With a mandate to preserve and enhance the purchasing power of Singapore’s reserves over the long term, GIC believes that its total portfolio approach gives it an edge over more traditional strategic asset allocation (SAA) models.
“We seek to deliver long-term returns above global inflation. To that end, one of our key metrics is the rolling 20-year, real rate of returns,” Dr Chiam Swee Chiang, Head of Total Portfolio Strategy at GIC, says in an interview with [i3] Insights.
GIC is one of three organisations that manage Singapore’s reserves, alongside the Monetary Authority of Singapore and Temasek. It is widely believed that GIC manages a meaningful share of the reserves, although the exact figure is not public. Over the 20-year period that ended 31 March 2021, GIC achieved an annualised rate of return of 4.3 per cent above global inflation.
“The fundamental challenge is to put together a portfolio that can deliver a strong real return over the long term, while adhering to the client’s [the Government’s] risk tolerance,” Chiam continues.
GIC’s solution is to use a total portfolio approach, incorporating both passive (beta) and active (alpha) return streams seamlessly.
The Thinking Ahead Institute, in its report Total Portfolio Approach (TPA): A global asset owner study into current and future asset allocation practices, states that TPA covers a spectrum of strategies, but has three aspects in common:
- It starts with very clearly specified investment goals
- There is a joined-up process with competition for capital amongst all investment opportunities
- It is dynamic and operates in real-time governance
Besides GIC, the institute notes that other intuitional investors that have adopted TPA include Denmark’s ATP, Canada Pension Plan Investment Board, Future Fund, New Zealand Superannuation Fund, QSuper and TCorp. All these investors believe TPA produces a performance advantage versus SAA on a like-for-like basis. The majority expect at least 50-100 basis points per annum to be added to the portfolio.
Policy and Active Portfolios
GIC’s overall portfolio is built from two parts: a policy portfolio and an active portfolio.[1] The policy portfolio is the key driver of returns over the long term and focused on beta or systematic risks. The active portfolio comprises an overlay of alpha or active management exposure.
Like the Canadian model, every alpha strategy is funded from the sale of a slice of the policy portfolio. Consequently, each strategy must generate sufficiently high return to compensate for the cost of capital and the higher risk involved.
Every [active] strategy is expected to deliver excess returns by outperforming its funding. This is alpha. The sum of these contributions of all the active strategies would be the expected alpha of the total portfolio
“Every strategy is expected to deliver excess returns by outperforming its funding. This is alpha. The sum of these contributions of all the active strategies would be the expected alpha of the total portfolio.” Chiam explains.
The active management activities are governed by a risk budget to ensure that the total risk of the portfolio remains within the client’s risk tolerance.
Alpha
For Chiam, the alpha portfolio is multifaceted. Frequently, alpha is thought of in the ‘pure’ sense: a return stream that is uncorrelated with the market and gives an expected outsized return for a level of risk. However, there is also alpha that is negatively correlated to beta and better complements the portfolio. The complementary alpha may not be as compelling as pure alpha in terms of excess returns, but it can help mitigate specific portfolio vulnerabilities and the risk of a severe drawdown.
“We think of these alpha sources as important building blocks for portfolio construction. The ultimate objective is long-term wealth compounding. Besides harvesting risk premia and hunting for higher alpha, complementary alpha potentially narrows or brings down the volatility of your path, allowing one to compound wealth more efficiently,” he says.
Another important facet is ‘structural vs. idiosyncratic’. It is important to ascertain the underlying drivers of alpha – be it structural exposures to risk factors, or idiosyncratic manager skills in security selection and deal underwriting – as this informs capital allocation and portfolio construction decisions. With a deep understanding of the underlying drivers, the appropriate investment horizon and assessment framework can be established accordingly.
Besides harvesting risk premia and hunting for higher alpha, complementary alpha potentially narrows or brings down the volatility of your path, allowing one to compound wealth more efficiently
In addition, it is important to consider the differences in alpha drivers in public versus private markets. Instead of simply labelling the private-public premium as just illiquidity premium, it is critical to discern the underlying driver – is the private equity premium in the portfolio driven by higher earnings growth, higher operating leverage, or better entry/exit multiples? This helps to ascertain forward-looking views of the premium and screen for unintended correlation across risk factors.
“Essentially, think of it as an alpha-beta spectrum (rather than alpha-beta separation), and construct your portfolio from there.” he says.
Limitations of SAA
The policy portfolio plays the crucial role of anchoring the total portfolio. However, there are limitations. First, the policy portfolio is built based on macro assumptions of what the global economy and markets will be like, but the future rarely eventuates as modelled. The active portfolio allows the total portfolio to be adapted as fundamentals shift (as opposed to reworking the SAA all the time).
Second, in a low-return environment, beta alone is not able to deliver the investment objective.
“That’s why we need to do more in the alpha space. We need the alpha to work harder,” he explains.
Third, market cycles are getting shorter so from a portfolio management standpoint, GIC recognises that its investment process needs to be able to capture some of these trends.
Of course, predicting and trading market crashes is not our game. It is not GIC’s competitive advantage. However, we design drawer plans to be enacted during severe dislocations between pricing and fundamentals. ‘Prepare, not predict’ is GIC’s way
“Of course, predicting and trading market crashes is not our game. It is not GIC’s competitive advantage. However, we design drawer plans to be enacted during severe dislocations between pricing and fundamentals. ‘Prepare, not predict’ is GIC’s way,” he says.
“Most SAAs are blunt, focusing on broad asset classes. However, today we face several policy and macroeconomic inflection points that could significantly change the trajectory of asset markets.
“Given the wide range of potential outcomes, we need a resilient portfolio. A total portfolio approach, and one that is more granular, enables us to design and implement an investment portfolio across asset classes and strategies that better targets a wide range of risks and returns. This ultimately puts us in better stead to generate good returns above global inflation in the long run.”
[1] You can read more about GIC’s portfolio management approach in the GIC Annual Report 2020/21
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.