Total portfolio approach: Large investors challenging traditional asset allocation

In the autumn of 2022, John L. Bowman, president of the Chartered Alternative Investment Analyst Association, met in a coffee shop in Singapore with Swee Chiang Chiam, managing director and head of total portfolio policy and allocation at Singapore sovereign wealth fund GIC, to discuss total portfolio approach, an alternative to traditional forms of strategic asset allocation, or SAA.

Over coffee, Bowman and Chiam discussed how a number of large institutional asset owners in New Zealand, Canada, Australia and Singapore — including GIC — had embraced total portfolio approach, or TPA, which “improves upon many of the long-entrenched practices of SAA when constructing their portfolios.” That meeting would eventually lead to CAIA creating its seminal report “Innovation Unleashed: The Rise of Total Portfolio Approach” on March 19.

Essentially, Bowman noted, TPA eschews the traditional concepts of asset allocation and passive benchmarks in favor of picking the best investment ideas for the portfolio designed to meet a total return goal consistent with the fund’s actual purpose. TPA may be described as “one unified means of assessing risk and return of the whole portfolio.”

The four institutional asset owners and co-authors of the paper — Australian sovereign wealth fund Future Fund, Melbourne; Canada’s largest pension fund, Canada Pension Plan, Toronto; sovereign wealth fund New Zealand Superannuation Fund, Auckland; and GIC — all consider governance, a healthy partnership with and structure among the board of directors, the starting point of TPA, Bowman noted.

In the CAIA report, Jayne Bok, head of investments-Asia at Willis Towers Watson, stressed that TPA is not a specific model with a singular destination. Rather, it comprises a range of approaches that can be tailored to each asset owner in order to design a portfolio that best represents the team’s long-term investment thesis.

To further delineate some of the differences between total portfolio approach and strategic asset allocation, while SAA seeks to outperform benchmarks, TPA focuses on the fund’s absolute-return goals. While SAA seeks diversification via asset classes, TPA wants diversification through control of various risk factors. And while in SAA-centric organizations, portfolio decisions tend to be implemented by multiple teams competing for capital, in a TPA house, there is just one team collaborating together on decision-making.

And crucially, while the board dominates the portfolio construction under the SAA model, the chief investment officer is much more empowered in a TPA approach.

Bowman said that in a 2019 global study of 18 asset owners that use forms of TPA, the Thinking Ahead Institute argued that the advantages of this new approach are more than just cultural and theoretical — participating funds felt that the approach yields 50-100 basis points of outperformance over traditional SAA methods.

Charles Hyde, head of asset allocation at the NZ$64.5 billion ($39.7 billion) New Zealand Superannuation Fund, cited that perhaps the best indicator of the power of TPA to increase returns is the recent Global SWF report of sovereign wealth fund and public pension fund returns over the past 10 years, which showed that three of the top five funds were adherents to the TPA — New Zealand Super, CPP and Future Fund.

CAIA’s own research on 10-year performance of their asset owner co-authors also yielded 140 basis points of annual outperformance against the NACUBO endowment composite during the same period. That said, the paper warns that tremendous changes in management, cultural transition and leadership alignment is necessary to migrate to a TPA mindset and therefore may not be right for many organizations, he said.

Ben Samild, CIO of Australia’s A$272.3 billion ($180.1 billion) Future Fund, said in an interview that while TPA means different things to different investors, “to us it means that every investment and divestment decision is carried out with reference to the needs of the total portfolio and not any subportfolio objective or benchmark.” The Future Fund has embraced TPA since its inception in 2006.

Ultimately, he noted, this approach to better decision-making guards against overdiversifying at the asset class level and underdiversifying at the portfolio level. Narrow asset class objectives and incentives tended to lead to suboptimal outcomes at the portfolio level, he explained.

TPA has led to good returns and a reduction in risk, Samild said. “Our asset allocation changes daily based on opportunities and sometimes quite significantly based on a changed assessment of the investment environment,” he added.

Samild also said that TPA does not necessarily require an expanded investment team. To the contrary, he observed, “as teams get larger and strong interpersonal relationships are more challenging, the approach becomes more difficult to scale and one needs to be extremely thoughtful about process and culture.”

NZ Super's Hyde said in an interview that TPA is an “umbrella term used to describe approaches that break down siloed thinking within a fund by creating a culture and investment framework that results in all investment decisions being viewed through a whole-of-portfolio lens.”

NZ Super adopted TPA in 2010. “The rationale for the change was the recognition that it made sense for our board to focus on governance and for most investment decisions to be delegated to management as this is where the investment knowledge and skill largely resides,” he explained. “This provided the investment team with the flexibility and freedom to be truly opportunistic investors.”

Moving toward a total portfolio approach requires a reassessment of team structures, benchmarking practices, compensation incentives and development of a collaborative culture. In contrast, the traditional approach involves allocating a fixed amount of capital to each asset class team and leaving it up to each team to decide how to allocate that capital.

“Because the return environment may not resemble what was anticipated when the allocations were made, this can lead to overinvestment in some asset classes and underinvestment in others,” Hyde stated. “It can also lead to overdiversification within asset classes.”

The main benefit of using TPA is that it enables an investor to be more flexible in responding to change in the investment environment. “It enables an investor to ensure that the marginal dollar invested is in the most attractive asset available regardless of asset class,” he added. “That is, it solves the problem of overinvestment in certain asset classes that arises when an asset class team with a fixed budget to spend has a dearth of attractive opportunities.”

In addition, TPA doesn’t favor the inclusion of any particular asset classes in the portfolio.

But since TPA by design requires a more collaborative approach to investing, this can present challenges since it requires more communication and coordination across the investment team.

But Hyde cautions that it’s hard to say definitively whether TPA has increased the fund’s returns since the counterfactual is unknowable. “As for risk, we target a level of risk in our portfolio and expect to earn returns commensurate with this level of risk,” he said. “TPA doesn’t change this risk target. We have confidence that this is the right approach because of its strong underlying logic.”

Hyde further indicated that “a lot of funds” have approached his fund seeking guidance as they contemplated moving to a total portfolio approach.

“Some have made the transition, others are still working on it,” he said. “It is a large undertaking to re-engineer an investment framework, team structure and culture and doing so could require buy-in from of a range of stakeholders. So, while I expect over time more asset owners will make the switch, it’s certainly conceivable that it won’t become the dominant approach any time soon. The most powerful catalyst for change will be if adherents of TPA continue to outperform non-adherents.”

TPA hasn’t affected NZ Super's asset allocations in any systematic way, he noted. “We still allocate risk budget in proportion to our assessment of expected attractiveness over time,” he said. “TPA just allows us to be more flexible so that we ensure we are investing in the most attractive assets at a point in time.”

However, he observed that TPA has changed the way the investment team functions in many ways but it has not led to an expanded staff. “In fact, having a smaller team is beneficial to the extent that TPA requires more communication and collaboration and this typically becomes harder in larger teams in which people are less connected, he said. “One change is that we have introduced a role which has the purpose of connecting our portfolio managers with the top-down view so that they are more total portfolio aware. Another is that we have abandoned the traditional asset class team structure — our teams are organized along functional lines with each spanning all asset classes. We have also developed a suite of total portfolio reports that allow everyone to see how each investment — both prospective and existing — compare with each other across all the relevant dimensions — including risk-adjusted return, liquidity usage and resource intensity. This provides the foundation for an informed discussion in real time about the merits of any given investment.”

Derek Walker, managing director, head of portfolio design and construction-total fund management at CPP Investments, said in an interview that TPA differs from a traditional portfolio in which capital is allocated to each asset class, and in turn each asset class team operates independently and is focused on running their silo of capital within the portfolio.

CPP had C$590.8 billion ($445.7 billion) in assets as of Dec. 31.

The key benefit of TPA is that it "allows us to better understand and quantify" the return-risk characteristics of each asset class, and how those asset classes in turn relate to underlying return-risk drivers, or factors, when we construct diversified portfolios. “By focusing on the underlying drivers rather than the asset class labels, this approach is also more flexible than a traditional SAA and enables us to take advantage of market conditions and our expertise when and where opportunities arise," Walker added.

CPP first implemented TPA in 2006. “The goal was to improve risk-adjusted returns for the portfolio to ensure the Canada Pension Plan Fund is strong and financially sustainable for the long term,” he explained.

Chiam of GIC said in the CAIA report that when TPA is done well, it allows an investor to design a diversified portfolio that is aligned with investment objectives and balanced across competing trade-offs. The key to its success, he added, hinges upon “an organizational culture built on long-termism and agility, with all employees sharing one clear focus — to deliver good, real returns for the total portfolio over the long term.”

GIC has an estimated $770 billion in assets.

Chiam emphasized that funds using TPA must embrace a long-term focus.

“This means that we are focused on fundamental value, rather than short-term changes in price, which are often influenced by market sentiments at each point in time,” he said. “This enables us to navigate short-term uncertainty, capitalize on market dislocations, and compound returns over time.