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Investment insights from Capital Group

The Total Portfolio Approach (TPA) has been front-of-mind recently for institutional asset owners, judging by the number of conversations we’ve had with them and the frequency of conference panels devoted to the topic. But what exactly is TPA and why is it relevant? How does an approach that incorporates multiple objectives, a focus on risk factors and better alignment across a multi-asset portfolio look in practice? And what does evaluating each investment against every other investment, its true opportunity cost in the competition for capital, really mean? Let us briefly unpack TPA and connect the dots on these concepts.

While it’s only recently become known as the Total Portfolio Approach, the benefit of employing a comprehensive strategy that assesses the risk and return characteristics across the entire portfolio should be clear to practitioners. Here are a few core tenets that stand out to me:
 

• The emphasis is on managing the total portfolio holistically, as the name suggests, and often includes an awareness of the underlying liability (even when not explicitly stated).
• Competition for capital means that each investment is considered according to what it adds to the overall portfolio, not necessarily against a narrow benchmark or relative to an index.
• Risk factors serve as a common language, placing public and private assets, including equities, fixed income, real assets and alternatives, on the same page.
• Clearly budgeting risk across many dimensions and objectives enables tradeoffs such as where and how risk can be taken, and in what magnitude.
• Aligning governance, accountability and culture enables better – and more collaborative – investment and stakeholder participation and communication.

TPA addresses several big-picture trends. The first is the increasing complexity in today’s portfolios. Forty years ago, a typical institutional portfolio may have only contained domestic public equities and fixed income, perhaps seasoned with small allocations to private assets. Today, portfolios consist of the full complement of global public equities, global public fixed income and all manner of alternative and private investments, including private equity, private credit, private real estate, infrastructure and more. Within public fixed income, multi-sector and below-investment-grade sectors span the duration and yield spectrum. Derivative usage can be commonplace, including within liability-hedging long duration strategies and in liquidity overlays. A more holistic approach, like TPA, can help allocators break the association between a given investment and where it’s positioned in the portfolio. Evaluating public and private equities as a unit (or a continuum) can help sharpen decisions around how much risk to take in these asset classes.

The emphasis on an investment’s role in the portfolio, and careful analysis around what benefits (and risks) it brings, is more clearly handled outside the rigid confines of traditional asset class sleeves. For instance, investments geared towards growth or capital appreciation can be found scattered throughout the portfolio, most obviously within public and private equities, but also in equity-related fixed income, as part of a real estate allocation, and in hedge funds and other skill-based strategies. The same is true for strategies intended to diversify against core equity holdings and those designed to provide exposure to inflation, which may be dispersed throughout the various asset classes. Understanding an asset’s role in the portfolio begins to bridge the gap between asset classes and risk factors, which drive returns across all asset classes. Ultimately, risk factors serve as both that bridge and as the warp and weft of a portfolio, providing some order among seemingly unrelated strategies.

Lastly, traditional performance reporting often leaves stakeholders with a fuzzy picture of the risk and return dynamics. Whether by way of a reference portfolio or a factor-based approach, TPA may support more meaningful performance reporting and attribution, which can inform stakeholder decision-making. It does this by focusing on overall fund goals, rather than relative value added over a benchmark (which may not be an accurate representation of an investment’s beta).

Several of the world’s largest asset owners, including CalPERS, Singapore GIC and Australia’s Future Fund, have deeply considered a more modern approach to asset allocation and portfolio management, which attempts to break down some of the siloes between asset classes, between factor-related investments, and between stakeholders.

One of the core principles is to form a detailed understanding of what each component (whether an individual security, a fund or an asset class) brings to the portfolio in terms of not just the expected risk and return but also the specific role it plays. I’ll save the discussion of risk factors and how they feature in TPA for our next article.

The emphasis of TPA is that the opportunity cost for an investment isn’t adjacent investments within its asset class or sleeve, but every other investment made in the portfolio. And that bleeds into the risk dimension as well. A whole-portfolio approach is required at each step of the governance and investing process, from the factor lens that defines a reference portfolio to each marginal investment that competes with existing investments for a place on the roster.

One key idea that surfaces repeatedly is that risk budgeting takes center stage, even more than with traditional strategic asset allocation approaches. And risk can and should be defined expansively to also take into account liquidity, drawdown and perhaps liabilities as well. This can be neatly incorporated into multi-objective optimization, which can accommodate and weigh several portfolio objectives simultaneously.

While a cohort of asset owners is at the bleeding edge of defining, implementing and communicating TPA, many practical applications can be considered by all types of investors, no matter their size, portfolio complexity or resources. Each of the concepts mentioned above, a holistic approach, competition for capital, risk factors and risk budgeting, and general plan alignment, can also be implemented independently. Connecting the traditional, more rigid, strategic asset allocation approach and full TPA is a spectrum, and different investors can use a combination of elements to tailor a program to meet their needs.