Beyond traditional asset allocation

Today’s challenging climate has led diversified investors like GIC, Singapore’s sovereign wealth fund, to explore different approaches to portfolio construction to build resilience. Grace Qiu and Ding Li, both senior vice presidents in total portfolio policy and allocation at GIC discussed their new research conducted in collaboration with various asset managers, at the Fiduciary Investors Symposium.

Before diving into the papers, Li described how three key components go into portfolio construction: risk, return and diversification. He said all assets are likely to have lower returns in the current market, creating a challenge for investors seeking to meet their targets. This makes diversification even more important, particularly given the increasing correlation between equities and bonds. He added that traditional portfolios are most likely to suffer in a stagflation regime.

Delegates also learnt more about GIC’s approach to diversification across different asset classes and geographies.

GIC’s investment framework is based on two layers comprising the policy portfolio, which targets long-term inflation-adjusted returns and the active portfolio, which consists of skills-based active strategies. The latter is run by internal and external managers, and aims to add value while mitigating systemic risk. Active strategies are funded by the policy portfolio, explained Qiu (pictured).

Liquidity

Qiu noted that investing in private markets supports diversification and bolsters returns but holds real liquidity risk.

Working with PGIM, GIC has published a paper, ‘Building a Better Portfolio, Balancing Performance and Liquidity’, on how to measure portfolio liquidity.

The framework has played a part in shaping GIC’s exposure to private markets via a balance sheet simulation based on the investor’s short- and long-term liquidity profile. This simulation allowed GIC to factor liquidity demands into its portfolio risk management.

Li explained that as investors hunt inflation-resilient returns and diversification, and allocations to private markets continue to grow liquidity has become a priority. He elaborated on the importance of finding a comfortable level of liquidity risk and warned that cashflows are not always constant in private markets.

Elsewhere, Li noted that maintaining strategic targets in private markets is also a challenge, requiring a commitment to keep deploying capital to top-tier managers.

Li suggested that investors capture the different components that will impact liquidity through an analysis of top-down asset allocation and capital market assumptions, and of bottom-up needs from GPs and portfolio managers. This would inform how capital should be deployed and the accompanying commitment levels. From this position, investors will be able to quantify their liquidity needs, reducing the risk of failing to meet capital calls and liquidity demands, and the ensuing reputational risk.

Diversification in emerging markets

In another paper, GIC worked with PIMCO to explore the construction of a regionally-balanced emerging markets portfolio. It found that investors should allocate broadly to emerging markets across different geographies and risk factors.

“Don’t leave these choices to index providers; design your portfolio in a granular and deliberate fashion,” said Qiu. Leaving emerging market allocations to index providers risks an imbalanced allocation in terms of risk and region, with indices often dominated by Asian public equity.

“Diversification is the only free lunch in finance,” she reminded delegates.

Qiu also noted that investing in emerging markets is an important source of return despite the higher degree of uncertainty associated with it. It typically has a lag or tail, and often goes through boom-and-bust cycles, she explained. Rather than espousing one strategy over another, Qiu said the key is to construct a multi-asset allocation beyond public equity, adding that investors should “allocate in a granular manner.”

She also suggested that skilled, high-conviction investors can add value through a dynamic overlay over their long-term strategic asset allocation to emerging markets.

Referencing a third paper, co-authored with Blackrock, Li discussed how GIC factors in uncertain macro scenarios into its portfolio construction processes.

The idea is based on constructing a portfolio with a more balanced outcome, and compared to an alternative approach, focusing on better handling downside outcomes where diversification is also key. Examples include investing in US equity to balance Chinese equity exposure, and increasing investments in real estate to counter stagflation.

Qiu also highlighted GIC’s ongoing work with MSCI to explore how macro risk will impact asset returns over the long term. The paper provides a framework that is consistent across asset classes, and will be published in the latter half of this year.

Qiu and Li concluded that investors should not rely on a single toolbox for diversification, and highlighted the importance of geographic diversification given today’s geopolitical tensions. In addition, to address the risk of stagflation, investors should consider portfolios comprising inflation-linked bonds, gold, and commodities, as well as private real assets.