Soup to nuts portfolio construction: common challenges for asset owners

by Andrew McDougall, CFA, CAIA , Global Head of Multi Asset & Niall OSullivan , Global Solutions Chief Investment Officer

One of the advantages of advising and managing portfolios is that we’re eating our own cooking; more often than not, challenges that we’re helping asset owners to overcome are the very hurdles we’re facing across our own portfolios.

Finding solutions to portfolio problems forces us to develop new ideas and put our thinking into action on an ongoing basis. Every new problem prompts us to take a step back, consider the issue in the context of the wider portfolio and objectives, and assess the best route to solving each challenge that arises.

Common challenges tend to be connected, and we’ve compiled a shortlist of some of the issues we’re seeing most frequently across portfolios.

Portfolios drifting from underlying objectives

The success of strategic asset allocation (SAA) and/or reference portfolios rests contingent on the clarity of underlying objectives. As investors face new complexities and stakeholder priorities evolve, an increasing number of clients are revisiting their objectives to refresh and determine their core priorities.  

Testing priority objectives ultimately leads to clearer assessment of successes – and failures – and what optimization across a portfolio should really be seeking to achieve. Those prioritizing portfolio resilience, for example, might consider adding or expanding a private markets allocation, or hedge fund exposure, to achieve more effective diversification - particularly in an environment where equity bond correlations are positive.

Over-reliance on capital market assumptions (CMAs)

Our colleague Rachel Volynsky has previously outlined the dangers of over-reliance on capital markets assumptions (CMAs), which should serve as a starting, rather than end, point in portfolio construction. CMAs are important, but not infallible. After all, almost every CMA model has been saying the US is expensive for the past 10 years, a period in which the US has outperformed many other markets by over 100%1.

To combat this, we complement our top-down models with a bottom-up framework to test the robustness of our assumptions. This has helped us, for example, come to the view that improvements in operational efficiency and revenue enhancements can potentially enable private equity to continue to outperform public market equivalents, even through a period of higher cost of capital. (Incidentally, the case for return enhancement over the longer term helps to explain why we continue to advocate a well-diversified private markets allocation as part of a robust total portfolio.)

Implementation capabilities lagging objectives

All that said, having the right objectives and assumptions will only get you so far if the implementation of ideas isn’t up to scratch. The space, or slippage, between thinking and action is why we have developed - and continually evolve - asset class playbooks to help clients build the portfolios designed to meet their needs, via strategies that account for risk, liquidity and fee budget in seeking to structure the optimal outcome.

We recently adjusted our equities playbook to ensure risk budget is deployed where we have the highest confidence in achieving objectives, given the evolving strategic landscape. This has led us to adopting more market-aligned allocations to emerging markets and small cap and generally avoiding peripheral asset classes such as listed real estate and listed infrastructure. 

More broadly, we believe that maintaining a dynamic overlay positions investors to capture opportunities as they arise. The ability to be dynamic has become particularly important through a more volatile backdrop, though governance budgets will not always stretch to enable this level of agility. If you don’t have the skillset in house, consider buying it in.

Exposures combining in unintended – and unexpected – ways

Portfolio positions can sometimes give rise to unexpected correlations or consequences, leaving investors exposed (or underexposed), particularly if they don’t know what to monitor or look for.

Take a portfolio with a US underweight: this position may be well considered, but if the portfolio’s active managers are also underweight US due to concerns about mega cap bias and concentration, and its dynamic asset allocation favors emerging markets, investors are inadvertently running a material underweight.

A strong portfolio needs the tools, systems and specialized knowledge to ensure that allocations are delivering as expected at the total portfolio level. This involves interrogating the data to map and monitor exposures, any unintended overlaps, and to assess whether the risk budget is being spent as intended, and so on.

Achieving a total portfolio approach

The principles of a strong total portfolio are well understood. Strength and robustness are premised on understanding and defining core objectives and determining a strategic asset allocation that will achieve those objectives. The benefits of active management can be harnessed in areas where an active approach can potentially drive meaningful outperformance. Dynamic asset allocation (DAA) can be deployed to take advantage of opportunities as they arise.

However, a strong SAA/DAA manager approach relies on a culture of collaboration, transparency and respect, reinforced by a governance framework that supports the tools and systems required to monitor portfolios for unintended biases.

Having all of these components in place should remove – or at the very least mitigate – any surprises. When and/or if the unexpected does arise, portfolios built on principles of strength can have the robustness to bounce right back on track.

1Source: Bloomberg data as of October 3, 2024.

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