Overview: The Asset Allocation Process
By the Centrifuge Credit Group
In our last two posts, we dug into the market structure and dynamics of the world’s two biggest asset classes: US Treasurys and US Mortgage-Backed Securities. In this post, we take a step back and explain the process through which trillions of dollars get invested across the myriad of asset classes: Portfolio Construction and Asset Allocation.
Asset Allocation
The process of asset allocation can be understood through five steps:
- Objective Setting
- Benchmarking
- Budgeting
- Investing & Diversifying
- Monitoring
Let’s look at them in turn.
Objective Setting
The first thing to do when considering asset allocation is to come up with a broad framework that defines risk tolerance and target return. This is essential as it grounds any consideration regarding investable assets within clearly delineated quantified risk and potential reward boundaries. Examples of important parameters to consider include:
- Investible amount
- Target return
- Time horizon/liquidity need
- Risk tolerance
There are many broad asset classes such as public equities, government debt, and mortgage-backed securities. There are even more sub-categories within each: US equities, UK equities, EM equities, LATAM equities, and more. Having a clear set of parameters helps the allocator navigate among the many options and keep a focus.
For example, a crypto project may have a set of parameters based on:
- $20 million of investable capital
- A need to at least cover its annual operating expense which amounts to 6% of its treasury
- A need to at least always have 60% of the asset in cash or cash equivalent to meet any unexpected demand
- A need to not have a drawdown of more than 4% within 2 standard deviations of its historic returns
Understanding the priority of one’s objectives is an important part of the process. For instance, for a stablecoin issuer, always having liquidity for possible redemption may be very important but not having any capital losses may take the number one priority spot as an undercollateralized stablecoin may simply be unacceptable. Thus keeping a significant part of the reserve in cash and cash equivalents that have demonstrated a track record of maintaining value may be the overarching constraint.
Take stablecoin issuer Circle as an example. Circle kept 25% of the reserves backing its USDC stablecoin in cash, and 75% of it in US Treasurys. Both were known to maintain value in times of stress and were highly liquid.
Benchmarking
From beating the S&P 500 with tactical sector tilt to targeting a specific return number,a range of benchmarks can be used. Below are the broad categories of benchmarks serving different purposes:
Source: BlackRock
Once an objective has been set, various benchmarks can be employed to guide, track and monitor allocation decisions and performance.
Since most of the allocation conversations in crypto are not about alpha generation or investing like a hedge fund where tactical tilts are required to beat any benchmark, index or asset-specific benchmarks are likely to be the most relevant.
Using the example above, the parameters (6% annual target, 60% in cash or equivalents, not suffering more than 4% price fall in a year with a more than 95% confidence) may narrow down the investable universe for portfolio inclusion to a majority leaning towards the highly liquid short-term US Treasurys and a minority leaning towards higher return fully collateralized US private credit assets. In such a case, the relevant benchmarks are similar maturity US Treasury holdings and US Broadly Syndicated Loan Index or the Middle-Market CLO index.
Budgeting
Once an asset class has been deemed appropriate for consideration given one’s risk and return parameters, it is important to understand the cost of accessing that risk opportunity.
If the crypto project in our earlier example were to allocate 70% of its investable amount to 0-3 months US Treasury Bills, what are the avenues that would allow it to access the target asset and how much would that cost?
Since the asset in question is not originated natively onchain, there needs to be a securitization process that transforms it into a tokenized version. This process normally entails an SPV setup where the onchain investors hold shares of a legal entity that has the right to purchase and sell the US Treasurys.
Since most crypto organizations lack the legal entities capable of representing themselves in a regulatorily compliant jurisdiction, there are legal fees involved in setting up such an entity. The more jurisdictions involved, the higher the fee.
Then, there are fees associated with actually holding the asset. For example, if the instrument an allocator uses is a public ETF, most likely there is a fee involved in holding the ETF shares offchain. When the shares get further tokenized, there will be fees associated with issuance and maintenance of the tokenized version of the asset.
From an investor’s perspective, fees reduce the return. If you are paying 20bps for a BlackRock US Treasury ETF offchain and another 50bps in onchain–not accounting any legal setup fees– your total return could be 4.3% instead of 4.8%.
One way to collapse that fee structure could be partnering with a manager capable of directly holding US Treasurys… This would save 20bps offchain. However, it’s important to consider the potential trade-offs, such as the absence of a proven track record and the operational risks inherent in engaging with a new manager.
In comparison, if an allocator wants to access higher-yielding private credit opportunities, most likely they will need to pay a higher fee. This is not surprising as good private credit deals cost more to originate. Note, there should be a strict credit analysis process involved.
For more details on establishing a cost-effective RWA legal structure, refer to the Establishing Real World Asset Infrastructure section in Arbitrum Treasury Perspective.
Investing
There are three important concepts to highlight when it comes to investing:
- Are you getting paid for the amount of risk you are taking comparatively?
If the most common pricing for companies issuing loans in the lower-middle market CLOs is SOFR + 600bps, and suppose SOFT is at 6%, and you have a macroeconomic view that the rates are 40% likely to stay where they are for the next year and 25% likely to go higher, then if a consumer financing company with less than $1 million in annual revenue offers 3 year 10% fixed loan may not be very attractive option. Whether you can access that CLO market is potentially another hurdle. But at least it gives you a good framework to benchmark the opportunities that you come across.
- Are you getting paid for the risk you are taking in an absolute sense?
Given the above macroeconomic assumptions, while it is hard to argue that one is getting compensated adequately to fund the loan deal mentioned above, it may be worth more diligence effort if a company with $10 million in annual revenue in the US government tax credit receivable space is offering 16% fixed with a 30 days withdrawal notice period. A thorough look into the company’s audited financials and track record to assess its underwriting policy as well as various risk mitigation strategies needs to take place to understand whether what seems like attractive yield at first glance is actually a good one given the risks involved.
- Are you taking on excessive correlation risk?
Beyond figuring out if one is getting paid enough for the amount of risk they are taking, from a portfolio perspective, there is another crucial step in the investment process: correlation analysis. Harry Markowitz, the Nobel Prize-winning US economist renowned for pioneering Modern Portfolio Theory, advocated for reducing overall risk by diversifying investments across uncorrelated assets while maintaining idiosyncratic risk exposure for the upside.
He showed that holding a well-chosen basket of unrelated assets that do not move in the same direction at the same time significantly reduces the risk of the overall portfolio while maintaining their individual risk exposure for return potential.
Apart from benchmarking, budgeting the cost and asset selection, the allocator should target a low correlation between holdings in a portfolio.
For example, to calculate the correlation between two variables:
Where
If there are more than two holdings in the portfolio, one should adapt the method for multiple correlation coefficient calculation.
More practically speaking, here is a chart showing correlations between broad strategies and asset classes:
Source: Guggenhaim Investments
Of particular interest is the generally low correlation Investment Grade Bonds (Bloomberg U.S. Aggregate Bond Index) and Cash (ICE BofAML US Treasury Bill 3 Month) categories have with the rest of the investable universe. This is in addition to their contractual fixed return nature and generally high credit quality and good liquidity condition.
Monitoring
Once strategic asset allocation has been made, it is important to keep an eye on the market and monitor:
- The portfolio and its constituents performance
- Changes in market conditions and their impact on portfolio performance
- Any rebalancing needs
Taking stock of how a portfolio has been performing is the first step in the monitoring process. Whilst it is very important to construct a well-balanced portfolio, its outcome may or may not match expectations.
For example, if the portfolio contains tokenized private credit assets, a change in economic conditions could prompt a fundamental change in the risks of the issuer. Take the 2020 pandemic’s impact on brick-and-mortar businesses.
Receiving regular updates and monitoring the issuer and the underlying loans provides a better real-time understanding of any potential issues you could be facing. Allocators should ask for and assess regular updates regarding the issuer’s financial health and be on alert for any covenant breaches and target remedies as early as possible. Furthermore, whether due to market performance or economic conditions, some parts may perform better than your benchmarks, while others may fall short. In both cases, rebalancing may be needed.
In a regular 60/40 portfolio, the higher volatility of stocks may cause the portfolio to become 70/30 after a while. If the allocator has a new set of macroeconomic expectations that supports a higher equity allocation tilt than previously, this is fine. But otherwise, there are risks in the portfolio that are unintended. According to BlackRock, an annual rebalancing may significantly reduce the unintended risks embedded and thus influence the outcome:
In a hypothetical scenario where two portfolios of 60% stocks and 40% bonds are invested at the start of 2003, the rebalancing portfolio gives up a little upside during the first five years vs the unbalanced portfolio as the best-performing assets are sold. But the dramatic fall in 2008 led to a much bigger fall in value for the unbalanced portfolio vs the rebalanced portfolio and ultimately led to better overall performance in the long run.
In a risk-first context where capital reservation is the number one priority and investments tend to skew towards Cash and Bonds, the same concept applies. For example, while the short-term 3 Month US Treasury Bills were yielding around 5.5% in late 2023 and the longer duration Treasury notes were crashing from 4% to 5%, it may have been counterintuitive to take on duration risk at the time. However, there is a non-zero chance that the Federal Reserve is poised to cut rates in 2024 and perhaps a zero allocation towards anything longer than three months is not the optimal allocation strategy, and thus a rebalancing is needed.
Rebalancing represents an opportune time to reassess one’s overall investment objectives and whether the current allocations are meeting them.
Navigating the path to achievement
At this time, asset allocation in the crypto-native context for the buy-side largely means accessing safe offchain assets and yield for treasury management purposes or collateral management for stablecoins. Both endeavors are relatively new phenomena. The process of portfolio construction and asset allocation is being figured out in real time. The good news is that this process has been refined and well-practiced in traditional finance for many years.
Objective setting, benchmarking, monitoring, investment selection, and monitoring are five key steps in this process that have been used to manage trillions of assets. It can be a time-consuming and complex process to navigate for an organization but it serves as a map guiding the allocator to achieving its financial objectives. Without it, it would be like taking a flight without knowing the the starting point, the route or the destination.
Disclaimer:
This post does not constitute or offer legal, tax, commercial or other advice and users of the post should not rely on it as such advice. Although care has been taken as to what is contained in the post, no attempt has been made to give definitive or exhaustive statements of law or any opinions on specific legal, tax or commercial issues and no representation is made or warranty given that the information is complete or accurate.
As more legislation and regulatory guidelines are issued or updated, the accuracy of the information contained in the post may alter. Anyone requiring advice on any of the matters referred to herein should consult lawyers or other professionals familiar with the appropriate jurisdiction and legislation.
Nothing contained in this post is to be construed as a solicitation or offer, or recommendation, to buy or sell any interest in any note or other security, or to engage in any other transaction, and the content herein does not constitute, and should not be considered to constitute, an offer of securities. No statement herein made constitutes an or to sell or a solicitation of an offer to buy a note or other security.
Well done 