By Erik Sherman

Over the last five years, the California Public Employees’ Retirement System (CalPERS) has been working to bring further its use of a total portfolio approach (TPA). It’s been a big change from siloed portfolio management.

Wilshire Advisors, a consultancy that CalPERS uses, wrote that  the Total Fund Portfolio Management (TFPM) effort inherited “the role of providing centralized trading efforts for Global Equity and  Global Fixed Income before those functions were migrated back into the asset class programs with TFPM focusing on managing Total Fund financing, and liquidity.” The group has also taken on centralized research and provision of  “a view of macroeconomic conditions and total fund risk reporting.” 

CalPERS may be the first U.S. pension to use TPA, according to BuyoutInsider. Some Canadian pensions have been adapting the methodology for years.

Traditionally, pensions and other institutional investors used strategic asset allocation. “Boards select a policy asset mix and asset class benchmarks,” James Davis, chief investment officer of OPTrust wrote last October at the Association of Canadian Pension Management/L’Association canadienne des administrateurs de régimes de retraite. “Investment managers then put together asset class portfolios that aim to add value by beating their benchmark. This reinforces siloed behaviour and a focus on line items versus the big picture investment objective.”

Instead, TPA looks to align investment team objectives with stakeholder interests “to generate total returns at a level of risk consistent with meeting Plan liabilities,” Davis added.

“It’s a global optimization as opposed to a series of local optimizations,” Manroop Jhooty, senior managing director and head of Total Fund Management at CPP Investments, tells CAiP. The firm has been using the approach since 2006.

Although the concept of a total portfolio approach borrows from the basics of modern portfolio theory introduced in 1952, it’s only in the last 20 years that some institutional investors in Australia, Canada, New Zealand, Scandinavia, and Singapore have adapted it, according to Benefits Canada. The concept is to maximize risk-adjusted returns across an entire portfolio rather than one silo at a time. The approach can lead to higher returns and lower volatility.

The theory is similar to some concepts mentioned during the business reengineering hype in the 2000s — in particular, the potential problem of sub-optimization. Consultants and experts argued that many companies had organization and compensation designs that emphasized the performance of individual departments. However, by doing so the overall organization could suffer because what is best for it might not be best for the department acting as a separate entity.

The two concepts can seem similar in ways. Some overall group determines allocations and individual investment teams still choose and manage assets. But there are some strong differences.

“Total fund management within CPP kind of has two broad functions associated with it,” Jhooty says. “The first is that we’re responsible for the design of the portfolio and the asset allocation.” That includes all of the research and analytics that go into the decisions. The group then presents its recommendations to the firm’s chief investment officer.

“We separately have a group of functions that are related more towards than managing the total portfolio to those targets,” Jhooty continues. “That team then runs all of our passive beta portfolios. We call it a balancing portfolio, but you can think of it as a completion portfolio that ensures the total fund is getting back to our risk targets, our various asset class targets.”

An important difference between strategic asset allocation and TPA is the stage of setting up allocations. It involves both research into what a realistic return for a given asset type might be and also deep investigations into risks.

“Ensuring a portfolio is not overly sensitive to growth shocks or overly sensitive to the downside to inflation shocks,” is how Jhooty puts it. “And that’s something you can’t get from a from a traditional SAA [strategic asset allocation] approach, which just looks at these assets as standalone widgets or as their own asset classes.”

Because asset silos are focused on what they need to know, the individual asset managers won’t know if a given risk in that portfolio might duplicate the same risk in other silos, unknowingly creating a supersized risk for the total fund.

“And that’s what TPA allows you to do,” Jhooty says. “It allows you to drill into the actual drivers of risk and return so that you can see if you’re overly concentrated or underexposed to a particular type of factor in [the overall] portfolio.” 

The individual asset managers still do their work, putting together the best collection of assets in their class that meet the needs of the total fund.

“You have to recognize the individual contributions that individuals and departments also bring to the table,” says Jhooty. “So, it’s finding the balance to align long term total fund returns to you know what people are delivering day-to-day. But you need that alignment across the first metric which is delivering maximized returns.”

While a powerful tool, not every pension fund will be able to fully use it. “Depending on your choice of implementation, it can be complex,” Jhooty says. TPA requires investment in personnel and systems. “I think the question comes down to the degree to which you implement it, but every institution can benefit from the ability to look through the portfolio to the return drivers.”