A total portfolio approach overcomes the governance, benchmark and inertia drags inherent in strategic asset allocation, and can add returns of 50-100 basis points above SAA, according to global head of investment content at Willis Towers Watson, Roger Urwin.
A total portfolio approach (TPA) to portfolio construction has been described as a “more joined up” process. Importantly it starts with clearly specified investment goals, there is competition for capital among all investment opportunities, rather than filling asset class buckets, and it is dynamic.
According to Urwin, SAA as an approach was a perfect construct for a time when boards were dominant, investment issues were less complex and managing outsourced fund managers was the major focus of asset owners. TPA is applicable now in part because internal teams have grown and portfolio construction has become more complex. It allows for a more dynamic asset allocation process where one team has one focus.
“SAA came about in the 1980s, starting in the US with consultants such as Frank Russell using it as a model of choice. At that time investors had limited internal teams and very few asset classes, now there are large internal teams and there are many asset classes they invest in,” Urwin says.
SAA measures a lot of things, according to Urwin, but not the most important.
“Lots of funds target outperformance of a policy benchmark by say 50 basis points, what could be more unmeaningful than that?”
He says TPA allows for improved dynamism, and so less inertia drag, is goals driven so eliminates benchmark drag and improves the quality of decision making through integrated decisions lowering governance drag.
TPA is also a more natural bed-fellow for allocating to more obscure assets such as esoteric forms of credit or catastrophe bonds; as well as the refreshing of a portfolio when new information, or prices, become available.
Around the world there are only a handful of asset owners that use TPA to good effect, most noticeably Canada Pension Plan Investment Board, ATP, the Future Fund and New Zealand Super.
Last year Urwin conducted an independent five-year review for NZ Super which included a rare AAA-rating for governance.
The review acknowledged the innovation the fund has shown in the early adoption of TPA, and that a combination of a high risk-profile and TPA have been the main contributors to added value, relative to the reference portfolio. The dynamic nature of TPA is demonstrated through the fund’s tilting program which has added 1.1 per cent to the fund’s reference portfolio over the past 10 years.
TPA is an evolution of the way capital is allocated and managed but is not used by many large institutional investors, in part due to the governance and cultural changes needed to implement it effectively.
“There has been limited progress in adopting the total portfolio approach which highlights the difficulty in innovation and governance in the industry,” Urwin says.
The $107 billion TCorp has just spent the past three years moving to a total portfolio approach.
“Mechanically it is not that hard, but culturally it is very difficult,” says Stewart Brentnall, chief investment officer of TCorp. “It is a cultural journey. You can’t just design a good process and give everyone an instruction manual, it needs a cultural change.”
From a structural point of view the TCorp team is now organised along skill or function lines, with an asset class specialisation nowhere in sight. Instead of allocating teams to asset class specialty the teams now include investment advisory, portfolio construction, partner selection, stewardship, and exposure management.
“The de-centralised model of SAA has introduced a lot of agency risk,” Brentnall says. “TPA means everyone has an eye on the investment objective.”
Urwin says the total portfolio approach also overcomes the Goodhart’s law inherent in strategic asset allocation or benchmark-oriented investing. Goodhart’s law, also referred to as “munchkining” in video game role playing, states that when a measure becomes a target it ceases to be a good measure.
“Munchkining is a video game concept where in role-play games the users play to the measure not the spirit of the game. SAA has more of that,” Urwin says.
Importantly, the use of a total portfolio approach, also means that risk can be monitored and managed at a total portfolio level.
“TPA allows us to dynamically look at the price of risk, and focus on risk not on assets. One of the problems with SAA is assets don’t describe the complexity of the risk that comes with them and the nature of the risk may be unhelpful to the total portfolio,” Brentnall says.
Risk across the total portfolio is now more easily managed and TCorp is using Blackrock’s Aladdin platform to “cut and dice” the portfolio on a security level, analysing the risks that different investments bring to the total.
“We can conduct risk analysis on many levels including a mandate, sector, client portfolio, or the whole of the state of New South Wales.”
TCorp manages a third of its assets inhouse across domestic cash and bonds and real assets. It still largely relies on external managers and Brentnall says that the whole of portfolio approach explicitly recognises that any partner needs to have a proposition strong enough to impact the total portfolio. This naturally has meant the fund has a smaller number of strategic partnership.
“We hire them on the basis that they improve the risk/return of the whole portfolio,” he says, adding a natural part of this is an evolution in the manager reporting.
Urwin says this means external manager relationships are deeper and “less alpha-ish” and more about value add.
TCorp and Willis Towers Watson’s Thinking Ahead Institute recently published a paper on TPA summarising a study of current and future asset allocation practices of leading asset owners. It looked at 18 funds across the US, Europe and Asia Pacific. Among the group portfolio construction practices varied widely, with the approach largely determined by the organisational design and governance structure.
Half of the investors surveyed in the report said they expected to get an upside return of 50-100 basis points from TPA.
|Strategic asset allocation||Total portfolio approach|
|Performance assessed by:||Benchmarks||Fund goals|
|Success measured by:||Alpha||Total fund return|
|Opportunities for investment defined by:||Asset classes||Assets|
|Diversification principally via:||Asset classes||Risk factors|
|Asset allocation determined by:||Board centric process||CIO-centric process|