Forum A meeting place for views and ideas Russell s Multi-Asset Model Portfolio Framework and the 2012 Model Portfolio for Australian Superannuation Funds Portfolio implementation Manager research Indexes Capital markets insights Portfolio construction
Russell s Multi-Asset Model Portfolio Framework and the 2012 Model Portfolio for Australian Superannuation Funds How should an investor allocate assets? This is a critical question and the answer will largely dictate the investment outcome, more than any other investment decision. The credit crisis has reaffirmed the importance of asset allocation for all investors - dispersion between the performance of different assets and strategies meant that overall results varied widely for different portfolios during times of market stress. Russell s Multi-Asset Model Portfolio framework is designed to help investors construct truly diversified portfolios to achieve their desired outcomes. Russell s Multi-Asset Model Portfolio Framework This Forum summarises Russell s Multi-Asset Model Portfolio framework, the process we have built and refined over time to construct robust, truly diversified portfolios, which systematically incorporate the best investment ideas from around the globe. The Model Portfolio framework has been designed to help investors navigate the multitude of choices available when setting a strategic asset allocation. To demonstrate how the framework can be used to help investors achieve their desired outcomes in practice, we have constructed a Model Portfolio with a specific target investor in mind as a case study - a balanced option in an Australian defined contribution superannuation fund. But it should be stressed that this is no one size fits all approach each investor will have their own unique set of objectives and constraints that must be included in the investment process particularly when constructing the asset allocation. In addressing the Model Portfolio question, we have first moved away from differentiating assets using the historical growth and defensive labelling. Instead, we have adopted five new portfolio segments that are more reflective of the different opportunities available in today s investment markets. Figure 1 sets out the five segments: equity (and similar assets which capitalise on corporate balance sheets); fixed income; real assets; alpha driven; and opportunistic. These portfolio segments are constructed in such a way as to be reflective of the underlying drivers of risk and return within each segment. Our best ideas asset allocation has been developed through a mix of quantitative analysis, qualitative assessment that is built on capital markets research, and industry experience. Figure 1 - Russell s Multi-Asset Model Portfolio segments Fixed Income Equities Alpha Driven Real Assets Opportunistic Our best ideas asset allocation within each portfolio segment has been developed through a mix of quantitative analysis, qualitative assessment that is built on capital markets research, and industry experience. This level of more granular asset allocations cannot usually be safely or robustly determined through classic mean-variance optimisation. The final stage is to blend the portfolio segments using quantitative modelling and risk budgeting to achieve an aggregate Model Portfolio with the investor s desired risk, diversification and return outcomes. The objectives of the 2012 Russell Multi-Asset Model Portfolio for Australian superannuation funds are to describe a starting-point asset allocation, which: Is appropriate for the default and balanced options of a typical, open defined contribution fund; Seeks to achieve a target return of CPI + 3.5% p.a. over a 5 year time horizon (after fees and taxes); 1
Underpins a truly diversified multi-asset portfolio; Is a strategic asset allocation, as opposed to tactical or dynamic; Capitalises on the illiquidity premium (up to 30% 1 in illiquid assets), accompanied by a daily liquidity version; Showcases the best investment ideas from around the globe which are currently implementable for Australian institutional investors; Starts from a blank sheet ; and Is not peer sensitive. In 2012, we have made some key changes to the construction of the Model Portfolio to enhance the consistency of the Portfolio s investment outcomes: 1. Reduce portfolio concentration and diversify equity risk A number of significant enhancements have been introduced to move away from a heavy reliance on the equity risk premium to drive returns and corresponding oversized risk exposure to equity beta factors: a. From equity beta into credit and alpha driven strategies b. From market capitalisation based equity indices to alternative beta benchmarks c. Newly investable class - Farmland d. Lower currency hedge ratios e. Risk budgeting that strengthens portfolio construction 2. Reaffirm active management While the primary focus is on asset allocation, active management in many key asset classes continues to deliver strong alpha propositions and offers some degree of risk amelioration: a. Alpha driven strategies are introduced to diversify equity beta b. Broader mandates to allow greater freedom for active management c. Alpha estimates are integrated into the modelling process These innovations feed into the qualitative and quantitative analysis to determine the recommended allocations within each asset segment. 3. Current valuations inform decisions: While the portfolio is not designed to be dynamic, the current valuation of some asset classes over the investment horizon of 5 years drives some asset allocation changes. a. Infrastructure preferred over property b. Private equity still out of favour c. Global sovereign bonds - poor value at current yields with significant downside risks d. Move risk from Australian equity to International equity 4. Process improvements: We have made a number of smaller changes as part of an ongoing refinement of the Model Portfolio process and to include emerging investment opportunities. a. Asset classes are growing up : from opportunistic to mainstream b. Tax assumptions refined 5. Projected Portfolio Return Dropped by 0.5% p.a. : Cash rates have dropped materially and the previous real return objective of 4% p.a. is no longer reflective of what is achievable in current market conditions. These innovations feed into the qualitative and quantitative analysis to determine the recommended allocations within each portfolio segment. Using a bottom-up approach, the recommended allocations within each segment are then combined together and blended at the total portfolio level using quantitative modelling and risk budgeting to achieve the final allocations to each portfolio segment as shown in Table 1. Table 1: Russell s 2012 Model Portfolio allocations to portfolio segments Portfolio Segment Model Portfolio Fixed Income 20.0% Equity 42.5% Real Assets 22.5% Alpha Driven 15.0% Opportunistic 0.0% Model Performance Characteristics*: Expected Real Return 3.5% Expected Volatility 8.7% Expected Probability of a Negative 1Y Return 20.6% Expected Probability of a Negative 5Y Return 5.7% * Characteristics have been calculated using appraisal based valuations for unlisted assets. For further information about assumptions used in determining Model Portfolio Performance characteristics, please refer to the full research report Russell s Multi-Asset Model Portfolio framework and the 2012 Model Portfolio for Australian Superannuation Funds. Model Portfolio Performance is simulated and takes into account superannuation tax (15%) and fees, and includes alpha estimates. The expected performance shown is based on hypothetical assumptions and should not be relied upon for the purposes of making an investment decision as projections, whilst based on grounds believed reliable, are not exact forecasts and do not take into account investor specific circumstances. 1 Unlisted assets exhibit varying degrees of illiquidity, e.g. average time to liquidate assets ranges from weeks, months, to years. For the purposes of illustrating the Model Portfolio parameters, we have simplified the measures to an illiquidity limit of 30%, and compared it against a daily liquidity alternative. However, in determining actual client portfolio allocations, Russell recommends using more sophisticated illiquidity measures in order to more accurately capture the spectrum of liquidity available for different unlisted assets. 2
Figure 2a - Risk-adjusted Efficient Frontier Expected Real Return (5 Year Geometric) %5 Russell Multi-Asset Model Portfolio Figure 2b - Diversification 2 - Model Portfolio vs Peers Expected Real Return (5 Year Geometric) %5 All Growth 4 4 High Growth 3 3 Growth Russell Multi-Asset Model Portfolio Balanced 2 2 Conservative 1 1 0 0 5 10 15 20 25 30% Probability of Negative Annual Return 0 Low Diversification High Risk 10 20 30 40 High Diversification Low Risk 50 60% Diversification Performance is simulated and based on assumptions net of 15% superannuation tax and fee estimates, including alpha, as set out in the full research report. The expected performance shown is based on hypothetical assumptions and should not be relied upon for the purposes of making an investment decision as projections, whilst based on grounds believed reliable, are not exact forecasts and do not take into account investor specific circumstances. Russell Multi-Asset Model Portfolio s expected real returns are simulated based on assumptions as set out in the full Research Report. Peer Portfolio allocations are actual and have been sourced from the Chant West Multi-Manager Strategic Asset Allocation Survey December 2011. Peer Portfolio expected real returns are simulated using the same assumptions. The expected performance shown for the Model Portfolio and Peer Portfolios are based on hypothetical assumptions and should not be relied upon for the purposes of making an investment decision as projections, whilst based on grounds believed reliable, are not exact forecasts and do not take into account investor specific circumstances. The resulting Model Portfolio has a significantly more diversified exposure than for a typical Australian balanced fund. The Model Portfolio is expected to achieve a real return of CPI + 3.5%, with a risk profile that translates to a probability of loss of only 5.7% over a medium term 5 year horizon (i.e. one 5 year period in every 87 years). In the short term, a negative return in any single year is expected to occur once every 4.9 years assuming smoothed appraisal values for the illiquid asset class assumptions. Figures 2a & 2b together illustrate how the key innovations introduced in the 2012 Russell Model Portfolio improve the portfolio s expected investment outcomes and the consistency of those results. In particular, a risk budgeting approach has been incorporated in the construction of the Model Portfolio to overcome the issues with classic meanvariance optimisation. The main issue with the conventional mean-variance approach is that small differences in the assumptions of highly correlated assets can be exploited by the optimiser to the detriment of delivering truly diversified, robust portfolios. Risk budgeting involves allocating assets based on their risk exposures rather than capital weights. Furthermore, the strict mean-variance efficient frontier does not represent real investment outcomes at all it is a mirage incorporating the limitations of the mean variance optimisation process and the error maximisation issues that accompany it. Additionally, the issue of parameter variability means that the frontier is not a discrete line but in fact a set of probability distributions with attendant uncertainty. In short, the strict frontier is not exact nor is it efficient or achievable in practice. In contrast, risk budgeting involves allocating assets based on their risk exposures rather than capital weights. It is more effective in enforcing true diversification within a portfolio by directly addressing the allocation of risk between different portfolio segments. To provide a more meaningful comparison of how the Model Portfolio weighs up against 2 Diversification is calculated by comparing the volatility of the portfolio assuming perfectly correlated assets, vs the volatility of the portfolio using the actual correlations in Russell s capital markets assumptions. This differential is then standardised by the volatility of the portfolio assuming perfectly correlated assets. The values are then plotted so that the high risk/low diversification portfolios are on the left and the low risk/high diversification portfolios on the right of the graph, i.e. portfolios on the right are more diversified. 3
Figure 3: Disparity between Capital vs Risk for Typical Balanced Fund vs Russell Multi-Asset Model Portfolio Typical Australian Balanced fund Russell Multi-Asset Model Portfolio 2012 11.0% 6.3% 15% 39.2% 42.5% Capital Weight 22.5% 43.5% 11.9% 2.0% 16.3% Risk* Equity Fixed Income Real Assets Alpha Driven 11.9% 20.0% 32.5% Risk* 2.4% 19.4% Risk Weight 1.1% 67.5% 83.6% * Risk from non-equity segments Source: Chant West (December 2011) and Russell Risk Analytics * Model Portfolio allocations are for illustrative purposes only and should not be construed as investment advice. The typical Australian Balanced Fund allocation is the average strategic allocation from the Balanced universe of funds in the Chant West Multi-Manager Strategic Asset Allocation Survey December 2011. the true opportunity set realistically available to investors, we have plotted a risk-adjusted efficient frontier using Russell s risk budgeting approach in Figure 2a. In addition, Figure 2b introduces another dimension of risk - diversification, to supplement traditional measures such as volatility and probability of negative returns. We believe this additional measure of risk is a more effective indicator of the degree to which a portfolio is truly diversified. Figure 2b shows how the Russell Multi-Asset Model Portfolio (with illiquid assets) is more diversified than peers targeting a similar real return in the Chant West Multi-Manager Strategic Asset Allocation survey (as at December 2011). Another way to quantify the increased level of diversification in the Model Portfolio is to use risk analysis. Risk analysis can be a useful tool for identifying concentrations in risk levels within the portfolio at an asset class level. Moreover, risk analysis will also quantify the amount of diversification within an actual portfolio that is a result of asset class weights, as well as the co-relationship of those asset classes. Figure 3 shows the typical disparity between capital allocation and risk allocation due to the significant differences in the riskiness of the different asset classes. It demonstrates how the 2012 Model Portfolio reduces the concentrated exposure from equities, diversifying into the real assets and alpha driven segments. For the purposes of the Model Portfolio, a key metric of diversification is the degree to which equity risk has been replaced as a dominant risk factor. For typical balanced funds in Australia (using Chant West s categorisation), only 16% of risk comes from non-equity asset classes. For the Model Portfolio non-equity asset classes account for nearly double that risk (32.5%). In summary, Russell believes that the process of developing a Model Portfolio framework is equally, if not more important, than arriving at the Model Portfolio. Although the Model 4
Portfolio is not a one-size-fits-all solution for all investors, it represents a blank sheet starting point. The Model Portfolio encapsulates the best investment ideas from around the world, which investors can build on as they consider their unique objectives and circumstances. Importantly, the rationale for assessing whether an asset or strategy is included in the portfolio (and at what % allocation) has been rigorously tested and debated, supported by Russell s investment philosophy, quantitative modelling and insights from Russell s Australian Model Portfolio Committee and their years of experience as investment practitioners during different market cycles. Russell has a unique heritage as an asset consultant and an asset manager. The consulting team has extensive expertise in superannuation fund management, particularly in the areas of asset allocation strategy, member investment choice and manager selection. Russell is one of only a few firms that offers actively managed, multi-asset portfolios and services that include advice, investments and implementation, with $152 billion in assets under management (as of 30/6/2012) and $2.4 trillion in assets under advisement (as of 31/12/11). Please contact your Russell representative to obtain the full research report containing the detailed recommendations in the 2012 Model Portfolio and discuss how these can be used to achieve your investment outcomes. 5
Russell Australian Model Portfolio Committee* Thomas Gillespie (Chair) Investment Risk Advisory Graham Harman Capital Markets Research Greg Liddell Managing Advisory Services Jerome Lander Investment Consulting Nicole Connolly Alternatives Andrew Sneddon Managing Multi-Asset Solutions Steve Murray Asset Allocation Strategies Raewyn Williams After-Tax Investment Strategies Peter Ballantyne Forecasting Strategist Portfolio * There have been many contributors to the Russell Australian Model Portfolio thought leadership in current and previous years as we have evolved our best ideas. In particular, we acknowledge the foundational work by past chair Kathy Cave. Daniel Mussett Head of Consulting, New Zealand Julian Darby Consultant Anne Lee Investment Knowledge & Communications Manager 6
For more information Call: Sydney +61 2 9229 5111 Melbourne +61 3 9270 8111 Visit: www.russell.com.au/institutional Issued by Russell Investment Management Ltd ABN 53 068 338 974, AFS License 247185 (RIM). This document provides general information only and has not prepared having regard to your objectives, financial situation or needs. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation or needs. This information has been compiled from sources considered to be reliable, but is not guaranteed. Some of the performance data shown does not take into account fees, charges or taxes and is not in any way an indicator of the net return to you as an investor. Some of the examples used in this presentation are based on hypothetical assumptions and have been included for illustrative purposes only. Any projections are based on reasonable grounds and have been determined by RIM to be relevant and reliable. However, these projections are not exact forecasts. Hypothetical back-tested performance is shown for illustrative purposes only and does not represent any actual performance. RIM does not represent that the hypothetical returns would be similar to actual performance had RIM actually managed a portfolio in this manner. Hypothetical, back-tested or simulated performances have many inherent limitations. Investors should not assume that they will have an investment experience similar to the hypothetical, back-tested or simulated performance shown. No representation is made that any portfolio will or is likely to achieve outcomes similar to those shown. In fact, there are frequently sharp differences between hypothetical, back-tested and simulated performance results and actual results subsequently achieved. This document is for WHOLESALE USE ONLY and is not intended to be viewed by retail investors. Copyright 2012 Russell Investments. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. R_NEWS_Forum_ModelP_V1FFFF_1207 MKT/4812/0712