Understanding the drivers of your portfolio risk and return, and then using that information to more dynamically adjust the portfolio, is one of the benefits of the total portfolio approach according to CPP’s Manroop Jhooty, whose total fund management team is exploring whether to include emerging factors in portfolio design.
CPP Investments has been debating what “emerging factors” it might consider alongside the macro factors such as growth and inflation that it uses in its total portfolio approach to design and implement optimal portfolios.
CPP Investments senior managing director and head of total fund management Manroop Jhooty tells Top1000funds.com that one of the advantages of the total portfolio approach (TPA) is the ability to look at emerging factors that can impact the return and risk of the portfolio. Geopolitics and climate change are two examples, with the fund using scenario-based testing to inform adjustments to the portfolio on a tactical, or even strategic, basis.
“When we think about geopolitics and climate change, one of the advantages of a TPA approach is you have the ability to factor-in emerging factors on top of the more foundational fundamental factors that can impact return and risk to your portfolio,” Jhooty says.
“Climate is one area still under development and we spend a lot of time thinking about that, getting the right data and the mechanism you want. We are thinking about transition scenarios, physical and transition risk to the future value of the fund.”
Jhooty says geopolitics is similar and the team uses scenario analysis to test different theses.
“Everyone knows the hotspots, the difficulty is ascribing risk premia to it,” he says.
“We do scenario-based testing and shock the portfolio. We look at prior geopolitical situations, run scenarios and use those to circle back and inform using judgement to adjust the portfolio on a tactical or strategic basis.”
Jhooty says the team has been debating recently what other emerging factors might be through which the portfolio should be assessed.
“How much of performance in markets is trend or momentum, or is there an emergence of a factor?” he says, pointing to AI as one possible example.
“Clearly it is a big driver of growth and a contributor to the appreciation of equity values in the US. You can argue it’s a trend but it is also structural in the way the economy is orienting itself and operating in the future, so it could be an emerging factor, potentially, because of a structural impact on the market.”
At the moment CPP looks through the lens of growth, inflation, discount rate on cash flows and risk premia which it believes are the primary drivers of valuation.
“We believe all valuation is based off cashflows, and they are a function of growth, inflation, discount rate on cash flows and risk premia of the asset. Every company and asset has a loading through that because of how we think about valuation,” he says. “We try to be as balanced [as possible] across the macro factors so we are not over exposed to one factor or another.”
Risk concerns
Right now, Jhooty says the team is thematically concerned about the impact of inflation on stock-bond correlations.
“Inflation volatility has translated into real rate volatility and the impact from a policy impulse perspective has changed stock-bond correlations and resulted in us wanting to double click,” he says. “Do we have a different regime we need to be conscious of? Arguably with inflation and the policy impulse, that relationship has changed. We are asking is it temporal or structural?”
Jhooty also says that fiscal tailwinds driving equity markets have continued to be positive for growth but are arguably not sustainable, so the team is spending time thinking about how fiscal policy might evolve and the implications of that.
“We are keeping a close eye on that in terms of a second layer of risk we are concerned about,” he says. “The market to a large extent has been narrow to a subset of names and to the US. Europe and Japan are doing well now so we are looking to understand the degree to which the narrowness will eventually revert. The US and a subset of names have been a large driver of returns.”
The benefits of TPA
Jhooty heads up the total fund management group for the C$625 billion ($457.4 billion) fund, which has two core functions: portfolio design, including target exposures, leverage and liquidity; and then implementing against those targets which includes management of balancing portfolios, financing portfolio leverage and liquidity and some tactical management.
The fund uses a total portfolio approach which allows design and implementation to be viewed through risk drivers and macro factors and then the rebalancing and management of liquidity and leverage to all sit in one team of 120 people, at the top of the house.
“Integration of the design to the execution in a single department creates a lot of synergies,” Jhooty says. “The people sourcing the exposures and the assumptions we are making with the portfolio are together.”
At the core of the TPA is bringing risk and return to the centre of the discussion and moving away from benchmarks. Instead of benchmarks, CPP employs an attribution mechanism to evaluate the portfolio choices made around risk and return.
“We look at each of those decisions and how they have performed on an ex-post basis,” Jhooty says. “Did we set the right risk targets? When we chose the right macro factors did we choose the right set? There could be a thousand portfolios to choose from that have a risk equivalency of 85:15. We made a portfolio choice at that time, so we try to extrapolate the other choices and how did our portfolio choice perform. It provides a lot of value to show the effectiveness of the process and decision, but also a mechanism to challenge your beliefs and assumptions.”
While the investment allocations may not look that different to other asset allocation approaches, Jhooty says the value comes from the ability to know where your risk and return is coming from, and the drivers. That information can then be used to more dynamically adjust the portfolio.
TPA requires a high degree of modelling the portfolio and that does create complexity and tradeoffs. But the benefits outweigh the complexity, according to TPA buffs.
“With SAA you don’t have those levers because you’re thinking in the asset space not the risk and return space, so you get a greater degree of control and ability to pivot the portfolio,” Jhooty says.
“This puts a greater emphasis on relative value. You’re not just trying to beat your benchmark in an asset class, but can look at the impact of a marginal trade in a more deliberate way. Those decisions and the dynamism from TPA are where the value comes in.”
