Switching to a total portfolio approach can ruffle a few feathers among investors. Sue Brake and Stephen Gilmore reflect on some of the pain points and benefits of implementing this approach.
The total portfolio approach (TPA) has become an increasingly popular way of managing investment portfolios among institutional investors as it allows them to reduce overdiversification and align individual assets better with the overall portfolio return objective.
Ultimately, this means an improvement in investment returns. The Thinking Ahead Institute has calculated it can be as high as 100 basis points compared to funds that run a strategic asset allocation (SAA) model.
But implementing TPA is hard because it requires an organisation to change its culture by forcing a high degree of collaboration upon investment specialists.
Not all investment specialists react well to such changes as they often have developed their own language and processes to assess new investments during their careers.
Moving away from asset class silos to an investment process where assets are judged on their contribution to the overall portfolio can leave some specialists feeling as if they have lost a degree of autonomy.
Sue Brake, former Chief Investment Officer of the Future Fund – an organisation that operates under the TPA model, although it calls it ‘joined-up’ investing – discussed this approach in a recent podcast with the Thinking Ahead Institute.
The joined-up [aspect] in this threatens people's sense of mastery and takes away their sense of autonomy. It's just a very difficult thing for humans to do – Sue Brake
“It’s really hard. I remember discovering at the time we were trying to do it these three intrinsic motivating factors that Dan (Pink, a career analyst) talks about: mastery, purpose and autonomy,” Brake, who is now a member of the Investment Committee at Aware Super, said.
“And it just really resonated, which is why I can still remember them, because the joined-up [aspect] in this threatens people’s sense of mastery and takes away their sense of autonomy. It’s just a very difficult thing for humans to do.
“I’ve led, or co-led, the TPA transformation in four different organisations now, multi-year transformations in four different organisations, and so I’ve seen it in various guises. But the pain is a common feature to all.”
Developing a Common Lanuage is Key to Successful TPA
Although Brake emphasised TPA is worth pursuing as the benefits ultimately outweigh the challenges, she pointed out high levels of collaboration do not necessarily come naturally to the competitive world of investment management.
“If you’ve got a culture that is high on mutual respect, learning, curiosity and humility, then it’s going to be a lot less painful. But in my experience, those things do not summarise investment organisations or investment individuals,” she said.
“The investment industry is full of deep experts on various things. And for me, the deeper the expertise, the harder it is to get over those intrinsic motivators. It’s something not to be taken lightly. You need a people plan. You need a change transformation plan.
“Often I see it in organisations, the way they’re trying to do collaboration is to have just these long days full of big meetings, where everybody feels involved, and it just gets very bureaucratic, and that’s not effective.”
One way organisations have tackled this problem is by developing a common language centred around risk. Often these organisations take the equity risk premium as the starting point to measure other assets against and develop a risk budget.
“I think the solutions are a common language that is mutually developed, rather than one person imposing it on someone who speaks a different language, because you’re asking someone who is fluent in one language to have a conversation in a different language in a highly technical field and that’s got to be respected,” Brake said.
“But focusing on that common language, or common risk budgeting approach, or common way of thinking about attractiveness, in a open and collaborative way is the right starting point.”
No Single Right Way to Pursue TPA
Stephen Gilmore, Chief Investment Officer of CalPERS, has too previously worked at the Future Fund and New Zealand Super, two organisations that both operate under the TPA model.
Gilmore was asked in the same podcast episode about the differences between the Future Fund’s and New Zealand Super’s approach. The main difference, he said, was NZ Super’s use of a reference portfolio in its approach to risk.
“[At the Future Fund] we had to come up with a common language for thinking about how to compare different asset classes. We had to think about various factors,” he said.
“We developed our own macro factor model and that was really the starting point to think about things in risk terms and to think about decomposing the risks into various factors, setting up a common language and encouraging a competition for capital across the portfolio.
“About the same time, New Zealand Super was also embarking on the process. They did it a little bit differently. They set up a reference portfolio. We didn’t have that at the Future Fund, and it is quite interesting comparing and contrasting the way the two organisations actually went about TPA.”
CalPERS is considering whether it will adopt a TPA model and the board is set to make a decision in November.
One always needs to take into account the starting point for these organisations and to be thinking about what makes most sense for the particular organisation. There's no single way of pursuing TPA
Currently, CalPERS is using an SAA model, which the investment committee of the fund reviews and approves every four years. But the investment team has a reasonable level of discretion in deviating from the SAA. For example, in listed equities the team can be seven per cent over or underweight compared to the SAA, while for fixed income the fund can be plus or minus six per cent.
Gilmore said if the board approved the adoption of a TPA model, it was likely CalPERS’ approach will look slightly different from that of his previous employers.
“We’ve been talking about using, or potentially using, a reference portfolio and [setting] active risk metrics around that,” he said.
Instead of having asset class-specific risk limits, under TPA an active risk limit would function as a risk measure for the overall portfolio and this would align it better with the investment objective of CalPERS.
CalPERS currently uses 11 benchmarks to measure its performance against and this doesn’t always give a clear picture of how the overall fund is performing.
“One always needs to take into account the starting point for these organisations and to be thinking about what makes most sense for the particular organisation. There’s no single way of pursuing TPA,” Gilmore said.
TPA is Worth Pursuing
Gilmore agreed with Brake that introducing a TPA model into an organisation isn’t easy and it will take time to develop a common language.
“It’s not straightforward because to make it work well, you need a high degree of collaboration. And a lot of organisations have started off being fairly siloed, asset class by asset class, so you need to have that collaboration conversation across asset classes, you also need to have a common language for comparing asset classes,” he said.
“Typically, people on asset class teams talk in different languages. So if you’re an infrastructure investor, you’ll be talking about discount rates. If you’re a real estate investor, you’ll be talking about cap rates. If you’re in private equity, you’ll be talking about internal rates of return. So you need to have a common basis for thinking about returns and risk.”
At CalPERS, Gilmore will work closely with its consultants, Wilshire Advisors and Meketa Investment Group, on a successful route to implementing TPA, including the development of a framework for setting active risk limits, if the board decides to go down this route.
But ultimately, TPA has many benefits and improved returns is a key one, he said.
“The main inspiration for that is better returns. There have been studies showing that those organisations that pursue a total portfolio approach have generated higher returns,” he said.
Although these studies rely on a relatively small sample of investment organisations, he said it made conceptual sense because investors are optimising the portfolio as a whole, rather than optimising for individual asset buckets.
“With an SAA, the tendency is to come up with an asset class allocation that you stick with for four or five years, perhaps, but a lot can change in four or five years. Markets can move around quite a lot,” he said.
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