The starting point for modern portfolio construction should be strategic allocation and the volatility versus those allocations, unlike the traditional approach of combining 'best in class' managers into a portfolio
Portfolio construction in a fund of funds (Fof) context is often overlooked and under-appreciated by both FoF managers and investors. The traditional approach to FoF management has been to select 'best in class' managers and combine them in a portfolio. Portfolio construction is undertaken by either an equal weighting of those managers, or an approach where the preferred manager has the largest weight. The result is a portfolio where risk is a by-product.
For the more modern portfolio construction process, the starting point should be the strategic allocations and the risk versus those allocations. Returns are then maximised for that given level of risk. This does not mean risk is avoided altogether but is kept within a defined 'risk budget'. Where risk is taken, a commensurate return is expected. This more robust methodology enhances the alpha of the manager selection decisions. Portfolio strategy therefore creates alpha through weightings to different asset classes, regions, investment styles and market capitalisation.
The result is an efficient portfolio where risk-adjusted returns are maximised.
Long-TERM RISK/ RETURN PROFILE
To create an optimal portfolio, it is important to start with the client's objective, underlined by their desired market exposure. To achieve this desired market exposure it is necessary to create the relevant benchmark. Then, on that basis, the decisions on asset allocation can be made by assigning weights to different asset classes. Benchmark determination is consistent with strategic asset allocation, which enables fund managers to create an optimum long-term asset mix commensurate with the level of risk aversion of the various types of investors. It is this optimal asset mix that is referred to as the benchmark.
The strategic asset allocation (SAA) changes only if investor circumstances change, as the long-term risk characteristics of various asset classes are much more stable than client circumstances.
The SAA should therefore be the starting point for all portfolios. It provides the long-term expectations for risk, and the level of return you can expect for that risk.
A FoF portfolio can deviate from the SAA in three ways:
• TAA - tactical asset allocations away from the benchmark.
• The inclusion of active managed funds- which attempt to outperform the SAA benchmark.
• Portfolio drift.
Tactical Asset Allocation
Tactical asset allocation (TAA) provides the opportunity for short-term profit-driven departures from the SAA. It can be used to enhance the returns and/or reduce the risk from a SAA. For example, an aggressive investor may have enough risk appetite to be 100% invested in equity funds, which provide the highest risk and the highest expected return in the long term.
Occasionally, however, equities become overvalued and highly volatile. In these short-term circumstances it makes sense to lower equity exposure. This would be a tactical allocation away from the SAA. Alternatively, even risk-averse investors may want to take advantage of equity markets when they become inexpensive, through a small tactical allocation to equities.
TAAs can be made using asset class, region, investment style, market cap bias, currency exposure and duration. When these allocations are undertaken in a risk-controlled manner, a significant amount of excess return can be generated without excess risk.
INCLUSION OF ACTIVELY MANAGED FUNDS
This is the most traditional way FoFs have created outperformance potential and risk. The old model of allocating equal weights to managers, or to blindly allocate higher weights to preferred managers is not a robust portfolio construction process. Each active fund in a portfolio contributes to the return and to the risk of the portfolio.
A modern portfolio construction process ensures that those funds that have the highest marginal contribution to risk are also the funds in which the investor has the highest conviction. Allocating weights to funds qualitatively would disregard the correlation between funds and can result in over or under-diversified portfolios.
A relatively simple example demonstrates the drawback of the traditional portfolio construction approach. Taking three different funds with the characteristics outlined below, the traditional models result in sub-optimal risk-adjusted returns. This means that more risk was taken than needed in order to generate the returns.
By applying a modern approach, risk-adjusted returns can be maximised. For the same level of risk, the investor can generate excess return over an equal-weighted portfolio or reduce risk and get the same level of return. These efficient portfolios are shown by the blue line in graph two. The same can be said for the simple method of placing a larger weight in the fund with the highest expected return. FoFs which follow the traditional approach are either generating sub-optimal returns or taking too much risk for the return they generate
PORTFOLIO DRIFT AND REBALANCING
FoF managers need to be aware of, and strictly control, portfolio drift across many fund characteristics and at two different levels, namely the underlying fund and the FoF levels.
As mentioned above, thorough portfolio construction considers and allocates for exposures to different asset classes, regions, investment styles, market cap bias, currency exposures and duration. A portfolio that begins with 40% equities, 60% fixed interest can rapidly drift away from these target allocations depending on the relative performance of one asset class versus the other.
A more subtle effect, but no less important, is the drift of value and growth investment biases within a portfolio. These investment style exposures can drift as a result of relative performance but compounding this effect is the challenge of dealing with those managers whose holdings and investment style are themselves evolving and changing.
An investor might place funds with a manager who has a core investment style with equal exposures to value and growth, but that manager can often drift from one style to the other. If this is left unmonitored, it can lead to undesired style exposures for the investor.
This 'style drift' was a significant trap which the old-fashioned FoF's fell into in 2000. Many managers positioned their portfolios with what they thought was a small growth bias, but at the same time, many core managers actually increased the growth bias in order to keep up with a runaway market fuelled by positive sentiment towards the technology sector. This further increased the growth bias of the FoF. When the bubble in the equity market finally burst later in the first quarter of 2000, these funds suffered the consequences.
Modern FoF portfolio construction monitors and controls for this particular danger, as well as for all the aforementioned other possible drifts within a portfolio. The modern approach uses multiple models, including returns-based style analysis as well as holdings analysis which ensure that portfolios are positioned and rebalanced in line with the managers' and investors' objectives.
The final step in a thorough and modern portfolio construction process is performance attribution. This allows the FoF manager to assess and question where they are succeeding and failing, in an attempt to further improve portfolio positioning and move portfolios towards maximised risk-adjusted returns.
A successful portfolio construction process should therefore aim to maximise the expected returns for the desired level of risk, making sure the individual weightings are a function of conviction, and contribute to the characteristics of the portfolio. The value-added skill of efficient portfolio construction is appropriate diversification. This should offset uncertainty surrounding financial markets by giving protection during rough periods and capturing opportunities in good periods.
For a modern portfolio construction process, the starting point should be strategic allocations and the risk versus those allocations.
Thorough portfolio construction considers and allocates for exposures to different asset classes, regions, investment styles, market cap bias, currency exposures and duration.
Performance attribution allows the FoF manager to assess and question where they are succeeding and failing, in an attempt to further improve portfolio positioning.
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