Institutional replication could smooth returns

By Mark Noble | November 18, 2008 | Last updated on November 18, 2008
5 min read

One of the key highlights from this downturn may very well be the performance difference between portfolios modelled after a traditional asset allocation mix, and those that emulate an institutional asset mix. Advisors may have to take a hard look at their client asset allocation and consider emulating institutional portfolios.

For almost 30 years, the debate within institutional investing has been between asset allocation and investment performance. The 1986 study by Brinson, Hood and Beebower, Determinants Of Portfolio Performance, concluded that more than 90% of a portfolio’s variance and performance is related to asset allocation.

“The big takeaway from the Brinson studies is that asset allocation matters,” says Stephen Foerster, a portfolio expert and professor of finance at the University of Western Ontario’s Richard Ivey School of Business. “The biggest determining factor in performance is creating the portion of your portfolio you invest in equities and fixed income and other asset classes. Less so is the extent to which you picked individual securities versus an index or doing a little bit of market timing, overweighting or underweighting equities versus fixed income on a quarter-by-quarter basis.”

In the U.S., the Harvard Endowment Fund and the Yale Endowment Fund have been at the forefront of asset allocation strategies, emphasizing a diversified portfolio of non-correlated assets.

Those strategies were adopted in Canada as well, and are widely used by pension giants like the Ontario Teachers Pension Plan and the Canada Pension Plan.

“Many large Canadian funds such as Teachers, the Canadian Pension Plan and so on, are really on the leading edge in terms of portfolio management. Retail investors have a lot to learn by trying to emulate what they are trying to do,” he says. “The important distinction, particularly when you’re looking at a pension fund, is that a pension fund has a very long investment horizon. It’s easy for Teachers to make a direct investment in timber, private equity or even real estate, and then buy and hold for a long period of time. That can be a lot more of a challenge for a retail investor.”

Canadian retail fund manufacturers are looking at ways to bring institutional solutions to retail clients. A perfect example of a successful diversification strategy is the Harvard Endowment Fund, which is broadly diversified across more than eight major asset classes.

“The Harvard endowment fund is the largest endowment fund in the world,” said Jason MacKay, vice-president of national accounts, Invesco Trimark, speaking at the company’s roadshow in Oshawa, Ontario. “Reporting from June [2007] to June 2008, its one year number was 8%, an impressive number given the market backdrop we’ve experienced of late.”

While that predates the sell-off that raked the market starting in September, the 8% return remains respectable. Harvard’s 10-year annual return is about 15%.

“In 2008, Harvard has eight asset classes,” MacKay continued. “The biggest category is real assets, such as real estate or commodities. These are the hard assets.”

A similar asset allocation exists for the Ontario Teachers Pension plan, which, according to its communications director Deborah Allan, made an aggressive push toward broader non-correlated diversification in the early 1990s.

“There are only1.6 working teachers for every retired teacher member of the plan. In 1970 that ratio was 10:1. That means we can’t withstand the volatility represented by the public market,” she says. “We had to ratchet back [from the average portfolio allocation of about 65% of equities] to about 45% — which are comprised of public and private securities. Our equity allocation was about 45% at the end 2007, with 33% of the plans’ assets in inflation-sensitive assets and 32% in fixed income.”

It’s the inflation-sensitive assets category that really differentiates institutional portfolios from the standard client portfolio. Asset classes like infrastructure and timber form large portions of this part of the portfolio. Until recently, they were extremely difficult for a retail investor to replicate, due to the scale needed to own these asset classes.

Yet, it’s these very asset classes that allow pensions to survive the volatility of a downturn, because for the most part they are not correlated to the equity markets.

“I’ve taken a look at the correlation of G-7 equity markets during 1970 to 1989 for example, and then compared it to 1990 to 2008. In most cases those correlations have gone up,” Foerster says. “We saw this back in October 1987; when we have a large negative event, markets tend to be even more correlated. If we go beyond that, there are clearly still benefits to diversification.

“If you compare Teachers asset allocation today to ten years ago it’s quite different,” he continues. “It has created an entirely different category that they call ‘inflation sensitive.’ That’s a different way of looking at things, and it’s where they come up with real return bonds, infrastructure, and commodities to try to get that lower correlation.”

With the expansion of the exchange-traded fund offerings (ETFs), it’s now possible for retail investors to try to bring more non-correlated asset categories into the portfolio.

MacKay says ETFs can fill the voids between actively managed mandates and hard assets.

“If you have the right combination of asset classes, like global real estate, emerging equities, cash and the right allocation of bonds, you could in fact replicate one of the best stock market performers in the world, but do it in a better risk-adjusted way,” he said.

Invesco Trimark’s first foray into offering institutional strategies to retail advisors came in June, with the launch of its Invesco Trimark Retirement Payout Portfolios. These use a mix of actively managed funds alongside the firm’s PowerShares brand of ETFs, which cover asset classes not included in the active mandates.

Some of the PowerShares ETFs included in the program are the FTSE RAFI U.S. 1000 Portfolio and FTSE RAFI Emerging Markets Portfolio. These are complemented by non-Trimark investment mandates, such as the Invesco Global Real Estate Fund. The portfolios are currency-hedged to reduce volatility.

Invesco Trimark emphasizes active management before all else, and charges an MER of 2.15% for the A series of its 2038 portfolio. Some in the industry have balked at that cost for a portfolio that includes ETFs. Invesco argues that while the ETFs themselves are passive, the overall portfolio is actively managed, and that active management and advice come at a cost.

The recognition that active management is required to effectively manage an institutional-type portfolio may have broader ramifications for those who manage client money. It opens the door for more people trained to manage institutional assets, like Chartered Financial Analysts (CFA), to enter the retail wealth advice market.

“Basically what’s happened is the retail clients and high-net-worth clients have become more sophisticated. They are demanding a higher level of service and greater access to asset classes and approaches to investing that they previously didn’t have access to,” says Stephen Horan, CFA, head of private wealth for CFA Institute. “The way the industry has focused itself around funds of funds and private equity funds, it made these asset classes accessible to an investor that previously had no access. Those assets are unique enough and sophisticated enough that they require quite a high degree of financial sophistication, and of course the CFA program lays the foundation to be able to handle that.”

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Mark Noble