Modern portfolio construction tools fit for adviser, client needs

Financial advisers and planners rely heavily on modern portfolio construction tools to navigate market volatility and provide their clients with best-of-breed portfolio management solutions. Among their concerns is whether these toolsets are evolving fast enough to keep up with financial market developments.

Asset allocation features strongly

“I would like to believe that portfolio construction methodologies are changing in line with market dynamics,” enthused Zama Zulu, a portfolio manager at Investment Managers Group.

She assumed the role of moderator for a panel discussion at the recent 10X Think Investing 2024 event, tasked with guiding panellists through ‘A look inside the modern portfolio construction toolbox’. Kamini Naidoo, Chief Investment Officer at Equilibrium Investment Manager, was first to the podium. She kicked off the discussion by stating that her team deferred to ‘strategic asset allocation’ when building portfolios. 

“We look at the performance of the long-term asset classes [to determine] how we can blend those together to achieve our targeted objectives,” she said. According to the CIO, the modern portfolio toolbox concept centres around how asset managers execute on the aforementioned asset allocation. “In the current environment, we have a lot more tools and levers to execute through those asset classes,” she explained. Portfolio managers can choose between active, passive or systematic strategies and execute these strategies through traditional markets and / or by using alternative investments like hedge funds. 

Eben Louw, a portfolio manager at Naviga Solutions, singled out accessibility and cost efficiency as game-changers in the portfolio construction toolbox context. He noted that many of the asset allocation building blocks had been around for some time but were only now becoming accessible to the retail investor. “We have a lot more types of investments at our disposal, and the retail investor can access all of them,” he said. Another often-forgotten tool is for portfolio managers to understand and leverage regulatory change. Recent changes have meant potentially higher allocations to offshore assets, hedge funds, and private equity, to name a few. 

AI in portfolio construction

Artificial intelligence (AI) emerged as a major influencer in portfolio construction. “We now use an AI tool as an input into our tactical asset allocation view, making that part of the process all the more robust in terms of how we make decisions [and ensuring that] we factor in all aspects,” Naidoo said. AI combines with improved data inputs throughout the process, allowing portfolio managers to respond faster and generate a holistic view of risk across the portfolio. “Our ability to analyse our portfolios and respond to the information that we are getting from those portfolios has improved as a result of some of the tools and technologies that are now available,” she said. 

Sean Neethling, Head of Investments at Morningstar Investment Management SA, framed his observations in the context of being a long-term fundamental investor. “Data [and our access to it] is more robust than what it was,” he said, “but the way we set up will pretty much be looking at asset allocation.” He reminded the audience that up to 90% of the variability of performance in portfolios could be explained by asset allocation, compared to 40% across funds. The fund manager believes that South African equities are “particularly well priced” at present and is upbeat on both nominal and inflation-linked bonds. 

“We try to understand these asset classes as well as we can, not only in terms of the performance but in terms of the variability of that performance,” Neethling said. The key is for portfolio managers to understand the drivers of risk and return on asset classes and sub-classes before allocating client capital to them. 

Challenges in the LISP environment

The set of challenges facing fund managers is somewhat different to those that financial advisers and planners encounter, but all stakeholders benefit from a broader understanding of the market. Zulu asked her panel to reflect on the main issues they faced when offering their solutions on Linked Investment Service Provider (LISP) platforms. For some context, financial advisers use LISPs as a streamlined platform for managing clients’ investments across multiple funds and asset managers, ensuring ease of administration and compliance. 

Meanwhile, portfolio managers face the challenge of aligning their model portfolios with the LISP’s operational constraints, including fund selection, fees, and rebalancing requirements, to achieve optimal client outcomes. Louw mentioned three levels of restriction that portfolio managers encounter in the LISP environment. First, wide discrepancies in trade settlement dates. “If you want to implement an asset allocation change or portfolio switch based on a current house view, one of your platform-based portfolios may only be able to implement that in a month’s time,” he said. 

The second issue develops out of fund selection. “A lot of the platforms do not offer access to all of the funds that we would like to see; you end up being faced with a bit of a misalignment problem … and in some cases, you cannot implement your first choice on certain platforms,” Louw said. And thirdly, the legacy structures of some LISPs mean that portfolio managers face constraints in entering positions in alternative investments like hedge funds. “We often encounter problems where certain LISPs do not offer hedge funds or other alternative investments,” he said. Another common complaint is the limited availability of exchange-traded funds (ETFs). 

Portfolio performance under scrutiny

Zulu steered the conversation to portfolio performance, asking whether portfolio managers had achieved their desired outcomes despite market turbulence and whether investors had shown a willingness to stay the course. “We have been better able to control outcomes in our cautious mandate funds; but once you move into the high equity space, where the underlying drivers of returns tend to be [affected by currency volatility] it becomes more difficult,” Neethling said. As for staying the course, the trick remains to align fund mandates with clients’ risk tolerances. 

Louw concluded with some comments on the optimal level of onshore versus offshore exposure. “Our strategic asset allocation offshore exposure in a higher equity portfolio is at around 35% at the moment,” he said. This exposure ebbs and flows between 35% and 40% depending on exchange rate fluctuations and the take-up of specific opportunities. The key message here: most risk profiles do not need more than 40% offshore exposure. And the caveat: if you have larger exposures to offshore fixed income, the currency plays a much bigger role in your asset allocation decision. 

DFMs struggling for scale, sustainability

A discussion about portfolio construction is incomplete without some comment around discretionary fund managers (DFMs). Zulu closed the presentation with a leading question about the South African market size and the number of DFMs plying their trade here. “We are probably going to see consolidation in the DFM market,” Naidoo concluded. “There are quite a number of DFMs out there, with scalability and sustainability among the main factors to consider when choosing.” 

Writer’s Thoughts:
Advisers must continuously evaluate whether the platforms and tools they rely on remain fit for purpose. In a rapidly evolving market, are your platforms enabling you to deliver on client outcomes effectively, or are they holding you back? Please comment below, interact with us on X at @fanews_online or email us your thoughts editor@fanews.co.za.