Increasingly more funds are embracing the total portfolio approach, but can we define the real benefit of this method?
The total portfolio approach (TPA) has been embraced by some of the top institutional investors around the world, including sovereign wealth funds and pension funds.
At its core, TPA tries to overcome the limitations of constructing investment portfolios based on asset classes, which can introduce over-diversification problems and lead to unintended skews.
Instead, it tries to foster dialogue between asset class specialists and judge investment opportunities on their impact on the portfolio as a whole.
And although one can argue that this makes intuitive sense, there has always been discussion about the impact of this approach on investment returns. Does it actually lead to better outcomes?
The Thinking Ahead Institute has not been shy in trying to pin a number to this question.
Based on a 2017 peer study of 26 large global asset owners, the institute found funds that had embraced TPA produced a 2.3 per cent higher return per annum over a 10-year period compared to those funds that use a strategic asset allocation (SAA) method.
But in an update of the study, conducted in partnership with the Future Fund, the institute found this number needed to be adjusted downwards to 1.8 per cent per annum, still a significant outperformance compared to SAA funds.
“We were surprised at the size of the gap,” Roger Urwin, Co-founder of the Thinking Ahead Institute, says in an interview with [i3] Insights.
“The size of the gap was actually related to governance quality. Now, it’s quite a sensitive subject because I don’t think you really would want to suggest that the leadership and the executive [of the 26 participating funds] might have poor governance, but often you have boards that have the wrong type of mandate or have the wrong type of composition.
“Obviously, boards that have a lot of domain knowledge are better than those that don’t and that’s a big difference. We found that organisations that had moved towards TPA use governance to their advantage.”
But Urwin suspects that even the downwards adjusted 1.8 per cent is still an overstatement of the benefits of TPA. In the past, the institute has used a range of 50 to 100 basis points as a good indication of the outperformance of TPA.
Urwin says he now leans to broadening that range to 50 to 150 basis points, depending on how an organisation has implemented TPA and the market conditions.
I've sometimes allowed myself to say 50 to 150 because there's more evidence that in fast-changing markets, TPA will do better than SAA – Roger Urwin
“I’ve sometimes allowed myself to say 50 to 150 because there’s more evidence that in fast-changing markets, TPA will do better than SAA,” he says.
“When you look at SAA recently, it has been very, very slow to pick up a new regime pricing. We’ve actually moved massively into a different regime of pricing because of interest rate changes. And it’s the SAA response to that which has been 12 to 24 months behind the pace.”
Yet he also says outperformance of TPA over SAA methods cannot be sustained above 2 per cent.
Although the study suspects the main benefits of TPA come from changes in the governance model, Jayne Bok, Head of Investments Asia at Willis Towers Watson, warns it is often not a single factor that determines the difference in performance, while comparison between funds is sometimes problematic.
“It’s still not like-for-like exactly because there are differences in risk taking, currencies and even in reporting time frames,” Bok says in an interview with [i3] Insights.
“So the thesis is 50 to 100, maybe 50 to 150, given the nature of markets at times, [but] it is incredibly difficult to compare.”
But Bok has seen more funds in Asia move to a similar model, starting with the implementation of a reference portfolio.
“Many of the funds that I work with have either started looking at reference portfolios or have adopted a reference portfolio,” she says.
“And because Asian funds are more conservative, the reference portfolios are typically 50/50 [equities/bonds] and I’ve seen quite a few that are more like 30/70.”
At some point, not implementing elements of TPA is going to form a risk as well, as most funds keep a close eye on how they perform against their global peers, she says.
“You’ve got GIC in Singapore, you’ve got NPS (National Pension Service) in Korea, who both have made public the fact that they are pursuing a TPA approach. At some point, if you are a large fund, you cannot help but look into this,” she says.
“I have spoken to two very large funds already in just the last month, where they haven’t adopted [TPA], but they wanted to know [about it].”
Reluctant Adoption
Not everyone in an investment organisation is always keen to follow the new TPA model, especially asset class specialists who tend to focus more on individual transactions than on an overall strategy.
Private markets and real estate are a good example of this.
“I’m going to call out private markets, which have a different culture in most set-ups. [They] love to do deals and it’s very much oriented around winning by outperforming their own benchmarks,” Urwin says.
“When you talk to organisations that are using TPA and you talk to their private market teams, they are a bit sniffy about TPA. They’ll say: ‘We have to do it that way, but I’m not thrilled that we do it that way.’ They’ll have a view in their mind that it’s not working as well as it should be.
“And what all TPAs have struggled with is how to attribute results successfully between different participants in the process because it’s all one pot. And I can only say again that the financial arguments are strong enough to try and overcome those types of frictions, which absolutely do exist.”
Local regulations can also form an obstacle to implementing TPA. In Australia, the Your Future, Your Super regulations pin a super fund’s asset allocation to a number of set benchmarks, whether they like it or not.
Urwin acknowledges the Australian regulations make it more difficult to implement TPA, but he believes it can still be done.
“Obviously, Your Future, Your Super creates a pressure, but in many respects TPA handles that by saying that there’s always multiple constraints on a TPA and one of them is Your Future, Your Super,” he says.
“So that is one of the constraints that comes in and with any constraint it costs you money. The constraint of using a benchmark costs you money, that’s one of the key principles that we’re working to [with TPA].”
You've got GIC in Singapore, you've got NPS in Korea, who both have made public the fact that they are pursuing a TPA approach. At some point, if you are a large fund, you cannot help but look into this – Jayne Bok
One of the key proponents of TPA in Australia is the Future Fund, which was a partner in the peer study this year. But unlike super funds, the Future Fund doesn’t have any active members and, therefore, doesn’t have an investment menu with set options. It is also not subjected to the Your Future, Your Super regime.
Starting with a Reference Portfolio
Not all proponents of TPA use a reference portfolio. Some of the funds, including several in Australia, start from the basis of an equity risk equivalent against which they measure all other investments.
The idea here is to create a common risk measure for assets that is not based on a benchmark and allows the fund to avoid all the trappings of relative performance.
Urwin says this aligns with the philosophy of TPA.
“A lot of this is [about] avoiding this psychological draw towards a benchmark. [Using benchmarks] is getting away from the overall goals of TPA, which is to produce returns that are in line with real goals as opposed to outperforming a strategic benchmark,” he says.
“So organisations that don’t like benchmarks have been drawn to use this equivalent equity exposure. By the way, not in large numbers as far as I’m aware.”
Yet, Urwin has some reservations about this method, especially for institutional investors that have long time horizons.
“I find that a slightly odd framing of the issue because you would have expected a certain amount of exposure to duration because these are long-term funds. So to be very much exposed to a combination of long-term assets, vis-a-vis equities, and short-term assets, or cash, is something I don’t fully understand,” he says.
Bok adds that most funds that practise TPA started with a reference portfolio before embracing the full approach.
“In my observation, going from a reference portfolio to TPA is an easier step and I think actually most of the founding fathers of TPA actually moved that way as well, so all three of the first [group] – CPPIB, the Future Fund and NZ Super – have started with reference portfolios. The concept of TPA happened later in most cases,” she says.
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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.