Issue: March 2012 / May 2012
Challenges in the new reality
Andrew Rumbelow, chief investment offi cer at Sanlam Multi Manager International, suggests that the conventional practice of managing portfolios closely to benchmarks may no longer be appropriate.
Considering broad acknowledgement that current market conditions are likely to prevail for some time, investment managers should relook how they meet investor objectives in policy portfolios. The ‘new normal’, vastly different from the investment environment prior to the global fi nancial crisis, implies that managers should adopt an investment approach less rigidly constrained around benchmarks.
Clients’ aversion to loss, coupled with periods of elevated volatility, could result in clients capitulating unnecessarily. Interpreting this volatility as true risk can ultimately lead to capital loss. Therefore, successfully navigating through this period may well call for investors to give up some of their most closely-held beliefs; in particular, the notion of an investment strategy centred on a fi rm asset allocation with tightly-defi ned constraints.
Benchmarks are essentially ineffi cient. Yet there is a massive assumption that current asset-allocation constructs in benchmark-constrained funds will meet end objectives (namely, real returns).
The norms of the past 10 to 15 years will not be the norms of the next 10 to 15 years. Consequently, an unconstrained approach will allow more fl exibility within this new environment to maximise returns. It also offers a strategy that should deliver real returns on capital.
An unconstrained approach defi nes risk in terms of capital loss. Ultimately, our aim as portfolio managers is to deliver real returns. Investors should be more concerned with this than with performance relative to an explicit asset allocation.
What then about benchmarking as a traditional measure of performance? Benchmarking can actually change investment managers’ behaviour. When using a benchmark, managers tend to focus more on the attractiveness of a portfolio in relative rather than absolute terms. Also, when benchmarking is involved, risk becomes measured by tracking error. Instead of looking at how the portfolio is faring in absolute terms, the focus shifts to comparison against the given benchmark.
Rumbelow . . . less constraint, more discretion
As a result, return also becomes relative. Negative performance can be construed as good performance if it manages to outperform the benchmark. How can this be logical? Surely it is more pertinent to measure the success of a portfolio against an opportunity set.
Increasingly, trustees are starting to include less constrained mandates in their portfolios. So portfolio managers should be moving away from constrained asset allocation in favour of unconstrained mandates.
However, investors need to be acutely aware of the risks involved in this less-constrained approach. While the level of outperformance can be signifi cantly higher, it can also mean signifi cant underperformance. Therefore the manager’s skill is critical.
For the past 25 years a framework, believed the most effective in meeting investment objectives, was widely adopted. In the 1980s it was argued that policy portfolios be defi ned using long-term historical returns and Markowitz’s “mean variance optimisation” (portfolio asset allocation by assessing the trade-off between risk and return). Investment managers have doggedly followed this approach ever since.
But our investment reality is now different. The most effective investment approach against this backdrop is to give managers as much discretion as possible to deliver real returns.