In this paper, the second in a three-part series on the Total Portfolio Approach (TPA), we discuss Governance under a TPA framework and the role of the reference portfolio in establishing a risk budget and delineating the roles between the Board of Directors and Management. In the next paper, we will utilise privateMetrics and infraMetrics to quantify economic risk exposure across private asset classes, and style factors within asset classes. This can then be used to aid in constructing a multi-asset portfolio with targeted exposures.

Reference Portfolio and Fund Governance

The reference portfolio is a simple portfolio of listed equities and bonds that establishes a risk tolerance level from the Board of Directors. Rather than start with a comprehensive set of capital market assumptions to form asset allocation targets or bands, the approved risk budget acts as a governance mechanism and clarifies responsibilities. The Board of Directors approves a risk budget, consistent with the objectives and constraints of the fund. Management is then responsible for allocating the risk budget across investment opportunities, desired risk factors, or asset classes. A potential blind spot, which we will discuss in the paper, is how private asset allocations get translated back into a risk exposure that is consistent with what was approved by the Board. In other words, can the Board have confidence that the actual portfolio has a similar risk profile to the reference portfolio?

TPA Continuum

The scope of the challenge with TPA depends on both the exposure to private assets and the use of targeted economic or macro risk factors in allocating across opportunities. Allocations to private assets need to be funded from the reference portfolio, creating the need for a proxy in listed assets. Perhaps as important, the reported returns of the private assets portfolio will show different risk and return characteristics to that of the listed equivalent, changing the overall risk exposure of the fund. Moving from the reference portfolio to a more diversified portfolio that includes private assets is expected to improve risk-adjusted returns. However, some of this improvement may be due to valuation frequency differences between listed and private assets, creating illusory Sharpe ratio improvements, and understated total fund risk.

Key Objectives

In this paper, we will use examples of how institutions employing the TPA define the reference portfolio and use it to establish a risk budget. From there, we show how privateMetrics® and infraMetrics® can be used to quantify active risk and return measures for private assets, leading to reasonable outcomes for total fund risk and risk-adjusted performance. More importantly, it shows that risk remains similar to the reference portfolio. Finally, we discuss several challenges with categorising private assets exposure into economic risk factor exposures derived largely from listed assets. This will provide a good segway into the third paper, which will evaluate these exposures and how they interact in a multi-asset portfolio.