Institutional investors often devote a lot of time and effort developing an asset-allocation framework that meets their fund’s objectives—from crafting a governance structure and oversight process to selecting long-term investment managers to monitoring portfolio exposures and risks. However, constraints on capital and resources can make it hard to manage these competing interests.
What’s more, despite best efforts to build a strong framework, real-world considerations have a way of intruding. For example, an investor may see greater alpha-generating opportunities in Europe relative to other regions and wish to allocate capital accordingly. Over time these tilts and concentrations can introduce meaningful divergence from desired portfolio characteristics and, ultimately, from performance objectives. A traditional framework may lack the transparency to monitor these deviations, and capital constraints may limit the ability to make adjustments to control these risks.
The chart below illustrates the ongoing performance impact that a 10% tilt to Europe and away from Japan created relative to the benchmark. Note how in 1999 this tilt led to underperformance of more than 4%. This example illustrates how the quest for alpha can easily be washed away by underlying beta performance.
Source: Parametric. For informational purposes only. Actual results may vary. Impact calculated as the calendar-year difference between the MSCI EAFE and a tilted portfolio. The tilted portfolio is approximated as MSCI EAFE + 10% MSCI Europe - 10% MSCI Japan, rebalanced monthly.
So how can a fund retain the flexibility it needs to take advantage of timely opportunities while still adhering to its allocation? With the help of a completion manager.
What does a completion manager do?
A completion manager can serve as a natural extension to a traditional framework, allowing for greater control over the portfolio management process. Through this portfolio completion framework, expected returns may also increase through an optimized allocation of capital.
While the types of exposures covered vary widely, a completion approach to portfolio management typically consists of four activities:
- Regularly monitor portfolio exposures relative to the policy target
- Generate portfolio analytics and reporting
- Evaluate exposure management alternatives, risks, and costs
- Manage portfolio exposures to mitigate unintended exposures (or provide flexibility to introduce active tilts)
There are two ways fund sponsors can implement a completion program: through a partially funded overlay or a fully funded completion sleeve. These aren’t mutually exclusive and are both complementary to an existing manager lineup. Let’s take a brief look at each.
Completion overlays can be thought of as an extension of traditional overlay management to include a more granular focus: countries, regions, sectors, styles, etc. Recall our example above of a fund’s alpha-seeking tilt toward European equities. While traditional analysis may show developed international equity as on target, a significant tilt toward Europe may introduce unintended risks relative to the benchmark.
The chart below illustrates how a completion overlay would seek to reduce this bias by removing beta exposure to Europe and adding exposure to a corresponding underweight region (Japan, for example), often via futures. This structure is intended to loosen capital constraints, allowing for allocation of capital to preferred managers while using an overlay to complete the policy asset allocation. The result is a significant mitigation of unintended risks, a retention of expected alpha, and an improvement in portfolio flexibility.
Source: Parametric. For illustrative purposes only. Chart does not represent actual performance results.
Beyond country and regional exposures, investors may want to manage at the style, sector, or factor level. In these situations a completion sleeve may be most efficient. For example, consider a portfolio with an unintended bias toward growth equities. A completion manager can analyze holdings to determine the extent of the growth bias and create a sleeve consisting of value companies to offset this bias, as illustrated below. The completion manager will regularly monitor the overall portfolio in an effort to maintain tracking error and other key portfolio characteristics within certain parameters.
Source: Parametric. For illustrative purposes only. Actual portfolio allocation and sizing of completion sleeve may vary.
Using Completion Overlays and Sleeves to Enhance Portfolio Flexibility
Did you know completion managers can implement completion overlays or sleeves to mitigate or actively manage otherwise unmanaged portfolio risks and tilts? This may increase return expectations through a more optimal allocation of capital.
Cash Securitization: The Challenge of Effective Liquidity Management
Although cash securitization has been implemented by institutional fund sponsors for many years, the topic remains esoteric for some. In plain language, this paper will clarify what cash securitization is and how it can be used within a broader liquidity management program.
Justin Henne, CFA, Managing Director, Customized Exposure Management
Justin leads the investment team responsible for the implementation and enhancement of Parametric’s Customized Exposure Management Strategy. Since joining Parametric in 2004 (originally as an employee of the Clifton Group, which was acquired by Parametric in 2012), Justin has gained extensive experience trading a wide variety of derivative instruments to meet each client’s unique exposure and risk management objectives. He earned a BA in financial management from the University of St. Thomas. A CFA charterholder, Justin is a member of the CFA Society of Minnesota.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.