In the latest episode of the Alternative Allocations podcast series, I had the opportunity to visit with Aaron Filbeck, Head of Content, CAIA Association, as we explored the Total Portfolio Approach (TPA) to portfolio allocation. TPA is a natural evolution of Modern Portfolio Theory (MPT) and Goals-Based Investing, seeking to allocate capital without the limitations and constraints of other approaches.
TPA moves beyond the Endowment Model popularized by David Swensen, which became the standard for many institutions. It recognizes the limitations of Markowitz’s Mean Variance Optimization in terms of providing optimal capital allocation. TPA recognizes the challenges of forecasting returns and the frailties of modeling historical data.
In Exhibit 1 we compare the typical strategic asset allocation to the total portfolio approach.
While institutions have begun adopting TPA, it is new to the wealth channel and presents a few challenges in implementing. I asked Aaron to define TPA, “There are four dimensions to TPA— governance, culture, a factor-based lens, and competition for capital.”
Governance provides greater flexibility and autonomy to the CIO in allocating capital, which obviously requires a culture that is comfortable in providing greater degrees of freedom. Governance and culture go hand-and-hand and require collaboration across teams to achieve goals. These dimensions can be challenging for advisors and require a degree of trust and specialization.
TPA suggests viewing investments through a factor-based lens to avoid unintended bets and biases. It is a recognition that certain investments do not fit neatly into predefined buckets. Hedge funds by their very nature are free to draw outside the lines, especially during periods of market dislocation. There can also be unintended bets across portfolios since there can be differences between asset class modeling and the underlying portfolios.
The dimension that intrigued me the most, and the biggest departure from MPT, was the competition for capital. In a traditional structure, members of the investment committee often come with preconceived biases. A strategist may tend to have a more favorable view of his or her area of specialization—a private equity strategist may see attractive valuations with secondaries, and the private credit strategist may favor commercial real estate debt.
With TPA, each idea is compared to the collective opportunity set—there is a natural and healthy competition for capital. Each investment must be considered as part of the larger whole—what impact does it have on the overall portfolio? Investments are never considered in isolation—but rather, do they help the overall portfolio?
TPA requires a buy-in from all stakeholders. For advisory teams, this may require a more formal structure than is currently in place. It may require establishing a governing document, outlining roles and responsibilities for the team, and formalizing the review process.
Aaron stated that, “. . . as you’re looking at new opportunities to put capital to work in a portfolio, rather than thinking about filling predetermined buckets, every single investment opportunity should be weighed against what’s currently in the portfolio and what is the best opportunity.” Of course, this could lead to taking bigger bets on asset classes that look attractive and avoiding those that look overvalued.
While this makes intuitive sense and ideally should increase the likelihood of achieving client goals, it requires discipline and commitment across the firm. I asked Aaron about some of the practical challenges in implementing TPA for advisory practices. He noted that “a couple of challenges that we tend to see both at the institutional level and at the advisor level is some of that soft stuff. So, culture is one of those things. How do you organize your team when you’re a one team culture? How do you build incentives around achieving those different objectives?”
In our view, TPA should be an aspirational goal for advisory practices. The adoption of TPA will likely be gradual and may require changes in staff, functionality, and incentive structures. The idea of utilizing a broader set of tools that increase the likelihood of achieving client goals makes sense to us.
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