They say fashion goes through cycles. The same might be true in portfolio construction and manager selection
In this guest article, Sunder Ramkumar and Brett Hammond from Capital Group talk about why objective-based strategies are poised to make a comeback and why advisors might need to rethink portfolio construction and manager selection
They say fashion goes through cycles. The same might be true in portfolio construction. Financial professionals increasingly recognize that real-world goals should guide portfolio construction. But the tools of portfolio construction have not caught up yet, and we need new thinking in order to meet the needs of 21st century investors.
Fortunately, the past provides a partial answer to this dilemma. To explain where portfolio construction might be going, we have to understand how we got here.
The earliest mutual funds pursued clear objectives of appreciation, income or stability that aligned intuitively with investor goals, and research found that fund attributes typically matched those objectives; appreciation-oriented funds tended to have higher returns, and income-oriented funds tended to have lower risk.
But three developments caused the world of investing to move away from this objective-based approach. First came “Modern Portfolio Theory” (MPT) in 1952, which suggested that investment risk could be quantified based on the standard-deviation or volatility of returns. MPT suggested that investors should seek to build diversified portfolios that have the highest expected return for their risk tolerance, along a mathematically calculated “efficient frontier”.
In 1964, the Capital Asset Pricing Model (CAPM) argued that the “market” portfolio of all listed companies is most diversified, and in a world where all investors seek to maximize risk-adjusted returns, a company’s equity market capitalization represents market consensus for its optimal portfolio weight. Thus, all investors could simply hold proportions of the market-cap-weighted index consistent with their risk tolerance. This put indexes at the core of investment thinking, and suggested that active management is risky and appropriate only if it consistently beats the index.
The adoption of CAPM then gave birth to passive investing in the early 1970s, when Wells Fargo and Vanguard launched index-tracking funds in the U.S. for institutional and retail clients, respectively.
Finally, the idea of “style” arrived when researchers noticed that a portfolio of “value” (i.e., low price-to-earnings ratio) and “small-cap” stocks had better risk-adjusted returns than the market as a whole. Style in its infancy was used to describe fund strategy. It was used to evaluate drivers of investment results, and group similar funds into peer categories to facilitate like-for-like comparisons. However, a descriptive tool quickly became prescriptive when consultants started to advocate that a diversified portfolio must hold each of the different styles, instead of focusing on differential return between styles.
Style-based investing became entrenched when Morningstar launched its style-box framework in 1992, and gave advisors a ready tool to track mutual fund styles across a grid of nine style boxes. As a result, investment mandates shifted away from investor-centric objectives like appreciation or income; instead, managers sought to deliver a style or market exposure while beating a peer group of funds.
Two developments in the 21st century have drawn style-based investing into question.
First, a growing body of research demonstrated that constraints on investment universe and strategy were costly and could hurt performance.
Second, global pension funds began adopting liability-driven investing (LDI). In the aftermath of the dot-com crash, pension funds found that a combination of declining interest rates and falling equity prices caused their funded ratios (i.e., the value of their assets to liabilities) to fall — even when many of their fund managers beat market benchmarks. Pension managers realized that success meant meeting pension promises, not beating market indexes. They began to invest in custom mandates that focused on matching their unique future liabilities, not beating broad fixed income indexes.
Today goals-based wealth management has begun to take hold amongst the investment community. Like LDI, the goals-based approach has sought to emphasize unique client goals in favour of a singular focus on risk tolerance and market benchmarks.
The move toward goals-based wealth management will require a rethink of portfolio construction and manager selection. In our view, objective-based investing will return — but it will build on previous academic research and complement existing approaches. Here is how:
- Investment advisors will need to evaluate how their portfolios align with client goals — not just benchmark indexes.
- As a result, there will be rising demand for objective-based mandates that link more directly to investor goals, rather than simply providing asset class or style exposure.
- Those who retain some of the ideas around diversification embedded in style boxes — but who also use more flexible, objective-based mandates — may well have the most success.
Of course, no one really knows exactly where we are heading. What we do know is that objective-based investing appears to be gaining momentum, and it is unlikely that we will continue to build portfolios the same way in the decades to come. This is an exciting area of evolution and one that we will seek to address in future research.
Sunder Ramkumar is a Senior Vice President and Brett Hammond, Research Leader in the Client Analytics group at Capital Group.
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