Changing the rules of portfolio construction

Portfolio construction should be a prime concern for investors: Academic studies show that it causes approximately 90 percent of variations in a fund’s returns over time. Moreover, research reveals that the performance difference between funds is accountable to about 35 to 40 percent to asset allocation decisions. However, a McKinsey study identifies a trend towards new approaches for portfolio construction: Traditional methods are seen as inadequate by senior executives of pensions and sovereign wealth funds, and CIOs and CEOs are willing to rethink strategies and processes more than ever.

Institutional investors are essential players in the global financial system. The largest pensions and sovereign wealth funds manage more than a trillion US-Dollar. McKinsey has surveyed more than 50 senior executives at more than half of the top 50 pensions and sovereign wealth funds with collectively more than 7.4 trillion assets under management. Two themes kept turning up: First, the world’s leading investors are evolving into true institutions that are more than the sum of their parts. Second, portfolio construction practices have become a top priority.

Many institutions used historical estimates of returns, correlation and volatility. Taking into account relevant constraints and constructing a frontier of portfolio options allowed them to select a portfolio that matched their risk and return objectives. Because estimates tend to change very little from year to year, major shifts in strategic asset allocation were rare besides long-term trends, such as increasing the allocation to illiquid assets. Thereby, investors have spent their time on searching for alpha through numerous means while reducing the costs of beta. While 20 percent of their time is dedicated to beta including strategic asset allocation, 80 percent is spent on increasing alpha - despite the high importance of the asset allocation mentioned above. However, “Hitting ‘repeat’ on strategic asset allocation from year to year has had the unforeseen consequence that institutions are not being paid for the risks they are taking. That’s costly: the payoff from getting SAA right is worth a decade of good deal making to create alpha at the margin,” says McKinsey in their article “How leading institutions are changing the rules on portfolio construction”.

Because portfolio construction and asset allocation drive the majority of long-term returns, institutional investors are planning to change that 80/20 alpha/beta management approach. Almost 80 percent of institutions plan to increase their central portfolio construction team by adding about three to five people. Moreover, executives expect allocation decisions to be based more on debates about top-down economic discussion than being given by the executive committee and board.

The liability profile of investors is going to be another driver of the strategic asset allocation and a topic this central team will focus on. Three-quarters of investors state to understand it already well or in a distinctive manner and yet, 91 percent are planning to investigate it even further. Over 60 percent, and McKinsey expects this figure to increase with deeper insights into liabilities, expect major investment decision to be based on liabilities.