Is modern portfolio theory dead? The principals at Toroso Investments LLC won’t go that far, but they do think MPT let down investors during the market pratfall of ’08-’09. And they believe they’ve constructed portfolios that more closely align with an investor’s risk tolerance and time horizon.

Toroso took shape last summer and spent the rest of the year laying the groundwork to roll out its portfolios to investors through a client base of financial advisors, managed account platforms, endowments and the pension and defined contribution markets. The firm threw itself a coming out party in February with an evening soiree on the floor of the New York Stock Exchange that featured a presentation by legendary economist Burton Malkiel and a spread that included tapas and Spanish wines.

Based in New York City, Toroso (a combination of “toro” and “oso,” the Spanish words for bull and bear) was founded by a trio of financial services veterans with fortes such as investment strategy, 401(k) design and marketing. CEO Larry Medin and chief financial officer Dan Carlson previously worked at Avatar Associates, an institutional money manager whose client base includes financial advisors and the 401(k) market. Chief investment officer Michael Venuto was most recently the head of investments at ETF provider Global X Funds.

Toroso’s basic premise is that MPT-style portfolio diversification, which seeks to maximize returns given a specified risk level, failed during the market crash largely because of the increasing correlation of world markets and various asset classes. The Toroso team––and many others in the industry––believe that MPT’s backward-looking assumptions to quantify future portfolio risk are flawed.

Points Of View
To remedy this, Toroso uses five core portfolios that address a particular economic scenario or point of view that anticipates 1) prosperity, 2) recession, 3) inflation, 4) deflation or 5) an environment that is “neutral.” Its underlying philosophy is based on Harry Browne’s permanent portfolio model putting equal weight on four asset classes––stocks, bonds, gold and cash––that independently tend to do well in one of four possible economic environments. The idea is that if one asset class implodes, it won’t sink the entire portfolio.

All of Toroso’s five core portfolio models have allocations to those four asset classes (gold is expanded to encompass the broader commodity asset class), which are weighted according to different economic scenarios. The prosperity portfolio has a heavier tilt toward equities, for example, while cash is king in the recession portfolio. Commodities take center stage during inflationary scenarios, while bonds––particularly longer-term bonds––do well during deflationary periods. The neutral portfolio has equal weights among all four asset classes.

Toroso’s partners say their portfolios can help advisors frame the issue of risk when they talk with clients by getting clients to express their current beliefs––i.e., their point of view––about where the economy is heading. And to their thinking, that creates a dynamic portfolio strategy that’s not based on conventional (or as Toroso calls it, “well worn”) definitions of risk or on unrealistic investor time frames.

“What we change is the amount allocated to each of the four asset classes, and that’s how we express the point of view of the client,” says Venuto, adding that Toroso can create customized portfolios for clients who want them.

“I believe that modern portfolio theory works, but it requires a 35-year time horizon,” Venuto says. He posits that Toroso’s portfolios are attuned to investors’ “life-adjusted” time horizons, making investment decisions based on events in their lives.

Exchange-traded products are the backbone of Toroso’s portfolios. But Venuto says that even though Toroso is for now housed in Global X’s Manhattan headquarters, the company isn’t pushing Global X products. “We’re willing to purchase any sponsors’ exchange-traded products.”

The ETP selection process, according to Toroso, is of equal importance to the underlying asset allocation process. “We look under the hood of ETPs and do fund optimization,” Venuto says.

As described in Toroso’s marketing materials, this method focuses on the interconnections between ETPs and the relative value of each ETP based on its fundamentals, rather than focusing solely on past behavior.

“Optimization is about finding ETFs like EQL [the ALPS Equal Sector Weight fund], which can improve the exposures and valuation metrics like price-to-earnings or price-to-sales ratios,” Venuto explains. 

Toroso believes its intense scrutiny of the underlying funds creates core portfolios with low volatility that can anchor a client’s investment portfolio and mitigate the risk of panic selling. “If the core holdings have low volatility, there is less likelihood that an investor will sell off a satellite holding at the wrong time just because of its volatility,” says Larry Medin.

Toroso applies the same scrutiny of ETPs to its separate suite of three fixed-income portfolios, all of which target specific yields and maturities to create portfolios meant to behave more like traditional bonds. This differs from the current focus among many bond investors on total return, which Toroso believes has resulted in greater volatility, increased correlations and the chasing of returns, among other drawbacks.

Toroso’s three fixed-income portfolios are structured as follows: short-term (with a targeted coupon of 3% and a targeted maturity of five years); intermediate-term (5% and 10 years); and long-term (7% and 15 years).

“A lot of times we make decisions on face value of historical results without realizing the world around us has changed,” Venuto says. “When you look at the history of bond returns during the past 50 years you have to realize that taxes trended lower and government spending increased during that time. Those trends are ending, and I think this changes how bonds behave going forward.”

Ready For Prime Time
Toroso’s portfolios have two levels of expenses––the firm’s fees, which will vary based on services included, and the fees charged by the platform providers who offer the portfolios. “It’s different with every platform, so we can’t give a ballpark figure,” Venuto says. “We’re very competitive with pricing, and our goal is to make this work with low turnover and expenses.”

Medin expects Toroso’s portfolios to make inroads in the defined contribution plan market. “Our indexes show we eliminate 50% to 60% of the volatility from the overall market’s performance,” he says. “And nothing works better in a 401(k) plan than something with low volatility.”

Of course, Toroso’s portfolios have no track record and the assumptions made about their underlying indexes are based on back-tested data that can be massaged to paint a rosy picture.

Toroso worked with index provider Structured Solutions AG to back-test the concept behind its asset allocation models. “The results are based on independent research and actual results of the various indexes blended according to the specified asset allocation,” Venuto says. “The Toroso portfolios follow the index asset allocation, but have the added value of Toroso’s fundamental research of the ETFs selected for inclusion in the portfolio. There is no ability to back-test the security selection component of the portfolios.”

As far as back-testing goes, Toroso says its Solactive Toroso Target Neutral Index (which has equal-weighted positions among stocks, bonds, commodities and cash) lost just 4.8% in 2008 when the financial markets in general went down the tubes. In times of extreme distress like that, Venuto says, such an allocation should work because it applies strict discipline so that (theoretically) an investor won’t make an emotional decision to rebalance or otherwise react to market extremes.

To date, Toroso’s primary custodial relationship is with TD Ameritrade, and financial advisors can get access to Toroso’s model portfolios through Placemark, FOLIOfn and Genworth, says Dan Carlson. In addition, Toroso has landed a few relationships in the 401(k) market.

The company has big aspirations, but as a new player on the ETF strategist scene Toroso might take a while to reach the scale it’s hoping for. It has yet to be approved by Genworth, for example, as a full-fledged ETF strategist on that company’s platform. For now, Toroso can use Genworth in an administrative function for its clients who want to use its strategies and have those accounts on Genworth.

“We have a very rigorous due diligence process to vet and approve managers we add to our platform,” says Michael Kim, senior vice president of business development at Genworth Wealth Management. “Toroso asked to be considered [to be an ETF strategist on the platform]. They’re in the queue and are going through the usual vetting process.”

Meanwhile, the team behind Toroso is confident they’ve built a proverbial better mousetrap by avoiding the perceived shortcomings of modern portfolio theory. If their portfolios can deliver the goods, they might be a preferred ETF strategist on a lot of platforms in the future.