Reflecting the rise of greater investment complexity and “black swan” risk, global asset owners are increasingly adopting a total portfolio approach (TPA), according to investors and researchers at the MSCI Institutional Investor Forums in the U.S. and Canada. Qualitative and quantitative challenges underpin this industry trend, and asset owners exchanged ideas on how to tackle each at the U.S. forum, at CalSTRS headquarters in Sacramento, and the Canadian forum, at PSP Investments in Montreal.
Because some of the megatrends that are reshaping investment performance and risk management have little historical precedent or agreed-upon performance metrics to track them, investors said they need new tools and taxonomies to help them execute their TPA.
A common refrain from attendees at the event in Montreal was, when it comes to TPAs, “the soft stuff is the hardest stuff.” Paramount to success, they agreed, is a comprehensive plan to change their internal culture: Creating a collaborative environment that breaks down silos between all different asset-class specialist investors, the broad investment team and the risk-management team, and even between a plan’s investment management group and governing board.
“Canadian pension funds have become some of the world’s leading long-term investors, and they are now at the forefront of key trends reshaping our industry, such as the shift to private assets, the increased focus on climate and sustainability and the adoption of a total portfolio approach,” Henry Fernandez, MSCI Chairman and CEO, said. “Events like this one help us understand how Canadian funds developed their competitive advantages, where they see challenges emerging in the years ahead and how they plan to adapt.”
Culture is everything: One TPA does not fit all
While large asset owners around the world have adopted TPAs, governance and investment structures vary widely.
Some of the earliest proponents of a TPA — including pension plans in Canada, as well as institutional investors in Australia, New Zealand and Singapore — did away with asset-class focused investment teams and eliminated benchmark goals. Others said they broke down silos between management of public and private assets, despite the challenges they face in comparing performance of the two markets.
More recent adoptees are taking a hybrid approach, said attendees of the U.S. forum. TPA newcomers are maintaining asset-class specialist investment teams and the performance benchmarks for them while also deploying total-return teams to foster discussion among these groups and identify opportunities that might have been missed in a strategic asset allocation (SAA) approach.
Whatever approach a chief investment officer takes, fostering collaboration is job number one. The right structure is the one that meets the portfolio’s unique goals and that leans into “what you’re good at,” as one senior U.S. investment leader put it.
A senior risk leader at the Canadian forum shared a framework that transformed her pension fund:
- Align incentives for investment and risk professionals alike to the performance of the entire fund rather than a particular asset class.
- Give the risk-management team a voice at the investment decision-making table.
- Outline channels of escalation so all teams know who is doing what and when, both during the day-to-day and a black swan event.
- Set a “tone from the top,” in which the chief investment officer shows willingness to listen to ideas from all corners of the firm.
It’s also essential to explain the shifts in structures and philosophies to governing boards and get their buy-in, participants said. Practical tips shared at the forums included meeting individually with board members to bring them along on the journey. Clear communication of TPA strategies and anticipated risk/return profiles is especially important in the U.S., forum-goers said, where board members often aren’t investment professionals.
TPA is about measuring risk
Rick Bookstaber, Director of Risk Research at MSCI, said asset owners leveraging a TPA need to create a risk culture that includes common language, common legends and common customs.
“The common legends are either a directly shared set of experiences that you draw from, or exchange of ideas and history,” Bookstaber explained. “You all at least have the same plotline for your story.”
MSCI Chief Research Officer Ashley Lester said at the U.S. forum that TPAs have become more prominent because of increased risk of black swan events, as well as greater investment complexity overall. Specifically, four key forces are pushing pension plans and other asset owners to seek new models and resources to assess risks and pursue opportunities: Climate change, geopolitics, the rise of private assets and the evolution of artificial intelligence.
Roger Urwin, Global Head of Investment Content for Willis Towers Watson, said at the Canadian event that these megatrends are why the notion of investment risk and the ways in which asset owners measure it need to evolve.
“In Risk 2.0, it has to go wider, it has to go softer — as in, it has to accommodate a lot of qualitative stuff, as well as all the quant — and it has to also go much longer,” Urwin explained. “Asset owners have so many risk measures in just the short term that haven't got the materiality they should have. That's where joined-upness comes in. It's about joining up teams across the organization. It's joining up across peer funds. It's joining up across ideas, and it's joining up across portfolios as well.”
Models that project physical portfolio risks under different climate-change scenarios are among the most important new tools, MSCI’s Lester added. Forum participants agreed that assessing physical risks is no longer the sole purview of dedicated sustainable investment teams. For example, real-estate investment specialists must consider extreme weather events like hurricanes. MSCI’s Bookstaber suggested that institutional investors’ risk management should now start with assessing go-forward physical risks before assessing financial risks.
The Holy Grail: Bringing together public and private investment opportunities
A total portfolio focus allows asset owners to better identify pockets of opportunity between public and private markets that increasingly interplay with one another as capital seekers continue to diversify their financing across both sectors, attendees agreed. While attendees of the U.S. forum particularly emphasized that private markets would offer better opportunities than public equities, they also said better benchmarks for private asset performance could serve as the “holy grail” to unlock those opportunities.
Irregular valuations and lack of history complicate measuring private-asset returns, MSCI’s Lester explained. He also argued that the investment industry needs to move beyond aggregate measures of private markets — a challenge that MSCI is presently trying to solve for by working toward generating indexes and insights at the holding, rather than the fund level.
Liquidity and cash-flow risks were also heavily discussed at both events among some investors who have upward of 50% of their portfolios allocated toward private assets now. MSCI research shows that distributions from recent vintages of real estate and venture capital funds are at their lowest since at least the 2008 global financial crisis. In addition, liquidity risk generally works on a different timescale than market risk, with distributions grinding out over quarters and even years.
Unlocking transition investing opportunities with a TPA
Forum-goers agreed that one megatrend with clear implications for the total portfolio is the imperative to decarbonize the global economy in response to climate change, giving rise to the concept of transition finance. Investors typically adopt two approaches, MSCI ESG Research found: portfolio decarbonization and financing the transition of higher emitters toward low-carbon business models. Both aim to lower the carbon footprint of a portfolio in the long run but use different economic strategies to achieve this goal
Energy-transition considerations can more fluidly be incorporated into TPA decision-making, said Julia Giguere-Morello, Head of Sector & Thematic ESG Research at MSCI.
Asset owners at each forum said they saw strong opportunities to invest in emerging energy technologies that aren’t commercially viable for publicly traded companies yet. A TPA has given those investors more flexibility to choose risk levels and allocation towards such opportunities in private markets.
“With a TPA, asset owners may better be able to tap into those new opportunities, like energy storage and ways to address battery bottlenecks,” Giguere-Morello added. “They can also potentially capture extremely complex technology questions around low-carbon steel or cement, which are the building blocks of infrastructure.”