In today’s investing environment, investors face the challenge of hitting their return objectives despite diminished return expectations on major asset classes. Some are doubling down on active management, focusing in particular on high-growth strategies such as private equity and real estate. Others have gone in the opposite direction, lowering their return targets and their overall volatility profiles.
We believe there is another path that has been relatively overlooked, one that re-conceives the whole asset management framework, making every asset class decision work harder for the capital invested. This approach is more intentional, more efficient and more precise about the assets one invests in and how they all fit together.
A step further
Historically, many portfolio managers have used market cap weighting as the centre of gravity for their investment policy. For example, investors would use a 60/40 framework of index funds split between equities and fixed income, and spend their time seeking active managers capable of outperforming the cap-weighted benchmarks. Where they could find promising sources of alpha, they would complement the cap-weighted core with active satellite exposures. The overall 60/40 mix, however, remained fixed, with little thought given to changing it.
This approach may simply not generate sufficient portfolio efficiency, particularly in a lower-return environment. As investors have come under more pressure, many have added to their rosters of active managers. However, our research has found that as active managers are added, they have the potential to cancel out each other’s bets, but not each other’s fees. This can leave an investor with the equivalent of a very expensive index fund.
Take the case of the large asset owner who allocates extra capital to small-cap managers to benefit from the perceived alpha opportunities. The plan will gain an overweight to the small-cap risk factor, with little stock-specific risk. This is because the union of all the small-cap managers’ portfolios ultimately ends up being a well-diversified portfolio holding nearly as many names as the broad benchmark.
While the investor started with the objective of increasing stock-specific risk, it winds up with factor risk – and not necessarily even the type of factor risk they would have consciously chosen. When institutions reduce their exposure to riskier assets, at some level they are identifying ‘low volatility’ as the factor most in line with their objectives and prioritising a smoother, less volatile return stream even if it means lower growth.
But why not go a step further? Why not re-conceive the entire 60/40 framework in terms of all the factors they want – and don’t want – exposure to?
We propose five steps to designing investment portfolios that hit your objectives.
1. Bring a new dimension to strategic allocation
The strategic allocation set-up is possibly the most important decision. However, the decision needs to extend beyond how much to allocate between equity, fixed income, real estate and private equity. It should directly target macro factors such as equity beta, fixed income duration, leverage and liquidity. The plan will still invest in asset classes, not factors, but the asset classes will carry factor exposures, and these should be consciously targeted.
2. Do not over-diversify
Beyond a certain point, active managers cancel each other out. Adding too many active managers forces the investment team to spend more time analysing an active programme that increasingly carries less active risk. Hire fewer active managers, but allocate greater capital to each in order to make a meaningful impact.
3. Use capital-efficient allocations
Particularly where yield curves are positive and upward sloping. Extend the fixed income duration, which is effectively a form of leverage without the borrowing. Simultaneously reduce the fixed-income allocation and roll the extra capital into low-beta equities, various multi-asset class strategies or other low-beta growth substitutes. If global growth continues to slow, inflationary expectations should remain subdued, keeping a lid on longer-term rates.
4. Consider asset and factor classes for additional returns
Both asset and factor classes play a vital role in your investment outcomes, so making sure your portfolio has accurately targeted your intended exposures is critical. Within equities, integral factor classes include Value, Quality, Size and Low Beta. Beyond equity, factor classes can include currency carry, currency valuation, fixed income slope, commodity curve, volatility and momentum, among others. Structuring factor classes so that they are insensitive to the economic environment can be beneficial. For example, Value tends to work best in a strengthening environment, so balancing this factor with a modest dose of Low Beta can help if growth continues to soften.
5. Track the factor portfolio valuation
Look to move away from a factor if it appears expensive. Crowding can occur in any asset or factor class, and knowing the price of these classes is the first step in forming a long-term view.
The game has shifted. Returns may not be easy to achieve going forward. Investors will be well served by adopting a more holistic mindset. We advocate targeting the aggregate factors to control risk, and factorising the underlying asset classes to harvest return. These shifts can have a meaningful impact on the total portfolio, even in a low and slow environment.
To learn more about factorising your portfolio, read our paper, More from the Core.
Kevin Anderson is head of investments, Asia Pacific at State Street Global Advisors.
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