Portfolio construction from a multi-manager perspective

Reza Hendrickse, Portfolio Manager at PPS Investments

Multi-managers invest by allocating capital to a selection of hand-picked manager strategies, from a broad universe. This approach of combining strategies leads to greater consistency in return outcomes, and results in portfolios that are sensibly diversified.

But this is easier said than done, with a key determinant of success being portfolio construction.

Portfolio construction should firstly be viewed through the lens of what the multi-managed solution is trying to achieve. For example, we construct portfolios differently, depending on whether the solution is targeting an inflation objective over a particular time horizon, whether it is seeking peer-relative outperformance, or whether it is trying to outperform an investable benchmark.

Depending on what the objective of the solution is, we find that combining both specialist managers (according to our asset allocation framework), as well as multi-asset managers (who follow their own asset allocation approach), leads to a robust multi-asset solution. We do, however, allow ourselves some freedom in deciding the specialist versus multi-asset balance, depending on the aim of the solution.

More fundamentally, it is the risk and return objective of a multi-manager strategy that determines its make-up from a strategic asset allocation perspective, which is the long-term split across various asset classes. Strategies that place higher importance on growth tend to hold more in growth asset classes (such as equity and property), while more defensive strategies would hold a higher weighing in income generating asset classes (such as bonds and cash).

It is possible to add value by tactically up or down-weighting asset classes depending on their attractiveness. One must be quite careful in doing so, however, because as studies show, the incremental value-add from applying a tactical asset allocation overlay is generally not as significant as one might expect. We therefore tend to be quite disciplined regarding when and to what extent we tactically alter the mix of asset classes in portfolios.

For us, asset allocation changes are driven by a house view process, which considers each of the major asset classes along three different axes. The first is valuation, which tries to establish whether the asset class is cheap or expensive. The second is the macro cycle, which would either present a headwind or a tailwind for the asset class, and then finally we also consider the prevailing trend and momentum conditions.
Most of the value-add over time tends to come from holding an appropriate long-term asset class mix, rather than from shifting in and out of asset classes, so we try to limit the frequency of tactical tilts. It is also useful to establish pre-determined ranges which dictate how far a portfolio may deviate from its long-term strategic asset allocation. These conditions help one focus on getting the big calls right, as well as managing the impact of potentially making a mistake.

Portfolio construction is not just about asset allocation, and the quality of a multi-managed solution is also very much dependent on the quality of its components, which are the underlying managers. Given that there are hundreds of unit trust funds available to choose from, it is important to have a structured approach to identifying promising managers and strategies. This is an important skill for a multi-manager, and we therefore spend a significant amount of time on understanding the universe.

There are two sides to any manager research process, the first being a quantitative one, which considers returns as well as other numerical and statistical data. The second considers qualitative information about the respective manager, such as its business, its people, and investment approach. It then becomes a question of whether the strategy stands out, and whether conditions are right for the strategy to be able to repeat its success going forward.

Portfolios can be constructed in many ways, but what is most important is that one understands the risks embedded in an approach. Sticking to a well-thought-out framework and following a disciplined approach is what is ultimately important, and what will bring about consistency in return outcomes. At the end of the day, the long-term nature of investing means that any approach to portfolio construction needs time, patience, and deliberate action to reap the rewards.