How to decompose complex portfolios and returns?
Elske van de Burgt, managing director investment performance at Ortec Finance, and Stefano Seung Jin Lee, managing director Australia & New Zealand at Ortec Finance, explain how investors can resolve challenges posed by complex portfolios.
1. The increasing complexity in portfolios is considered by some institutional investors as one of the biggest challenges in their asset allocation. Why is this happening?
A combination of different factors results in this increased portfolio complexity: rates have been low for a prolonged period so investors have been looking for new sources of return, mainly in private assets. At the same time, there is an increased risk perception for inflation. And the rise of environmental, social and governance (ESG) metrics to make portfolios more resilient also increases complexity.
It is challenging for investors to get to grips with the various asset classes and the roles they play in the portfolio. They can find it difficult to maintain oversight and look at the bigger picture. From a technology perspective, it is also important to ensure the risk and performance solutions are able to keep up with a more complex portfolio.
2. How can investors cope with this challenge?
It is important for investors to have a holistic approach that aims to balance their strategic objectives and investment approach. Investors need to ensure the added complexity serves the purpose of meeting the required investment returns and that the extra amount of risks taken remains within their tolerance band. In our view, scenario analysis is a very strong tool to find the right balance and it allows investors to actively monitor the risk tolerance. The higher complexity nowadays also results in more requirements from tools such as modelling capabilities of private assets and climate risk.
A continuous monitoring process is needed to ensure that the strategies employed do not deviate from the investment policy statement, that risk limits are not exceeded and the required returns are delivered. So it is very important to have sophisticated scenario models and to have strong performance attribution tooling that is able to deal with increased complexities.
3. So, despite efforts made by investors themselves to make sense of return, it is becoming more crucial to assess the exact return of the investment strategies taken. How difficult is it to determine the return break-down of a complex investment portfolio?
Ortec Finance’s approach starts with the belief that fund performance is driven by bigger picture decisions such as the strategic asset allocation and a host of other investment decisions. To make an accurate assessment, it is critical to start with a clear picture of what investment decisions have been made and who are responsible for them. This may look difficult if multiple people are responsible, for example, if the board and external consultants together determine the strategic asset allocation and the rebalancing policy. Then the added value of this step should be split between them according to a pre-determined weight.
Getting a full picture of all investment decisions is a very rewarding exercise. Ortec Finance’s software has been built around breaking down investment decisions. Once defined, investors can start to measure and attribute the added value of each investment decision and assess its effectiveness on a case-by-case basis. Another benefit is that this breakdown of decisions made can also enhance the forward-looking risk models.
4. What benefits can PEARL, which is Ortec Finance’s performance attribution solution, bring to investors regarding the increasing proportion of alternative assets in investment portfolios?
The main challenges of private asset investments include stale pricing and the availability of limited data. At the same time, the role these assets play in the overall fund performance is increasing and hence it is necessary to enhance reporting qualities. We already cover challenges like dealing with proxy exposures, late valuations as well as relevant metrics of private assets such as internal rate of return (IRR), public market equivalents (PME) and direct alpha.
PEARL is our leading software solution for performance measurement and attribution for complex investment portfolios. To counter limited availability of data in analysing private asset investments, we are partnering with Burgiss, a leading provider of data for private assets. By combining the in-depth data available via Burgiss with the analytical possibilities of PEARL, we can really show the added value of alternative assets in a portfolio. This game changer will help many asset owners come to an even more appropriate allocation to these assets.
5. As investors are becoming more cautious of currency risk, how can PEARL help investors better manage or mitigate this risk?
Currency exposures are an important driver of fund returns and hence the management of the currency dimension takes an important place in the investment decision process of institutional investors. The majority of our clients prefer to manage this dimension separately via an overlay programme. This makes sense since it gives this important driver the right attention.
From a performance attribution perspective, it is important to understand the investment decision-making around the currency dimension to come to a consistent integral evaluation model to fairly evaluate the market and currency investments. PEARL is able to model and attribute the various decisions made in the process of currency management, such as currency allocation, proxy hedge, timing and operational impacts. On top of that, dedicated attribution models are built in, which can be used to evaluate individual investment portfolios in a consistent and fair way, like the Karnosky-Singer model.
6. As a final question, how is Ortec Finance helping investors incorporate ESG into their investment portfolios, given the higher interest in sustainable investing?
ESG is on everyone’s agenda right now and developments are succeeding one after another very quickly. It is a very broad topic, and Ortec Finance has chosen to focus most on climate risk. We believe in taking a holistic approach to find valuable applications in both our forward-looking solution as well as performance measurement & attribution.
In our forward-looking solution, we have come up with a unique approach to combine climate, macro-economic conditions and financial updates in the modelling. This top-down approach allows us to assess the overall impact of climate risk on the investment portfolio and the ability to reach strategic objectives. We have seen an incredible amount of interest in this approach and are proud to be working with institutional investors around the globe supporting their climate scenario analytics. We engage in various thought leadership initiatives, such as a recent joint publication on GIC’s ThinkSpace on ‘The Role of Climate Change Scenarios in Investment Portfolios’.
Another key application is to assess the impact and effectiveness of ESG policies. Client requirements are shifting, where they no longer only want to gauge the impact on return, but also on the ESG metrics themselves. That’s why we initiated a research project with an ESG data provider to come up with new approaches for assessing the impact of engagement activities.
ABOUT THE SPEAKERS
Elske van de Burgt, CFA, Managing Director Investment Performance
Van de Burgt holds a master degree in econometrics. Since joining Ortec Finance in 1997, she has worked with many global clients in PMA and risk.
Stefano Seung Jin Lee, Managing Director Australia & New Zealand
Lee has a wealth of experience servicing asset managers and asset owners for performance measurement and attribution solutions in Australia & New Zealand. Before joining Ortec Finance, he worked at eFront, Factset and Dow Jones.