Reference portfolios offer investors the ability to map out a model for their scheme’s risk and return characteristics, but like all tools, their effectiveness depends on how they are used. Emma Cusworth reports.
“There is not much difference behaviourally between a reference portfolio and a traditional strategic asset allocation approach. Managers still hug a market-related benchmark. Some wouldn’t want to work any other way.”
Barbara Saunders
In a world increasingly focused on liabilities, value, diversification and dynamism, the evolution of the reference portfolio (RP) approach to asset allocation appears to make a lot of sense. Like all tools, however, its effectiveness depends on how it is used and how good the underlying assumptions are.
The notion of a reference portfolio was first introduced by the Canada Pension Plan Investment Board (CPPIB) in a move that reflected a shift away from passive indexed portfolios towards more active management and a higher allocation to private market assets.
Since then, other pension plans including the New Zealand Super Fund (NZSF) and the UK’s Universities Superannuation Scheme (USS) have adopted the same approach, which, in the words of the NZSF, is a “notional portfolio of passive, low-cost, listed investments suited to the fund’s long-term investment horizon and risk profile”.
In essence the reference portfolio maps out the long-term journey plan of a pension fund and is designed to be a model for a scheme’s desired risk and return characteristics rather setting out a desired asset allocation framework (as the traditional strategic asset allocation (SSA) approach does). Its role is as a theoretical benchmark, not a guideline for what the invested portfolio should contain.
Sally Bridgeland, senior adviser with pension fund investment governance consultants, Avida International, says: “The idea is to create something that is more specific to what a scheme is allowed and wants to invest in. It is about deciding where point B is when the portfolio is mature and how to measure and monitor progress against that process.”
So far, the approach is just beginning to edge into the UK market, but things are changing. According to John Finch, investment consultant at JLT Employee Benefits, uptake is expected to increase, “especially,” he says, “in the context of the growing trend towards fiduciary management, where reference portfolios can help set the journey plan”. “It sets the centre point for what an investor wants to achieve over the next 20 years,” he explains. “The investor can deviate from that, but the reference portfolio acts as a reference point.”
Others, including the NZSF, have described the RP as an “equilibrium” concept, such that it is structured based on the fund’s assumptions of the average long-term value of various asset classes over long periods, regardless of what is actually happening to those values in any given market conditions.
This latter point is of particular importance because it means the RP is not influenced by short term market conditions, which a traditional SAA approach would be. This underlines another key difference between the two approaches – while a SAA would typically be set on a calendar basis in order to update it based on the prevailing market conditions, the RP should only be changed to reflect fundamental changes in market conditions or the objectives of the scheme.
BETTER GOVERNANCE
Advocates point to this difference as an important governance benefit of the approach. USS, for example, stress that under the RP approach the trustee board focuses on strategic scheme objectives, the investment committee on the appropriateness of the overall investment strategy and delegations, and USS Investment Management Limited (a wholly-owned subsidiary of USS and the principal investment managers and advisor to the scheme) on the specifics of asset allocation, implementation and reporting.
The NZSF similarly reports that the RP approach is “first and foremost a governance construct” and encourages greater separation and delegation of value-adding activities from the Board to internal management, allowing the Board to take a more top-line view while the internal management can “focus on adding value to the portfolio”.
Better delineation of responsibilities is an importance governance benefit because it relieves the board of the need to understand the broad range of highly complex products, structures and strategies associated with implementing investment decisions.
Stephen Holt, head of institutional business at Principal Global Investors, says: “Use of an RP approach fits well with a governance framework where a board sets high level objectives and risk tolerance, and an executive provides a tactical overlay and makes practical implementation decisions. This in turn gives a clearer potential measure of the value added by these activities.”
FOCUS ON ADDING VALUE
The ability of the RP to provide a clearer way to measure and monitor the value being added across the decision-making process is another oft-cited benefit. Bridgeland says one of the main drivers behind the growing interest in RPs is the desire to make, monitor and measure asset allocation decisions better. “A reference portfolio helps discover which parts of the decision making process are adding value to help understand what is happening in the portfolio,” she says.
The aim of both the NZSF and USS is to add more value to the portfolio than the reference approach would do. In the case of USS, its goal is to beat the RP by 0.55% per annum on an annualised basis over rolling five-year periods, net of applicable costs.
As a consequence of the above approach to adding value, some, including the NZSF, argue it also creates a greater focus on absolute return. Since inception on 30 September 2003, the NZSF has returned 9.83% per annum. The reference portfolio has returned 8.51% per annum, representing 1.32% per annum of value added by active investment.
Others, however, argue that because the reference portfolio is a static benchmark – like a traditional SAA approach – it is still inherently a relative rather than absolute approach.
“The danger with reference portfolios is that the same approach is taken to managing the portfolio,” says Keith Guthrie, CIO of Cardano. “A fundamentally different approach to portfolio construction on absolute returns is necessary.”
GREATER FLEXIBILITY
Another aspect of the value-additive argument made in support of reference portfolios is the greater flexibility afforded to the investment management decision makers to respond dynamically to changing market conditions. This allows them to take advantage of a broader choice of investment options available today.
Avida’s Bridgeland argues the main reason for the increased interest in reference portfolios is the growing appetite for illiquid assets. “It’s a symptom of the way things mature over time and the desire to include assets that are not represented by indexes and that don’t trade in the same way,” she says.
According to USS, the need to outperform the RP with a similar level of risk, and the improved governance achieved by delegating decision-making to “those best placed to respond dynamically to changing market conditions”, are both key contributors the divergence of the invested portfolio from the RP in terms of the assets included.
The NZSF, meanwhile, says the different approach to allocating capital – looking at the underlying economic drivers of risk, returns and correlations rather than at asset classes – can improve the true level of diversification of the actual investments in the fund versus a more traditional strategic asset allocation approach.
The arguably greater degree of dynamism afforded by RPs is another key aspect behind the increased interest in the approach. As JLT’s Finch points out: “The move to reference portfolios is being driven by the wider choice of assets and the need to take a more tactical approach. The markets are more volatile today so there is a need to move around more and a reference portfolio provides a greater degree of discretion versus a traditional strategic asset allocation approach.”
However, this question of greater flexibility is met with some scepticism in the industry.
PGI’s Holt says, in theory, the RP approach would provide greater flexibility. It would not typically specify allocations to private markets or provide a detailed framework for how exposures are implemented. “The freedom to diverge from the RP would depend on the investor,” he argues, “but given that RPs tend to be relatively simple constructs, at least superficially, a significantly greater degree of divergence would be expected relative to a SAA. Investors would look to express their views on current market conditions in the actual portfolio.
“That said,” he adds, “in practice the RP provides a guide, and it would need to be supplemented with a current investment strategy. There may also be a high degree of flexibility around an SAA. It depends on the investor.”
Barbara Saunders, managing director at P- Solve argues that even though a manager has the discretion to deliver against the RP benchmark in whichever way they see fit, there will always be a temptation to hug the reference portfolio.
“There is not much difference behaviourally between a reference portfolio and a traditional strategic asset allocation approach. Managers still hug a market-related benchmark,” she says. “Some managers wouldn’t want to work any other way.”
Saunders believes investors are better served using a simpler ‘target plus’ approach, setting a return target such as cash plus a certain percentage and laying out an appropriate level of risk.
“It would be better to do things the way clients need them to be rather than what managers want to do,” she argues. “Stating required return and acceptable risk characteristics gives managers the ultimate flexibility. Most clients with any form of fiduciary management are using a required return approach as a guiding principle. For most schemes, if they are using a reference portfolio approach, it has been created to mandate a manager that wouldn’t accept a more flexible required return and risk approach.”
Cardano’s Guthrie, meanwhile, argues both the RP and SAA approaches can offer flexibility. He says: “Perhaps people apply [a RP] with wider tactical limits, but you could do that in the normal strategic asset allocation framework just as easily.”
WHAT’S IN THE DEFINITION?
“There is also the huge question of what the correct reference portfolio is,” Guthrie continues. “What’s the methodology for constructing this?”
This problem is not unique to RPs – quite the opposite, it is identical to that faced by those responsible for setting a strategic asset allocation benchmark. “We believe that is the most important, misunderstood and overlooked problem in modern investment management,” Guthrie says. “It is overlooked because it’s a problem most investors have no clue how to solve.”
Ultimately, the question associated with both approaches is: if you knew nothing about the state of the world or the economy and you had to invest blindly, how would you invest a long term portfolio?
“Once you have such a benchmark it can form a useful tool for analysing whether your portfolio decision making is adding value in a return or a risk sense over time”, says Guthrie. “But the portfolio decision making and construction needs to be completely independent of the strategic benchmark/ reference portfolio.”
