This chapter will guide the reader through the process of building an investment portfolio. The investment portfolio represents the translation of the pension fund's financial objectives into an investable solution for the coming period that can realistically be implemented. While investment managers and strategists may present this process as highly sophisticated, complicated, and requiring unique expertise, from the viewpoint of a trustee the process can be broken down into a limited number of steps, allowing the board to focus on the questions that matter.
This chapter discusses the nature of a good investment portfolio, what the roles of the stakeholders are in determining the portfolio, how to choose a portfolio that achieves the fund's goals, and the main assumptions to be aware of.
Creating the investment portfolio involves seven steps, the starting point being: (i) the investment objective itself, and ensuring it is clearly formulated and realizable. Next, determining the investable universe and how it is implemented and evaluated, namely: (ii) the allocation to a number of asset classes, (iii) a description of the way the asset classes should be implemented (subcategories and investment styles are determined here), and (iv) a set of benchmarks to guide implementation and provide a basis for evaluation. The next steps shape the implementation of the portfolio: (v) a rebalancing procedure between the assets is determined, (vi) a specification of the objectives for the fiduciary or investment manager is drawn up, often in the form of an outperformance target, and (vii) a risk budget determined, specifying the degrees of freedom that the investment manager has around the benchmark. The board writes down the steps in a strategic investment plan. This, in turn, forms the basis for the formal mandate that is given by the board to the investment management organization.
We will start with a brief paragraph on the question of who has ownership of which decision. This is important, because in this part of this investment process there is an intensive interaction between the board investment committee and the organization taking the responsibility for implementing the plan.
Portfolio construction can only take place within the frame of the choices that the board has previously made. Chapter 6 discussed the investment policy statement (IPS) as an important document for trustees for shaping and directing the investment management process. Recalling the main elements of an IPS, we can distinguish those that form the framework for the investment portfolio—any portfolio should be in line with, and adhere to, the beliefs, risk appetite and strategy; and objectives that the board has established.
If the board has not made these choices beforehand, or if these choices are only more or less implicit, then portfolio construction and implementation will lead to suboptimal results, and will generally leave a board rudderless. Without clear objectives, the board might be more interested in comparing results with other pension funds than discussing whether its own goals are being realized. Without a clear, well-thought-out and communicated risk appetite, the board is doomed to make detrimental choices during financial crises. Without a strong set of beliefs, the choice of investment styles will be based on the preferences of the asset managers and not necessarily on those of the participants.
Within the framework of strategy, objectives, risk appetite and beliefs, portfolio construction then consists of a number of well-defined steps:
The process of building the investment portfolio is usually spread out throughout the year, with three milestones that are relevant for the board:
In parallel, the internal performance of the investment portfolio is evaluated. Using longer data series, trends can be identified. Investment strategies and asset classes of which the performances are below expectations are singled out. For the investment strategies, the analysis first considers the selection within the asset classes. If the poor results are attributed to this, one must ask whether the investment style still make sense, whether the drivers are still in place, and whether the manager simply is not performing or whether it is the investment style itself that is losing its rationale and attraction. On a broader level, the asset classes themselves are evaluated. Do the capital market expectations for the different asset classes still justify keeping them within the portfolio, or are new asset types becoming more attractive and should they be included in the portfolio? These analyses lead to a set of recommendations to maintain or change the number of asset classes and their form of implementation. Here too, the board ultimately decides which recommendations to follow.
Whichever approach the board chooses to determine the portfolio, it is best for it to discuss the choice in advance, including identifying pitfalls and suggesting measures to avoid them. Finally, the board decides on the definitive portfolio, adding the requirement of assurances that implementation will be consistent, and that potential return/risk losses due to an implementation gap will be mitigated. This is then written down in the IPS, which can be used to amend the mandate for the investment management organization.
The board is responsible for developing the investment policy. The task for the board is to maintain an overview of the different steps, how they interact, and what the role of the board members should be. Board members can easily succumb to the temptation of forming pet theories about asset classes, interest rates, or investment opportunities. It may be true to say that this shows involvement in the subjects that the board has to deal with. But it is not the role of a board to outsmart the financial analysts or investment strategists. What the board can do, however, is challenge their assumptions to test the robustness of the analysis and subsequent recommendations. Below we again review the steps in the IPS, but now with the addition of the specific question: what is the focus for the trustee? Exhibit 8.1 below shows the factors on which the framework of the investment portfolio rests, along with the focus for the trustees.
Building an investment portfolio requires some decisions and steps. What these steps are and what the focus for the trustee should be are shown in Exhibit 8.2.
A board of trustees is responsible for developing an investment plan that is the best possible option for realizing the fund's goals, given constraints on the amount of risk, horizon, liquidity, and any other constraints. The previous discussion has focused on the steps needed for portfolio construction, which run the risk of overshadowing the real purpose of the process for a board. What exactly, then, is the best possible investment portfolio? We provide you with a list of criteria (also shown in Exhibit 8.3) for judging the quality of a portfolio and for comparing, scoring, or ranking the quality of different portfolios.
A good portfolio will help the board:
When actually scoring the quality of a portfolio, it is a good idea to assign a weight to each of the criteria, thus helping the board to develop the portfolio that best meets its expectations, as well as providing a framework for a disciplined evaluation of it. For example, for some boards the ease of controlling a portfolio may have a high weighting, whereas other boards might give maximum weight to realizing the primary investment objective.
Among the criteria, there are definitely a lot of trade-offs that a board must consider. For example, trustees might expect to be able to generate another 0.5% annual expected returns at the “cost” of carrying out a number of complex and hard-to-control investments.
Boards are not in the business of predicting financial markets or economies. Yet portfolio construction hinges largely on a small set of assumptions, particularly capital market expectations. Questions ensue such as “What will we earn on equities in the coming period, and is it enough to compensate for the investment risk that we have to incur? And what will interest rates do?” These questions are at the core of the fundamental assumption in financial theory on the trade-off between risk and return (see Chapter 4). Capital Market Assumptions (CMAs) are used by investors and advisors around the world to guide their strategic asset allocation and set realistic risk and return expectations over different time frames. These assumptions help investors formulate solutions aligned with their specific investment needs. They cover expected (excess) return, risk, and correlation over different horizons. A coherent set of CMAs is an economic scenario. It is crucial to generate different scenarios that challenge the achievement of the goals or force trustees to think of the unthinkable.
Determining the CMAs for a broad group of asset classes thus involves analyzing the interaction of risk, return, and correlation. In order to capture these interactions, we use what economists call an “equilibrium model.” Equilibrium describes a situation in which all expected asset returns are a fair reflection of their risk and correlations and does not refer to any specific time horizon. What it means in practice is that for asset classes that are reasonably correlated with one another, expected returns in excess of cash are approximately proportional to risk, but for asset classes that exhibit low correlations, expected returns can be a bit lower than from the proportional application of risk.
CMAs can be developed in different ways. The most frequently used approach is to break the CMA down into different components. For example:3
Similarly, a bond is broken down into its components:
Capital market expectations may seem like a pretty objective exercise, but we should not be fooled. If we estimate the expected risk-free rate and the term premium, we are building up insights into expected returns. However, we also know that the level, or level of change, of the risk-free rate is correlated to the level, or level of change, of the term premium. Developing CMAs requires an intertwined choice: determining the economic and financial scenario on which the CMA is based, and the horizon that is required. Estimation with a high risk-free rate and low term premium is historically consistent with a period in which central banks have been active in raising interest rates to slow down expected inflation.
Diversification is a much-used term within pension funds. Two questions are of importance for trustees. First, do the trustees share the same notion as to what diversification means for the fund? Secondly, do the assets chosen for diversification stand the test of time, are some of them perhaps only temporarily attractive, or are they truly new and do they diversify risk premiums?
Pension funds are clearly fond of diversification. Since 2002, they have ventured into credits, emerging markets equity, infrastructure, hedge funds, and private equity, while in recent years factor investing or impact investments have experienced an upswing in investment portfolios. Diversification, discussed in Chapter 4, can have different meanings to different people. Trustees should raise the question of which purpose or combination of purposes is relevant to their fund, as each approach leads to a different portfolio:
How many assets are needed for diversification? Having come to a common understanding of diversification, do the assets chosen for diversification stand the test of time, should the set be expanded, or are just a few assets sufficient for effective diversification? In allocating the assets, regulators expect the trustee to diversify the holdings and to exercise prudence. In other words, trustees should not bet the house on anything too risky in the portfolio.7 However, views on diversification have changed dramatically in the past decades. Pension funds in the 1970s were content with bonds and real estate, assets that were considered to be “safe.” But returns were low, so funds progressively moved into equities, commercial property, foreign securities, and derivatives. New technology made this possible. In the 1990s, the pension fund industry experienced a makeover when the combination of Asset Liability Management (ALM) techniques, deregulation, and portfolio optimization approaches gained ground, widening the scope of assets to invest in. The risks were higher, but so were the rewards. Additionally, higher returns brought down the relative costs of running the fund.
In hindsight, it appears that only a limited number of strategies break through and help to diversify effectively. In other words, trustees should quiz their investment managers and advisors critically, because introducing new strategies does not necessarily achieve diversification. Alternative investment strategies have suffered from two problems. First, the success of many new strategies was boosted by the same factors: low interest rates and robust economic growth. This, in turn, encouraged investors to use leverage to enhance returns. Some alternative investments share more factors; private equity gives investors exposure to the same kind of risk as publicly quoted equity, albeit with added leverage. When prospects deteriorated, investors were forced to sell all those asset classes simultaneously. Secondly, some of the asset classes are rather small. This illiquidity is attractive since it offers higher returns. As more investors get involved, the market becomes more liquid, and the higher return is eroded. However, when everyone tries to sell, illiquidity rears its ugly head again—there are no buyers to be found and prices tumble. This is very unpleasant when pension funds have to value their investment at market value. Still, investment managers increasingly look to add new—alternative—investments to bolster diversification advantages,8 which can mitigate these risks to a large extent. However, there is no point in adding new strategies if the investment does not offer a genuinely different source of return, or if the asset is already overvalued. In other words, the bar for new investments to count as a true “diversifier” has been raised substantially, and if these investments are true diversifiers, their relative size in the investment portfolio will be limited.
Along with the search for alternative investments as a source of diversification, factor investing has gained traction, viewed by some as a replacement for the current approach to diversification. Interest in factor investing started with the Ang, Goetzmann and Schaeffer study,9 commissioned to investigate why active returns of the Norwegian Fund were disappointing. A major finding was that a large share of active returns could be attributed to systematic factors; five years later, major pension funds such as the Alaska Endowment Fund, the Dutch PFZW or the Danish Arbejdsmarkedets TillægsPension (ATP) all implemented a form of factor investing. From the outset, it seemed like a sensible development. Asset returns can be attributed to a few distinct underlying factors such as macroeconomic factors, firm attributes or style factors, with these factors representing sources of systematic risk and return. This approach aims at providing a relatively precisely defined exposure to factors that may explain differences in asset returns and, to a large degree, the excess returns of actively managed portfolios. The factor approach creates the opportunity to construct portfolios with asset selection based on the knowledge of underlying factors, or even design portfolios using factors rather than assets.10 Within this factor framework, which is rooted in the Asset Pricing Theory (APT) developed in the late 1970s, any asset can be viewed as a bundle of factors that reflect different risks and rewards. Therefore, it makes perfect sense to focus on these factors, allowing investors to identify them and understand what really drives asset returns. These insights help to develop portfolios that realize the required risk profile not only before, but also during, volatile periods.
Rebalancing is regarded as a technical component of implementing an investment portfolio plan, where portfolio weights are adjusted in line with the risk appetite of the fund. This policy details when and how the policy portfolio is adjusted in line with changes in the cover ratio or financial markets, how to adjust the assets to the weights of the strategic benchmark portfolio, and whether the rebalancing is done on a frequent regular basis or based on specific triggers.
Rebalancing on the basis of constant policy weights represents one possibility. At the other extreme, the fund can have a solvency program in place, which adjusts the level of policy weights depending on the amount of downside risk the fund is willing to accept given the funding ratio and financial market volatility. Similarly, the solvency program adjusts the level of policy weights depending on how close the fund is to achieving its long-term goals. Sometimes, funds allocate part of the bandwidth around policy weights to TAA (tactical asset allocation), which involves making short-term adjustments to asset-class weights based on short-term expected relative performance among asset classes. The assumption is that investors can take into account short-term opportunities with the aim of achieving the best performance for the portfolio, bearing in mind the level of risk defined.
At times, a portfolio's actual asset allocation may purposefully and temporarily differ from the strategic asset allocation. For example, the asset allocation might change to reflect a pension fund's current circumstances when these are different from normal. The temporary allocation may remain in place until circumstances return to those described in the investment policy and reflected in the strategic asset allocation. If the changed circumstances become permanent, the manager must update the investor's IPS, and the temporary asset allocation plan will effectively become the new strategic asset allocation. TAA also results in divergence from the strategic asset allocation, and responds to changes in short-term capital market expectations rather than to investor circumstances.