Diversification may be the only free lunch in finance, yet even seemingly well-diversified portfolios can harbour hidden biases and correlations. These can lead to excessive weightings of certain strategies or a portfolio that expresses too many similar ideas, overexposing it to particular risks. In a difficult market environment, when traditional correlations break down, it can come as a nasty surprise. This is where good portfolio construction shows its worth.
Letting the best ideas shine
Portfolio construction does not preclude the ability to increase or reduce the overall risk in a portfolio, or to add or exclude specific asset classes - these decisions remain dependent on investors' objectives, guidelines and preferences. Instead, it aims to optimise risk-adjusted returns for a given set of constraints and to embed diversification and resilience into the investment process. The quality of investment ideas and strategies remain paramount, but portfolio construction identifies the best way to put them into practice.
Josh Lohmeier, head of US investment-grade credit at Aviva Investors, likens this to creating a framework that lets your best ideas shine. "Any great portfolio construction process needs strong idiosyncratic ideas. Portfolio construction is how you build a portfolio around those great ideas to provide resilience and downside protection."
A robust, repeatable portfolio construction process can uncover and remove biases and correlations, allowing investors to add return without taking additional risk. This is as true for funds that invest in publicly traded assets such as bonds and equities as it is for real assets like infrastructure and real estate. Instead of blindly following an inefficient benchmark index, investors can construct portfolios of well-understood assets that allow their expertise to add value - identifying and optimising return drivers, ensuring diversification and taking a forward-looking view to managing risk.
Addressing inefficiencies in tracking error and indices
Active managers will often follow a bottom up and simplistic approach to portfolio construction; purchasing the securities they like, avoiding those they dislike and determining whether they are happy with the resulting overall risk and tracking error. It is a good start, but more specific risk allocation techniques can help deliver more resilient investment returns.
"Tracking error is a very important tool for understanding how you are deviating from your preferred benchmark, but it is not necessarily a great tool for measuring risk," explains Lohmeier. "When we think about portfolio construction, we always want to acknowledge what our tracking error is and where it is coming from. Those deviations need to be value-creating and risk-reducing; it is really about defining how you are attacking that inefficient benchmark."
Simply aggregating the best investment ideas does not mitigate basic index inefficiencies - forfeiting an opportunity to generate excess return repeatably.
Tracking error can increase investors' exposure to risks embedded in an index by maintaining inefficient index concentrations or discouraging the inclusion of non-index ideas.
Similar inefficiencies can be found in real assets indices, at Aviva Investors, as highlighted in the analysis of MSCI commercial real estate indices.
Even the most comprehensive real estate indices provide incomplete coverage in terms of sectors and geographies. Like all indices, the coverage and weightings evolve as a function of holdings rather than real economic activity. Just as an equity index will tend to overweight stocks that have been bought the most and gone up in price, a real estate index will change as assets trade between investors who contribute to the index and those who do not.
A desire to retain portfolio exposures in line with the benchmark can result in investors buying into markets as they get more expensive. A prominent example of this is the increased ownership of central London offices by overseas investors who do not typically contribute to MSCI. This has led to a big decline in the share of central London offices in the index over time - a market that we feel holds a lot of value.