Institutional investors should revisit their approach to constructing equity portfolios to take advantage of innovations in the industry, according to a report by Towers Watson.
While investors have been diversifying away from equities in recent years, equity risk premiums remain an important driver of returns. Towers Watson stresses that the essential building blocks of an equity portfolio remain market capitalization-weighted passive equity and active management.
But the market has changed significantly in the past 15 years, including two “significant market bubbles/cycles with the dot-com bust and the global financial crisis,” the report said. “As a result, investors’ understanding of behavioral biases has evolved and we have been reminded of the importance of macroeconomic, social and political issues.”
Because of that, the company says equity portfolios should also include what it calls smart beta. There are various smart beta strategies, including fundamentally weighted indices and risk weighted indices. There are also thematic approaches that give investors exposure to a particular long-term driver like the scarcity of natural resources. Many of these are held in exchange-traded funds.
Recent improvements in data availability, quantitative management techniques and lower costs have created the opportunity to isolate these sources of active management and construct dedicated smart beta products.
The main objective of smart beta is to capture a particular risk premium for a low cost. When deciding whether or not to use this approach in their portfolios, investors must research the validity of the risk premium or smart beta strategy as there can be many different strategies and definitions.
The report also found that it is important for asset owners themselves to have a robust portfolio construction process. It is no longer sufficient to have an allocation to bulk beta and one or two active managers to construct an equity portfolio. It is now squarely on the asset owner to develop their own portfolio construction skills or delegate the task to a third party.
Investors also need to understand the philosophies and investment styles of the active manager and build sufficient diversification across the full spectrum of investment styles, the report stated.