Your target asset allocation (based on 2007 data) advocates relatively low equity exposure (49%, based on the mid-point of your range) and bond exposure (14%), with relatively high allocations to real assets (27%) and “special opportunities” (8%).  Can you describe the rationale behind these targets?  Which asset classes do you expect to perform the best in the coming years, along with providing the best diversification benefits?

My key recommendation for the “typical US investor” is to lower the allocation to equities and, within that, the allocation to US markets.  This reflects the fact that the growth dynamic and value proposition are going global.  Indeed, even if you are wholly invested in the S&P 500, you are increasing your participation in non-US markets, because its constituents are much more globalized than in the past.  But, things are happening so quickly it makes sense to have a greater direct exposure to markets on the international side.

I recommend a lower than traditional equity exposure because of new investment opportunities that don’t fit readily and easily into traditional and historic approaches.    For a long time, investors did not have to worry about inflation.  It is clear today that we are in a world of higher inflationary pressures.  As a result, advisors need to think about appropriate inflation protection for their portfolio.  That is why there is a real assets category.

Opportunities are also arising in areas that are not well-defined in terms of traditional asset classes.  For example, preferred securities in the capital structure do not fit easily into traditional asset classes (i.e., as debt or equity).  But preferred securities are becoming increasingly important as investment vehicles. The same is true for climate and water related infrastructure.

Advisors must recognize that good investment opportunities are more global in nature, including in emerging and frontier markets and that many opportunities might be excluded by the traditional mind set.  Inflation is going to be a bigger factor over the next three years.

One of the themes in your book is that “the next few years will belong to those who prudently manage risk.”  You discuss a tendency of retail investor to outsource this function and to succumb to “agency problems.”  How can advisors best position portfolios for risk management and avoid these dangers?

There are two sets risk.  First, those that - at least in principle - can be delegated to external managers, which often translates to an issue of how well you choose your investment vehicles.  In the past, this has been less of an issue for many because buoyant global liquidity lifted all boats and forgave mistakes.  With the erosion of global liquidity, it now matters a lot.  Advisors need to look not only at the return potential for each manager and investment vehicle, but also at their history of risk mitigation.

Second, someone (either the advisor or through an asset allocation product) must look at the risk characteristics of the portfolio as a whole, and make sure they are consistent with rapidly changing correlations and herd behavior among certain managers.  This can be done by advisors directly or through asset allocation products (e.g., target date funds) that do this explicitly.

Another principle you advocate is the separation of alpha and beta in portfolio construction (something we have written about in our publication).  Why has this principle gained in importance and how can advisors best implement it?

The dispersion of returns among actively managed strategies has become very large.  In the old days, the dispersion resembled a “fan chart.” It started with relatively small dispersion in fixed income classes, to larger ones in public equities and very large ones in illiquid asset classes.

Today, we are seeing much more dispersion across all asset classes. The result is, unless you are absolutely confident of your active management choices, it is better to go passive.

The cause of this greater dispersion is that markets are more volatile.  We came from a period (until the middle of 2007) that was very good to investors.  Risk premia across all asset classes were compressing, delivering high returns and declining volatility.  As long as investors were exposed and levered they did well.  Now investors can get easily caught with the wrong position in a highly volatile environment.   The hurdle for active management has gone up.  You have to be sure you are actually getting something.  You are paying higher fees and being exposed to more risk.

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