Executive summary:
- A total portfolio approach (TPA) is becoming an increasingly popular alternative to a strategic asset allocation (SAA).
- Some of the benefits we see to a total portfolio approach are greater dynamism and agility and a clearer view of risks across the entire portfolio.
- However, a total portfolio approach isn't for everyone, as it often involves changing a rather successful organizational structure involving several asset class teams all striving to outperform their respective benchmarks.
Russell Investments was founded 88 years ago, so unsurprisingly there are only a few colleagues remaining who can describe the office environment before the advent of email and the internet. Such technology represented a paradigm shift in how we work. Many have speculated that we’re currently living at the dawn of the next evolutionary wave: artificial intelligence (AI). Paradigm shifts are often difficult to see at the beginning, until they reach a certain critical mass. Recent media coverage about how best to construct and manage portfolios has many wondering whether institutional investors are facing a paradigm shift right now.
Strategic asset allocation vs. total portfolio approach: Which is right for you?
The world of institutional investing has seen relatively minor paradigm shifts since Harry Markowitz and others introduced modern portfolio theory and the efficient frontier in the 1950s. What followed was the widespread adoption of the strategic asset allocation (SAA)—the combination of asset classes with the highest probability of achieving the desired risk and return goals. At first, asset classes were primarily limited to public equity and fixed income. As the world economy developed, new investment types like private equity, private debt, real assets, and hedge funds were added. There were also debates about the efficacy of insourcing or outsourcing certain investment activities. Throughout these evolutions, the concept of the SAA remained strongly entrenched, often serving as the institutional portfolio’s north star. Despite its popularity, the SAA has several shortcomings and is not the only game in town. Taking a total portfolio approach (TPA) has been an increasingly popular competitor, with some practitioners suggesting that it’s a more efficient guide toward true north.
We at Russell Investments have been thinking and writing about TPA for over a decade. As an OCIO provider, we have the data, systems, and expertise to implement a bottom-up approach to portfolio construction that seeks to achieve our clients’ objectives. With these tools, our portfolio managers can assess the impact of a portfolio change or a new investment in the context of the ultimate objectives. But TPA is not for everybody, and we’ve seen very few of our large market institutional clients adopt such an approach. A recent feature story by the CAIA Association acknowledged many of the challenges associated with converting to TPA. As a firm, we can identify with the growing pains of converting to a different portfolio approach, and I’d like to address a few of the solutions we’ve developed, particularly those related to implementation.
5 things to consider when implementing a total portfolio approach
1. When assessing risk exposures, TPA tends to look at factor exposures instead of asset class exposures. In such an integrated, global economy, many investments have overlapping exposures across asset classes. Moving to a factor-based approach is a way to see the risks more clearly across the entire portfolio. As a leading thinker in this space, Russell Investments has been utilizing a factor-based approach for several decades. It is through this analysis that we can seek to optimize the factors for which we expect to be compensated while minimizing others. Through our portfolio management tools, we can assess the impact that each new investment will have on the total portfolio. These tools allow us to quickly run ‘what-if’ analysis on portfolio changes to assess the impact on factor exposures and expected return and estimate how they’d perform in various market scenarios.
2. TPA gives more authority to the chief investment officer (CIO) and the investment staff to be nimble because market dynamics can change quickly. Having a platform in place to quickly adjust portfolio exposures or derivative hedges is critical. An overlay platform is the quickest way to implement macro-level portfolio adjustments. With highly liquid, capital-efficient derivatives, a portfolio’s exposures can be adjusted in a matter of minutes. To alter a portfolio’s risk/return profile, hedge a certain downside risk scenario, or express a view with a known time horizon, option contracts are an incredibly useful addition to the toolkit. Adopters of TPA also tend to be more inclined to use leverage (via derivatives) to help balance their risk exposures.
3. Proponents of TPA emphasize the benefits of greater dynamism and agility. To identify the highest areas of market conviction, it’s critical to have strategic partners with long track records of analyzing and forecasting markets. Enhanced asset allocation (EAA) utilizes a suite of quantitative models as the foundation for identifying compelling market opportunities, which are then expressed through offsetting long and short derivative positions.
4. When portfolio changes are longer-term in nature, trading physical assets will be needed. A trusted partner in transition management will be one that doesn’t just consider the activity as a trading exercise, but one that appreciates the impact at the total portfolio level by seeking to minimize performance slippage.
5. Coordinating widespread changes to the public equity portfolio, for example, can be a daunting task to do quickly, especially if several external managers are involved. One method to improve the efficiency of managing several relationships is through enhanced portfolio implementation (EPI). With EPI, a single portfolio is used to implement the views of several external managers. So, instead of calling five equity managers, you only call one. This uses staff resources more efficiently while simultaneously lowering transaction costs.
The bottom line
To reiterate, TPA isn’t right for everyone. Converting to TPA often involves changing a rather successful organizational structure involving several asset class teams all striving to outperform their respective benchmarks. The SAA structure has benefited from the separation of duties and accountability. But it’s not without its shortcomings either. Whether your institution is considering TPA or looking for ways to modernize the implementation of its SAA, seek a trusted partner that can meet you where you are at and help navigate the way forward.
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