Hello and welcome back to the Institutional Beat podcast, where we cover interesting and relevant topics for institutional investors. My name is Julie Ducharme. I'm a portfolio manager on the PH&N Institutional team, and I'll be your host today. Now today we've got a topic that I think is going to be of interest to a lot of listeners. Well, in fact, I'd be hard pressed to find an institutional client that wouldn't take something away from today's topic, because we're going to unpack two investment decisions that all investors routinely grapple with.

First one is coming up with a policy asset mix, and then, selecting funds to implement it. And the million-dollar question that we're putting to the test here is, does one matter more than the other? And joining us today to tackle this is my colleague, Joanna Mejza. She's director of Institutional Portfolio Solutions, and the co-author of a recent article that takes a fresh take on this exact question.

Joanna – welcome to the show.

Thank you, Julie. It's great to be here.

So before we dive into the specifics of this research, I think it'd be worthwhile if you could give our listeners just a brief overview of what the Institutional Portfolio Solutions, or IPS team, does for our clients, our institutional clients at RBC Global Asset Management.

Yeah, absolutely. Institutional Portfolio Solutions or, IPS for short, is essentially our internal investment consulting team. We handle the portfolio modelling, research and development, and thought leadership that helps guide strategic client advisory. I really like to think of my team as sort of, problem solvers. Investors come to us with unique goals, various constraints, and the need to make decisions in the face of uncertainty. Our role is to help them work through all of that, to quantify and understand the trade-offs involved, and ultimately, hopefully, find solutions that best align with their goals.

Yeah, and having personally problem solved with our clients using your team’s support, IPS’s support, you know, I can vouch for that – that it's like having our own personal investment consulting SWAT team on call. And you generate a lot of our thought leadership within your team. But recently you've  raised your game even more, by starting a broader initiative called IPS Insights, and this article is the first published installment. So, can you explain why you started the IPS Insights?

Yeah, of course. As you can imagine, we work on a lot of different projects and see a variety of investor situations, and this gives us a unique perspective on what institutions are dealing with. Often we see common threads, like several pension plans looking at similar de-risking strategies. And when that happens, it tells us others are probably asking the same questions.

Yeah.

So IPS insights is a way for us to take those observations and share them on a larger scale.

Yeah. So not something that's going to come out on a quarterly basis, but rather when new and interesting trends are emerging and you feel that it's important to dig into them. Well, so let's do that, let's talk about your inaugural publication. For listeners, they can look at the description of the podcast, and you can see the link, to the paper that's available on our website.

It's called A New Perspective on the Importance of Different Investment Decisions. Why did you choose to tackle this topic?

Well, we decided to revisit this topic because there is a sort of adage in the industry that 90% of a portfolio's performance is driven by asset allocation, which implies that asset mix decisions are far more important than fund implementation decisions. And since this idea probably shapes how investors approach their decision making, we wanted to take a closer look at this belief.

We wanted to understand where it comes from, what the evidence says, and whether it is as cut and dry as its frequent use would suggest.

Yeah, and I'm glad you did because, you know, as someone like me who's been in the industry for a long time, and I've seen what active management does to the overall plan return, I've naturally questioned this 90% figure. But I will admit it's been a pretty useful argument on several occasions where we want to help institutional clients focus, you know, really pay attention to the importance of long-term asset mix because it's so critically important to get that right, but it's very easy for committees to get swept up in constantly doing investment manager finalist roadshows, right? So, that balancing act has been challenging. But tell me, how did you go about it and how did you tackle the research?

Our first step was, tracing the origin of the claim. And this led us to a paper published almost 40 years ago. The authors were actually motivated by a very practical observation: They had noticed that many of their institutional clients were spending most of their time and effort selecting investment managers.

Yeah, not surprising.

And very little on their overall asset mix. So, their goal was to measure and compare the impact of those decisions. And their analysis resulted in the now famous 90% figure, or 93.6%, to be precise. It was a significant finding for its time. But as we dug deeper, we found several other papers that had revisited the question. And sometimes they reached very different conclusions.

Right. So we've been quoting this 90% figure for four decades now. But you're suggesting that this figure, this 90%, might not be as definitive as it's often taken to be.

Yeah, exactly. There was actually quite a bit of a debate in the literature, and I think the number was so high that it really caught people's attention, and some were skeptical. So of course, they tried to replicate it or challenge it. And several critics ended up finding figures that were significantly lower. So this made us curious; what would we find if we did our own analysis?

Obviously drawing inspiration from past studies, but also adapting our approach. For example, reflecting how much the investment landscape has changed since then. And we see that evolution firsthand when working with our clients. Fifteen years ago, asset mix modeling was mostly about high-quality bonds and large cap equities.

Now the conversation covers so much more. It includes global credit, a wider spectrum of equity opportunities, and an-ever evolving universe of alternative strategies.

You know as I'm listening to you and I'm thinking about this 90%, I'm wondering like, why didn't I question that paper, myself? So, it's interesting how there's been all this, competing research on it, but we still hang our hat on that 90%. So tell me, how did you how did you refresh the analysis? How did you tackle it?

Well, we realized that much of the disagreement was on the way the investment decisions were measured. Not for fund implementation, where you just compare manager returns to their benchmark, but for asset mix, where the baseline is less obvious. The original study, for example, effectively assumed cash as the benchmark – they framed the asset mix decision as a choice between investing, or not.

But critics argued that this isn't a reasonable assumption, because institutional investors need to invest their assets. A more meaningful comparison would be between the portfolio they select and an alternative one, like an equity index, or maybe even the average asset mix of their peers. And naturally, depending on which baseline you use, you end up with very different results.

Right. And I've never worked with an institutional client that had cash as a benchmark, so it seems natural to question that. But if there's no consensus on the baseline for the asset mix, you know, how do you get around this in doing your analysis? Because you have to kind of anchor it around something. Did you use, you know, buckets of different investor risk profiles? Like, what made sense here?

Well, the more we thought about it, the more we realized that a single, universal benchmark is simply too limiting. It would mean that for example, a pension plan and an endowment  –  which have very different return objectives, risk tolerances, time horizons, constraints, etcetera  – they would be evaluated in exactly the same way. Which in our mind, is unrealistic.

Completely unrealistic, yeah.

Yeah. Think for example, of a closed, mature, pension plan in de-risking mode, versus an endowment with a long horizon focused on capital preservation and ongoing disbursements.

Right.

Their objectives and constraints are simply not comparable. So, a sensible baseline would need to somehow incorporate investor-specific circumstances, and this led us to the concept of a reference portfolio.

Well, I'm so excited we got to this part, because I think this notion of a reference portfolio is just too underused in our industry. And I think that's where we're going with this conversation. So for the benefit of our listeners, I'd like you to explain the significance of a reference portfolio, because I know it's a concept that's used by some very large, very sophisticated investors.

If we think of, say, the Maple Eight pension plans, some of them use it. But can you, for our listeners, can you spell it out in a little more detail? Because it's not widely adopted by our regular institutional client base, and certainly not commonplace in the industry right now.

Yeah, so the concept of a reference portfolio is actually attributable to CPP. But, as you said, it's mostly used by large institutions, like the University of Toronto Endowment and PSPP. That said, the idea can be useful for investors of all sizes. Essentially, every institution has a long-term return target and risk tolerance for its invested assets.

And a reference portfolio is the simplest, cheapest, and most liquid portfolio of stocks and bonds that reflect those objectives. So, in other words, it's the investor's goals mapped into a plain vanilla portfolio. For example, the base CPP is 85% equities and 15% bonds, while the University of Toronto's is closer to 60/40.

Okay, but if you have so many different investor schools, in fact, all the investor schools will be unique to them. Just in the example you gave, you’ve got CPP with 85/15 versus University of Toronto, which is 60/40. How do you incorporate a reference portfolio into your analysis?

Well, to really understand the impact of asset mix versus fund implementation decisions, we first needed a way to clearly separate them. So we developed a three-layered framework made up of three distinct portfolios. And the first layer is the reference portfolio. It represents each investor's desired risk/return profile, and it serves as the foundation, and it's unique to every investor.

The second layer is the policy portfolio. It reflects all the asset class and allocation choices that build on, or differ from the reference. And finally, the third layer is the total portfolio. It shows how the policy is implemented through choices like active management and manager selection. And this setup makes it easy to isolate the two types of decisions.

When moving from layer one to layer two, we capture asset mix decisions, and when moving from layer two to layer three, we capture fund implementation decisions.

Right, which makes complete sense. So now you've created a structure that allows you to break down those two different types of decisions that a committee would be responsible for, and be able to measure themselves against. So take us a little further into the analysis and, and how you solve for it.

There was a lot that went into the analysis, from the data handling to the methodology and assumptions we used. But there was also another dimension we wanted to account for. Recall that, our premise was that every investor is different, and we wanted to reflect that reality into the analysis. So to do this, we built a range of risk/return profiles and different opportunity sets to see whether those differences would actually change the results.

So as I said, there were a lot of moving parts. It makes for a good reading, or so I like to think, but maybe not the most exciting podcast material. So I think that for today's conversation, it's probably best to stick to what really matters, the findings, and what they mean in practice.

Yeah, I think that's a good idea. I mean, for those listeners who are disappointed that we won't be getting into the formulas in technical details, I'd encourage them to go and read the article for themselves. But for the purposes of our listeners today, how about a summary of what came out of this work and what we should take away?

Interestingly, we found that which decision is more consequential – asset mix or fund implementation – it really depends on the investor's unique circumstances. And three factors really stood out. So, I'll just list them. First, their risk/return objectives. Second, the range of asset classes they choose to invest in, or their opportunity set.

And third, the alpha and tracking error profile of their investment managers. So to illustrate, let me just give you an example. When an investor has a larger and more complex opportunity set, asset mix decisions can have a big impact. But having access to that broader opportunity set also tends to increase the potential effect of implementation decisions. For better or worse.

And the relative importance shifts depending on how these factors combine. And with so many moving parts and so many variations across investors, we think it shows that there is no single number that applies universally, whether it's 90% or anything else.

Okay. So the answer is, it depends. But you give a lot more detail of course, in the paper. But in summary, you're challenging this long-held adage that asset mix is overwhelmingly more important than fund implementation. And if anything, there's equal reason to look at both. Is that a fair observation?

I think it simply challenges the one-size-fits-all view on investment decisions. In some cases, asset mix will be more important, but, in others it won't. And that said, an investor cannot know the outcome in advance. So in our minds, focusing on a number can be a bit of a trap. Instead of trying to rank investment decision by importance, best to treat them as equal. Which is our paper's conclusion.

Great. And it does it does that mean that our clients have to kind of rethink how they're…I'm just trying to think through here, like, what does that mean for our investors, practically speaking? Should they be changing the way they make their decisions or how they come to setting policies? If they want to kind of consider some of the recommendations in this paper?

We think investors should focus on understanding what drives the impact of their investment decisions, and which factors can make the biggest difference in their own context. But maybe even more importantly, it's about having a strong governance framework around those decisions. Something that allows them to be measured, monitored, revisited with equal attention. And our approach offers a practical way to do just that. Helping investors spot issues early, take corrective action, and keep improving over time.

And as fiduciaries, that allows them to also really assess their effectiveness, not only at implementation, but also on those strategic calls they've made at the asset mix level and really measure that success over time. So let's say our listeners and our clients want to follow or maybe adopt some of this framework, and put it into practice.

It would require implementing or working with a reference portfolio. We know that some institutional investors, most of the large ones, are using this today. How realistic is it for our, you know, everyday clients of different sizes and backgrounds, to implement this? You know, to me, it looks like a pretty straightforward exercise, but is this something that your team has, has helped with in the past? And is this something that you can accompany our clients with, down the road?

We can definitely help clients with that. Whenever we engage with an institution, we start by really understanding their objectives and the constraints they face. From there, we look at potential asset classes, run the modelling, and refine the results so they actually work in practice. It's a back-and-forth process. We listen, we guide, and we help them make decisions.

So if an investor wanted to adopt a reference portfolio as a starting point, we could easily build that into the process and tailor it to their needs. That way, investors can see not just the value added by their fund selections, but also how effective their asset mix decisions really are.

And I think that really bolsters or improves the overall governance of those assets and of those plans, that they oversee. Thank you, Joanna, this is so interesting, thanks for sharing all this analysis with us. You know, it's so nice to flip these long-held concepts on their heads and look at the world from a different perspective.

You know, as a fiduciary, it's easy to get caught up in implementation. But to keep that high-level perspective and long-term strategic asset mix and to be able to measure your committee's success at it, I think is the real food for thought here. You know, I suspect that my more curious clients are going to welcome this discussion.

And whether it's working directly with them or alongside their consultants, in this consideration of a reference portfolio to quantify what they've been told is the most important part of a plan's return volatility over time, is going to be interesting. I'm really looking forward to dosing that part of the decision making with the same attention that's warranted with implementation.

So thank you so much for unpacking this for us, and for spending the time with us today, Joanna.

It was my pleasure. Thank you.

So that wraps up today's episode of the Institutional Beat. If you enjoyed this episode, please don't forget to subscribe to the podcast so you can listen in on future episodes.