LONDON, Thursday 13 February, 2014 – Institutional investors should revisit their approach to constructing equity portfolios in order to take advantage of innovations in the industry, according to an article in Towers Watson’s new publication: Equity investing: Insights into a better portfolio. The article notes that investors have been diversifying away from equities in recent years, yet insists that the equity risk premium remains an important driver of returns.
According to Towers Watson, the building blocks of equity portfolios have evolved beyond market cap-weighted passive equity and active management. Now a third pillar, smart beta, targets systematic factors, non-market cap stock weighting or thematic investment opportunities, to capture particular premiums, typically at very low cost.
Jim MacLachlan, Global Head of Equity Manager Research at Towers Watson, said: “Developments in equity markets and the industry have added complexity and breadth, in terms of available products and portfolio construction tools. It is no longer sufficient to have an allocation to bulk beta and one or two active managers to construct an equity portfolio. The onus is now firmly on the asset owner to develop their own portfolio construction skills, or delegate this task to third parties.”
Asset owners must be adept at manager selection, as well as portfolio construction, in order to identify skilled active managers from a universe of many thousands of competing products. A core principle is to make sure active managers are best in class and providing differentiated strategies which cannot be replicated more cheaply elsewhere using smart beta. Asset owners should introduce new channels for risk and reward, for instance through the implementation of long-short alongside the long-only portfolio, or more activist strategies.
Jim MacLachlan said: “We are open minded about where to look but often the best specialist equity managers are found in boutiques established to provide greater focus. In some cases, they may be managing money for high-net-worth individuals or running hedge funds. Often the mind-set or skill-set of these investors is different. For example, high-net-worth managers tend to think in terms of absolute return rather than relative to market indices.”
Investors targeting high levels of expected excess returns through active management may want to consider amplifying niche strategies through highly-concentrated (10-20 stock) mandates within an equity portfolio, comprised only of the active manager’s best ideas. Studies have shown that portfolio managers often add value in their high conviction stock picks but destroy value with the unintended underweight positions in the portfolio. Having more concentrated portfolios with assets focused in the managers’ highest conviction ideas should offset unintended underweight positions and lead to better outcomes.
Jim MacLachlan said: “In a highly competitive world, we believe asset owners should simplify their strategy (for example, go passive) or raise their game, in order to deal with this complexity and benefit from it. Whilst there are greater expected rewards from the latter approach, it requires more internal governance and portfolio construction skill from the asset owner and therefore may not be suitable for everyone. Asset owners should determine what level of complexity is appropriate, given their requirements and their governance levels.”
The new publication provides practical insights into equity portfolio construction, manager selection and manager monitoring. It includes articles on:
Best-in-class equity structure - what is best practice when considering equity portfolios?
Using smart beta in equities - examining their rationale and their role in an equity portfolio
Assessing investment skill in equity managers - and the perils of assuming past performance is indicative of future performance
Quantitative investing - will quants strike back? - why quant still has a role to play
Concentrated equity products - and why Towers Watson generally prefers them
Understanding emerging markets equity - how to best access the expected growth in these markets.
Towers Watson Investment
Towers Watson Investment is focused on creating financial value for the world’s leading institutional investors through its expertise in risk assessment, strategic asset allocation, fiduciary management and investment manager selection. Towers Watson’s Investment business has around 800 associates worldwide, assets under advisory of over US$2 trillion and around US$60bn of assets under management.
About Towers Watson
Towers Watson (NYSE, NASDAQ: TW) is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. The company offers consulting, technology and solutions in the areas of benefits, talent management, rewards, and risk and capital management. Towers Watson has more than 14,000 associates around the world.