An Advance in Portfolio Construction

What’s the secret sauce for making a multi-asset strategy successful? This past December, in Singapore, I asked the speakers on my panel at the 6th Annual Southeast Asia Institutional Investment Forum and their answers all shared one thing in common: risk factor allocation.

These experts, hailing from some of the largest and most sophisticated institutional investors in the region, also explained what this means in terms of implementation.

Risk Factor Allocation Is the New Free Lunch.

There is a saying in the investment business that “diversification is the only free lunch.” In that sense, it is rather accurate to state that, in the context of multi-asset strategies, risk factor allocation has become the latest and most effective approach to diversification. It’s the new free lunch.

In the days of balanced funds, most multi-asset portfolios invested in no more than a handful of asset classes. This is because the fundamental rationale for having balanced funds is that stocks and bonds tend to have low or negative correlation over time.

The number of asset classes in some large institutional portfolios has ballooned, however, in recent years due to investor demand for differentiated and more sophisticated products. This has created a problem that is fundamentally against the principle of allocation: many of these more granular “asset classes” are highly correlated with each other(!) so they bring minimum diversification benefits.

Chiew Kit Tham, managing director at GIC, told the conference participants that they have pared back the number of asset classes in their program from 39 to six for this reason. GIC is a sovereign wealth fund set up by the Singapore government and manages hundreds of billions of the country’s foreign reserves. Instead of asset classes, GIC now focuses on a set of factors that they want to be exposed to: equity risk with a bias towards emerging markets growth equities, real estate, and private equity. They consider these the main drivers of their portfolio risk and return. Secondary drivers include factors such as momentum, size, value, credit, and carry.

Richard Brandweiner, CFA, CIO of First State Super, added that they have also shifted attention away from asset classes. “Benchmarks asset classes are quite arbitrary and are increasingly less relevant. We focus on what systemic exposures we try to capture with a certain asset class and target a portfolio with the desired mix of exposures,” said Brandweiner.

In a similar vein, Nachcha Protpakorn, deputy secretary general of the US$20 billion Thai Government Pension Fund (GPF) discussed their focus on long-term macroeconomic drivers. She believes the practice allows them to take advantage of shorter-term opportunities without wandering too far away from the long-term policy portfolio.

Proper Portfolio Construction Is Critical in Reaping the Benefits of Risk Factor Allocation.

The shift from asset classes to factors requires changes in the portfolio construction process.

For example, target allocations to specific asset classes become an afterthought. Brandweiner’s advice: “Avoid silos in thinking. Think of portfolio construction from a factor perspective, such as duration, credit, and currency. There is no bucket for a particular private equity or infrastructure fund but think of their contribution as a group.”

Tham gave a similar example: To add high yield to a portfolio, an investor will need to reduce exposures to the equity and credit factors. Similarly, there will be no target allocation to active and passive components of the portfolio.

These components are switchable in terms of exposures to factors. Once appropriate funds are identified based on their risk-return trade-offs, etc., allocations can then be set in line with their factor exposures. Tham highlighted a case where they would sell the “policy portfolio” to make room for the new active funds added.

Constraints defined in terms of asset classes will also need to be adapted. This follows through from the previous two points. Although it sounds simple, this can often be the sticking point for funds with old guidelines set in percentage of assets allocated to certain asset classes. So be forewarned before you set out on this route.

All speakers also highlighted the importance of understanding the economic rationale beyond running regressions on the few factors.

Risk factor allocation is one of the most important advances in portfolio construction techniques in recent decades. Institutional investors are catching on to the trend but, as we have demonstrated, the devil is in the details. In the next installment of this series on multi-asset strategies, “Benchmarking for Success,” we’ll share with you practitioner insights on how to set proper benchmarks.

This is the third article in the multi-asset strategies series. The first and second posts were, respectively, “Multi-Asset Strategies: A Primer” and “Three Key Decisions in Formulating an Asset Allocation Strategy.”

For more in-depth coverage of these topics, Multi-Asset Strategies: The Future of Investment Management is available to CFA Institute members.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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