So we talked previously about using a market-cap based approach in order to construct a portfolio, but there are times when you might want to incorporate other asset classes or have different investment objectives that could be better met using a different portfolio construction approach. So we're going to talk about three today. The first one is a model-based asset allocation approach. The second is an active-passive framework to include active funds or allocations within a portfolio. And the third one is a time-varying asset allocation. And all of these can be used if you'd like to allocate beyond a core equity and beta allocation within your portfolio.

So model-based asset allocation can be used if you're looking to incorporate asset classes that are beyond your traditional high level equity and bond allocations. And we call these sub-asset classes. So for example, if you wanted to include growth or value equities within a portfolio, different kinds of bonds or fixed income, or if you wanted to say, extend your allocations to alternatives, commodities, property are two examples of that.

So this model-based asset allocation can be used in order to allocate between those different types of sub-asset classes. Now, in order to do this, you’ll need return expectations or projections over a long term time period for each of those sub-asset classes that you're including within the model. And then you’ll also need correlation expectations as well, so how do those different asset classes interact with each other or how they're expected to interact with each other, so that when you're constructing the portfolio, you have an expectation of what the risk and return of those asset classes is, but also how they interact with each other to give you an overall expectation of the portfolio's risk and return.

So when allocating to active investments, a lot of the time actually portfolios will be a mix of both passive investments and active investments. And so we talked previously about using kind of market-cap passive approach as a great starting point for a portfolio. So when you're adding in active funds into a portfolio, you’re also adding something we call active risk.

And this is essentially the risk of deviating from that market-cap portfolio. So when constructing an active and passive portfolio, it's really important to understand what impact adding in that additional risk has. So an example of that is active managers who tend to have more volatile performance compared to market-cap. So it's really important to go back to that goal of discipline to make sure that if you are constructing a portfolio, you have the discipline to be able to hold an active manager for the time period that you need within your portfolio and you can kind of weather that volatility that will come with the active manager.

So Vanguard has an active-passive framework which helps investors determine the optimal mix between active and passive within a portfolio. And as part of that, we encourage investors to look at what the expectation is from a risk perspective of including active managers within a portfolio, but also the expected alpha you would expect to receive from investing within these funds.

Cost obviously comes into play as well. It's a really important driver of returns, whether you're investing in an active or a passive portfolio, so the framework also incorporates that. And including all of these inputs into the framework will help investors decide what the optimal mix of active and passive is for their portfolio.

So a time-varying approach to asset allocation is actually very similar to the first one we talked about, which is around model-based asset allocation, but as you can tell in the name, it varies over time. So times when you would want to consider using a time-varying asset allocation might be if your investment objective requires you to change your asset allocation in order to meet those objectives.

So, for example, you might be targeting a certain level of income or a certain level of return that you want to achieve within a specific time period, and in order to do that, you need to be able to change that asset allocation because market conditions will change over time and therefore your asset allocation would also need to change in order to meet those objectives.

So when constructing a portfolio, setting your goals is a really great place to start. So understanding what a client's goals are or what the portfolio’s goals are, because once you've done that, you can then use that to determine what the most appropriate methodology for portfolio construction is. As part of that goes back to Vanguard's four investment principles. It's important to consider those throughout the portfolio construction process as well.

So, for example, including costs as a consideration because costs have a huge impact on a portfolio’s outcomes over the long term, ensuring that the portfolio has balance, so including diversification within the different asset classes to ensure that returns are not too bumpy over the time period that you've agreed and that also enables clients to have the discipline that they need in order to hold that portfolio for the length of time that you've agreed, but also it should give them the best chance of achieving their investment objectives over that time horizon.