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February 14, 2014updated 04 Apr 2017 2:30pm

Towers Watson urges investors to reassess equity portfolios

Institutional investors should revisit their approach to constructing equity portfolios in order to take advantage of innovations in the industry, according to an article in Towers Watson's new publication: Equity Investing: Insights Into a Better Portfolio.

By Verdict Staff

Institutional investors should revisit their approach to constructing equity portfolios in order to take advantage of innovations in the industry, according to an article in Towers Watson’s new publication: Equity Investing: Insights Into a Better Portfolio.

The article notes that while investors have been diversifying away from equities in recent years, equity risk premiums remain an important driver of returns.

According to the publication, the building blocks of equity portfolios have evolved beyond market cap-weighted passive equity and active management.

Smart beta is now a third pillar that targets systematic factors and nonmarket cap stock weighting or thematic investment opportunities in order to capture particular premiums, typically at a very low cost.

Jim MacLachlan, global head of equity manager research, Towers Watson, said: "Developments in equity markets and the industry have added complexity and breadth, in terms of available products and portfolio construction tools. It is no longer sufficient to have an allocation to bulk beta and one or two active managers to construct an equity portfolio. The onus is now firmly on asset owners to develop their own portfolio construction skills or delegate this task to third parties."

Asset owners must be adept at manager selection, as well as portfolio construction, in order to identify skilled active managers from a universe of many thousands of competing products. A core principle is to make sure active managers are best in class and providing differentiated strategies that cannot be replicated more cheaply elsewhere using smart beta.

Asset owners should introduce new channels for risk and reward, for instance, through the implementation of a long/short portfolio alongside the long-only portfolio, or through more activist strategies.

MacLachlan added: "We are open-minded about where to look, but often the best specialist equity managers are found in boutiques established to provide greater focus. In some cases, they may be managing money for high-net-worth individuals or running hedge funds. Often, the mindset or skill set of these investors is different. For example, high-net-worth managers tend to think in terms of absolute return rather than relative to market indices."

Investors targeting high levels of expected excess returns through active management may want to consider amplifying niche strategies through highly concentrated (10 to 20 stock) mandates within an equity portfolio, comprised only of the active manager’s best ideas.

Studies have shown that portfolio managers often add value in their high-conviction stock picks but destroy value with the unintended underweight positions in the portfolio. Having more concentrated portfolios with assets focused in the manager’s highest-conviction ideas should offset unintended underweight positions and lead to better outcomes.

MacLachlan added: "In a highly competitive world, we believe asset owners should simplify their strategy (for example, go passive), or raise their game in order to deal with this complexity and benefit from it. While there are greater expected rewards from the latter approach, it requires more internal governance and portfolio construction skill from the asset owner, and therefore may not be suitable for everyone. Asset owners should determine what level of complexity is appropriate, given their requirements and their governance levels."

The new publication provides practical insights into equity portfolio construction, manager selection and manager monitoring. It includes articles on:

  • Best-in-class equity structure. What are best practices when considering equity portfolios?
  • Using smart beta in equities. Examining their rationale and their role in an equity portfolio
  • Assessing investment skill in equity managers. As well as the perils of assuming past performance is indicative of future performance
  • Quantitative investing: Will quants strike back? Why quants still have a role to play
  • Concentrated equity products. Why Towers Watson generally prefers them
  • Understanding emerging-market equity. How to best access the expected growth in these markets

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