process – instead of selecting dozens of assets from a universe of many thousands, you have a series of relatively simple (and isolated) decisions to take.

  • And top down maximises the diversification of smaller accounts, for which a random bottom-up selection is most dangerous.
Allocation diagrams

Two levels

Two levels

Next, Rob presents a series of asset class breakdowns, showing risk weights in normal font, and cash weights in bold.

  • Where no cash weights are shown, Rob assumes that volatilities within that section are equal, so that cash weights and risk weights are the same.

Mixed levels

Mixed levels

Note that Rob’s allocations have no home bias to the UK, whereas I would keep some.

  • I plan to spend (my life) in UK (no currency risk), I have more information about the UK economy, and I can invest more cheaply at home.

ETF tickers

ETF tickers

This table uses individual ETFs to access multiple countries (ie. regions).

Rob uses minimum ETF allocations of £3,600 in these tables, based on a £6 commission.

  • For iWeb (£5) you could use £3K, or for YouInvest (£10) you could use £5K.



This table has an extra row at the bottom to total regional exposures.

Asset classes

Here’s Rob’s top-down map of assets.

Asset classes

Asset classes

The key difference to what I’ve presented in previous articles about portfolio construction is that Rob is more rigorous about alternatives.

He splits them into three:

  1. genuine alternatives
  2. equity-like alternatives
  3. bond-like alternatives

Rob’s reasoning is the behaviour of each group during the 2008 financial crisis.

I assume that bond-like alternatives have bond-like volatility, and equity-like alternatives are about as risky as traditional equities. 

Amongst the group of genuine alternatives, some have equity-like volatility, whilst others have an unusual risk pattern that is a little lower on average. I assume similar levels of risk for genuine alternatives as for equities. Overestimating an asset’s risk is safer than underestimating it.

The correlation between equities and bonds varies over time, but has averaged around zero. By design the correlation of genuine alternatives to both equities and bonds is similarly low, and may even be negative.

I’m less concerned than Rob about abnormal correlations during a crash, because I expect to hold enough cash to be able to ride it out.

  • Rob doesn’t believe in holding cash, whereas I include it within the Bonds section.

At the same time, I believe that Rob’s classification should lead to an allocation plan that is superior to mine, so I propose to adopt it.

Note that Rob ignores derivatives like futures an options.

  • They are a complicated method of gaining exposure to an asset class, rather than a class themselves.
Max SR

Since all three pairs of correlation values (equity/bond, bond/alternatives, equity/alternatives) are close to zero, it’s safe to assume they are identical.

This lead’s to Rob’s max SR portfolio, with 55% (cash) in bond-like assets, and a total of 66% in alternatives.

Max SR

Max SR

This will be scary to most people, and Rob suggest that a 10% allocation is more reasonable.

Rob offers some reasons why alternatives might get a lower weight:

Many alternatives don’t have well behaved risk, and have a nasty habit of becoming much riskier very quickly.

Since alternatives are usually more expensive to access, their post-cost SRs are lower.

  • There’s also the potential for embarrassment when straying too far from the classic 60/40 portfolio.

The total market value of alternative assets is much smaller than that of bonds and equities.

In my opinion any initial allocation between 0% and 25% is reasonable.

I will probably stick with 10%, though that’s a topic for another post.

Here’s Rob’s max SR portfolio with a 10% alternatives cap:

Max SR Alt 10

Max SR Alt 10

Still way too much allocated to bonds for me (and therefore too low a return).

Max return

To get maximum returns, Rob also caps bonds at 10% (by risk, equal to 22% cash).

Max return Alt 10

Max return Alt 10

This will be my starting point when I review my own allocations (in a future post).

No alternatives

Rob also offers allocations that exclude alternatives entirely:

Nine portfolios

Nine portfolios

Rob recommends the top three rows for portfolios larger than £130K, and the bottom three rows for those with less than £30K.


Let’s start with Rob’s definition of the three groups:

  1. Equity-like alternatives will do badly when there is poor economic news, or when investors get scared. Certain hedge fund strategies also rely on risk remaining low, and lose money when it increases. The many “hedge funds” running supposedly uncorrelated strategies that went bankrupt in the financial crisis of 2008 are testimony to this.
  2. Bond-like alternatives are sensitive to higher interest rates and spikes in inflation. Some assets fall into this category because they are positively correlated to US treasury bonds, as in times of panic they are also safe havens for scared money.
  3. Genuine alternatives have relatively little to do with either of the main asset classes. Some of them even have a negative average return; but because owning them is like buying an insurance policy they are still worth throwing into your portfolio.

Rob does not include SWAG or exotics like BitCoin.

True alternatives

Let’s start with insurance.

  • These instruments generally have negative (real) returns, as well as negative correlations with bond and equities

Rob’s list is:

  1. Gold, silver and platinum
  2. Long volatility funds (put – and call – options on indices)
  3. Tail protect hedge funds (cheap option strategy)
  4. Short-biased equity funds
  5. Insurance currencies (Swiss franc, dollar, yen)

There are two true alternatives:

  1. Managed futures (CTAs, which go long and short)
  2. Global macro hedge funds

Rob said that he couldn’t find any UK ETFs with Hedge fund exposure.

There are the two Brevan Howard funds (Macro and Global), which I suppose count as investment trusts.

  • Most of the other listed hedge funds are activist-style, but there are also Highbridge multi-strategy and Boussard and Gavaudan Holdings – I’m not sure what their styles are.

There is also a UK ETF that tracks the VIX (the S&P 500’s volatility).

Rob also couldn’t find a way for UK investors to hold Swiss Francs directly, other than in a brokerage account.

  • There are no UK ETFs, either, it would seem.

You could use spread bets, but I would imagine that the holding costs are prohibitive.

Note that holding stocks and bonds from safe-haven countries will provide some exposure, so you could overweight here.

Gold and other precious metal ETFs are more straightforward.

Here’s Rob’s internal allocation of true alternatives:

Genuine alts

Genuine alts

A larger share for insurance-like assets will bring down the risk of the total portfolio, and so might conceivably improve Sharpe Ratios. But this will be at the expense of lower returns.

Equity-like alternatives

Here’s Rob’s list:

  1. Private Equity
  2. Venture Capital
  3. Property
  4. Commodities (industrial metals and energy)
  5. Other hedge fund strategies (equity neutral, fixed income relative value, FX carry, volatility selling).

If you want to know if a hedge fund manager is selling an equity-like strategy, ask them how they did in 2008. If they lost money they’re probably running an equity-like strategy.

Exposure to ETFs or more expensive ITs.

  • You may already have some exposure to VC through VCTs and EIS (as I do).

Property exposure of many flavours is readily available via ETFs and REITs.

  • But most investors in the UK have too much property exposure already, through their (expensive) home.

Commodity exposure is available via ETFs (ETPs), which suffer from contango drag.

  • Or there are spread bets, which I would expect to be expensive in the long run.

ETFs depending on the level of contango.

There are also funds for things like forestry, timber and agro-businesses.

The UK has no hedge fund ETFs, but we have the ITs I mentioned above.

Here’s Rob’s breakdown for equity-like alternatives:

Equity like alternatives

Equity like alternatives

Bond-like alternatives

Here’s Rob’s list:

  1. private debt
  2. peer-to-peer lending
  3. infrastructure / asset-backed securities
  4. long bond hedge funds

Private investors have quite a lot of options in the space now, though arguably not a lot of it is high quality.

  • There are infrastructure and asset-backed ITs, plus direct P2P (including sophisticated options like Wise Alpha) and P2P ITs.

For me, the problem with direct P2P (apart from low returns for the level of credit risk) is the tax treatment.

  • You can only shelter the income by using up your ISA allowance, so you need a compelling reason to invest.

Rob prefers high-yield (junk) bond ETFs to P2P.

Here’s Rob’s weighting:

Bond like alternatives

Bond like alternatives

ETF suggestions

Rob provides a few suggestions for ETFs that could be used in the alternative space.

ETF genuine alts large UK

ETF genuine alts large UK

There are five genuine alternative ETFs – mostly precious metals.

Rob notes about gold:

For a smaller retail investor it makes sense to allocate the entire genuine alternatives portfolio in gold, as it’s straightforward and cheap to get exposure to it.

The resulting cash weighting for gold comes out at 8%. This is probably the largest amount of gold I’d countenance holding.

If you weighted your asset class allocation by global market capitalisation then only around 2.5% of your portfolio would be in gold.

I don’t think I’ve ever held more than 5% in gold, and probably have less than 1% at the moment.

Equity like small UK

Equity like small UK

There are seven equity-like ETFs.

Equity like small UK

Equity like small UK

There are four bond-like ETFs.


The going has been a bit easier today, and we’ve covered a lot of ground.

I won’t know quite how useful it has been until I build a model allocation and compare to both my current holdings, and my existing target allocation.

  • But before that, we have to get through the next three chapters on equities (between and within countries) and bonds.

Until next time.

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Mike Rawson

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 35 years, with some success.

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