The total portfolio approach is gaining interest as a new investing strategy for pension funds and other asset owners, but its novel status may be deceiving.
Indeed, the concept behind this approach has been at the core foundation of modern portfolio theory since the days when Nobel Prize winner Harry Markowitz showed that maximizing the risk-adjusted return of the total portfolio could lead to high average returns and low volatility.
What is new and interesting is that, since the mid 2000s, some institutional investors in countries such as Australia, Canada, New Zealand, Scandinavia and Singapore have redesigned their entire investment framework to maximize the benefits of a total portfolio approach.
This new framework, which can be described as a risk-budgeting structure, uses risk factor budgeting as the guide to investment decision-making. It contrasts with the traditional strategic asset allocation framework that emphasizes asset class exposures rather than risk factor exposures.
Proponents of risk-budgeting structures find that a risk-factor-based approach allows them to better manage the risks inside the entire portfolio. This, in turn, facilitates portfolio diversification and agility— resulting in higher risk-adjusted returns.
To understand how the risk-budgeting structure framework can be beneficial for pension funds and other investors, the two models must be compared to get a sense of how the pros and cons play out. The strategic asset allocation framework, which has dominated the investment landscape, is based on the premise that a balanced and stable asset mix is good for a fund’s long-term risk-return performance.
By setting a target asset allocation, the strategic asset allocation framework establishes a clean and manageable governance structure in which the board has visibility and, in many cases, full ownership of the asset mix. Strategic asset allocation develops flexibility by setting a fluctuation range for each asset class around the target allocation. The fund’s management team operates within these ranges and actively invests the capital in each asset class with the goal of beating the asset class benchmark.
However, the strategic asset allocation framework has four main inefficiencies. First, there’s a risk of rigidity, especially if the asset mix is set by the board and has small fluctuation ranges. Second, there’s a risk of under-diversification. Due to asset allocation silos, management teams across different asset classes may end up inadvertently exposed to the same risk factors. For example, the different teams managing public equity, private equity, fixed income, real estate and infrastructure might all separately decide that data centres are the next big investment opportunity. They then invest their assets in data centres, rendering the total portfolio disproportionately exposed to the same risk factors.
Third, there’s a risk of weakening a fund’s stewardship. This is because management teams in different asset classes may end up having contradictory forms of engagement with a firm that they are all invested in. Finally, there’s the risk of creating a ‘Tower of Babel.’ The separate management teams may use different software programming languages and methodologies, which makes it difficult to communicate and further entrenches silos.
The new risk-budgeting structure framework aims to reduce these inefficiencies by changing the responsibilities of the board and the management team. Instead of choosing the target asset mix, the board sets a risk budget for a number of key risk parameters such as market volatility, funded ratio, inflation exposure and liquidity. The management team is responsible for investing the assets in line with the risk budget.
A consequence of the risk-budgeting structure framework is that the management team has a greater responsibility than in the strategic asset allocation framework. It now manages both the total asset allocation and the security selection inside each asset class. This requires additional decision-making. Not only this, but the team in charge of the total fund must work in collaboration with every individual team to ensure that risk exposures are properly modelled and sized. It also requires a strong culture of collaboration inside the fund and a robust risk aggregation framework, which can be difficult to implement in the presence of highly illiquid assets such as private credit and infrastructure for which data is scarce.
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The current enthusiasm for a risk-budgeting structure raises the question of whether funds using strategic asset allocation should switch to this new framework. It really depends on the context. Does the fund have sufficient resources and support from the top to change its governance structure and take on that increased complexity? The risk-budgeting structure framework can lead to greater portfolio diversification and agility if it’s carefully done, but it can also backfire if the management team and the board aren’t equipped to deal with additional complexity.
Funds using strategic asset allocation have alternative pathways through which they can further leverage the benefits of total portfolio approach. Some of these funds have become highly agile by setting strong governance structures and large fluctuation ranges around the target asset allocations. Other funds have been able to maximize portfolio diversification through increased collaboration across individual teams. This is often the case for funds managing assets in the $10 billion to $50 billion range because the teams are small enough to meet around the same table and jointly review strategic investments. These examples show it’s possible to push a total portfolio approach inside of a strategic asset allocation structure.
The concept of total portfolio approach is far from new; it’s the underlying conceptual foundation on which modern investment infrastructure is based. What’s unique and interesting is the potential of the risk-budgeting structure for asset owners, which draws on total portfolio approach thinking to maximize a fund’s ability to generate high risk-adjusted returns over the long term.