Repurposing a Passive Allocation With a Completion Portfolio

As soon as an asset owner allocates capital to more than one manager, an interaction effect exists which will have an impact on the investor’s overall portfolio outcome. What unintended risks result from the combination? What desired exposures are not covered? How does an investor manage these? These are all important questions to be addressed when managing a total portfolio outcome. Unfortunately, for the asset owner, the individual managers are not able to do this on their own.

Why? By design, money managers are not privy to each other’s holdings. They are focused on delivering excess returns using their specific area of investment expertise. Because of this, their unique investment insights are reflected in their respective account within the overall portfolio. But there’s a drawback to this so-called agency problem: unintended risks may emerge in the overall portfolio, due to the interactive effect between managers. Simply put, the combined positions of all managers may result in a bias toward a particular risk overall, related to sector, region or factor. These risks may not be fully aligned with the investor’s preferred positioning, based on long- and short-term investment opportunities and desired risk allocations.

So, what’s the investor to do? How can these unintended risks and biases be removed so that the overall portfolio is aligned the way the investor wants it to be?

Enter completion portfolios.

Completion portfolios: The right tool for the job

We believe that completion portfolios are a powerful tool for an investor allocating to multiple manager strategies. This is because the explicit role of these portfolios is to complement the existing managers and align the total portfolio with desired risks and exposure. The completion portfolio can manage that interaction effect, with its objectives being three-fold:

  1. Preserve and enhance unique investment insights from active managers, largely driven by security selection
  2. Manage composite level risks and exposures to desired levels
  3. Enhance returns incrementally, as compared to using a passive alternative allocation

How the interaction effect leads to unintended risks

Unintended risks can come in different forms, from biases toward certain regions or sectors to biases in factor risks and risk budgeting challenges. In a prior Russell Investments blog, we explored risk biases in more detail and similarly walked through examples on how to manage around them. As an example of how manager interaction effects can materialize into unintended risks, below is an example of a simple three-manager structure. In this example, we use managers from Russel Investments’ global equity portfolios and observe how risks in a composite portfolio differ from risk within the individual manager strategies. Often with the interaction effect, common factor biases can outweigh the higher conviction and repeatable sources of alpha expected through manager’s stock selection. So while risks like these are obviously unintended, they’re also very real.