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FINANCE: Three Trends Shaping the Future Of Investment Portfolio Construction

 





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‘ONE OF the wheels of the Wells Fargo coach came off with a big scandal hitting our community bank last year. It’s a good example of how things go wrong when you take your focus off the client.’ The importance of acting in the interest of clients was one of the key messages from Nico Marais, head of Multi-Asset Class Solutions at Wells Fargo Asset Management, speaking at the 2017 i3 Summit hosted by Sanlam Investments and Glacier by Sanlam.

Wells Fargo has 18 000 advisers all struggling with the same issues as advisers here in South Africa – ‘a dynamic, unsure and sometimes scary environment,’ said Marais.

Too little focus on asset allocation

One of the problems in the asset management industry today, according to Marais, is that the vast majority of CFA charter holders are hiring and firing portfolio managers, while a very small percentage is focussed on asset allocation and building portfolios. According to Marais this is the wrong way round and he sees portfolio management change dramatically in the future.

‘We have become so focussed on selecting managers that we’ve forgotten how to put together a portfolio. Clients are looking to us for solutions. They want to know what they need to retire, and what will happen to their portfolios when the market loses 20%, for example.’

The evolution of portfolio construction is squeezing true alpha

Marais argues that portfolio construction is in the midst of its most dramatic change in half a century. From the birth of modern portfolio theory in the early 1950s through to the mid-1990s the majority of institutional investors simply allocated 60% of their capital to equities and 40% to bonds to achieve optimal asset class diversification. Since the mid-1990s, portfolio construction has gone through three evolutionary phases and is now in its fourth phase.

‘As the industry evolved there were more and more building blocks. But the law of active management tells you that as your breadth decreases, your ability to outperform decreases,’ Marais reminded the audience. As a result, alpha came under pressure as portfolio managers’ building blocks became more granular.

Not only has there been a shift towards passive since the 1990s but a potentially more disruptive move towards smart beta – directly eating into what was always viewed as traditional alpha. ‘We have seen the emergence of factor ETFs, hedge fund replication, thematic ETFs and ETFs in the commodity space,’ Marais remarked.

‘This shift towards smart beta has made life even harder for traditional managers as shifts, say, from value to growth or between factors can often dominate the idiosyncratic drivers of stock returns,’ said Marais. ‘For any multi manager it is key to have these smart beta building blocks, but also to understand how to incorporate them.’

Marais said there are three trends that affect advisers in the world today: the growth in passive investing, the shift towards outcomes – either stock selection to asset allocation, products to solutions or institutional toward individual retirement – and lastly the rise of robo-advice.

Passive is a threat but passive is not perfect

In terms of the first trend, passive management, Marais reminded the audience that active global equity has seen net outflows over the past few years and that passive is a real threat. ‘What are you going to do when Vanguard comes to SA?’ Marais asked the audience. ‘It’s impossible to compete with Vanguard on scale.’

He said, however, that passive managers are still held ransom by their benchmarks, which are not equally diversified across value, growth, quality and momentum. They have biases that could hurt you. Increasingly investors are looking at benchmarks and saying ‘I’m not comfortable with that value bet or more commonly that tech bet (e.g. Facebook).’ New tech dominates many of the traditional benchmarks. So, there’s a move towards benchmarks that are more equally weighted and better diversified among factors.

Combining smart beta has become the new active

In terms of the second trend, the shift towards outcomes, Marais said, ‘Selecting and combining smart beta components intelligently has become the new active. For Wells Fargo one of the fastest growing areas at the moment is factor ETFs and almost all our solutions contain these.’

Marais said his research showed that hedge fund replication is currently not happening that successfully. But the replication has moved towards traditional active US small cap equity, where great work is being done in carving out alpha where there’s still alpha to be found. The top 200 investors in the world has extensively adopted factor investing as well as ESG investing. Wells Fargo is finding ESG to be in high demand. Investors are increasingly interested not only in alpha but also in the ‘do good’ aspect of investing.

In the US there’s a massive shift towards outcomes and clients are expecting higher level discussions. They want to know which risks are the drivers of their returns. As a result there’s a slight separation between product construction and advice. ‘Your clients really depend on you for advice and thought leadership. And many UK advisers have since outsourced the portfolio construction part or they became extremely sophisticated advisers themselves.’

‘We have become so obsessed as an industry on the active vs passive debate and fundamental vs quantitative, that we forget how these can work together,’ said Marais. Where do fundamental and quantitative analysis overlap? Marais gave the example of quantitative analysts moving right into the realm of traditional stock pickers. ‘If they take the artificial intelligence skills of quants, using word recognition in their analysis of company reports, traditional active managers can create profiles of significantly more companies than they are able to visit themselves.’

Robo-advice doesn’t work on its own

On the third trend, robo-advice, Marais encouraged advisers to use the online platforms available for asset allocation, manager selection, risk analysis and nearly all aspects of back office management. These technologies have the potential to make your client experience much richer and streamline your administration process.

‘However,’ said Marais, ‘I have not seen robo-advice work on its own. It’s increasingly a tool being used by existing advisers or managers. Vanguard is applying robo-advice to their existing book, which is what makes them successful. The new feet coming in are very expensive to gain. And a machine can’t deal with clients when markets fall by 20%. The service component, not manufacturing, is the future of financial advice.’

An enormous amount of opportunity around

‘I think our industry has been a little too fat, too lazy and a little unwilling to respond to what our clients want. There is an enormous amount of opportunity but we have to be agile, focus on the client and stop being defensive about what comes our way,’ said Marais. ‘This industry will transform and you could be a great part of it or you could be left on the sideline.’


 
 
 
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