Forget alpha and beta as the sole indicators of what should go into your clients’ portfolios. Instead think: optimization, risk and whether to incorporate forward-looking views, to name a few, a Morningstar seminar was told in October.

“We don’t just have alpha [choosing a fund manager] and beta [asset allocation] anymore,” said Paul Kaplan, director of research at Morningstar Canada. “When we do our risk budgeting these days, it has to move past that.”

He said one factor being given more consideration by asset allocation managers these days is strategic or “smart” beta, referring to the growing group of indexes and investment products that track them. But even then, he said, managers now have to include other factors as well.

Alpha and beta

But when it does come down to plain alpha and beta, Kaplan said the two are equally important.

Geoff Wilson, head of TD Asset Management’s asset allocation team, said it’s easy to get distracted by adding on factors to asset choices like smart beta. Instead, said Wilson, investment management teams need to remember their particular clients’ concerns over the long haul.

“There are a lot of intersensitive stocks [sensitive to both equities and bonds] and they can meet your long-term needs,” said Wilson. “But I think you have to bring back the idea of ‘what are my long-term needs?’ and ‘how is it best to meet those?’ So I do think there are ways to filter around what the experience is in the intermediate term as long as you focus on the long term.”

How much risk?

Michael Gates, director of the multi-asset strategies group at U.S.-based BlackRock Inc., said the decision as to how much risk to put in a portfolio is one of the most important decisions a fund manager makes when selecting assets.

Gates, who is responsible for BlackRock portfolios for Canadian and U.S. mandates, said those assets are what form the suitability decision for many financial advisors. “One of the worst things I think can happen is that investors think they’re getting A when they are actually getting B. So it’s a critical, fiduciary decision that an advisor is making.”

When Gates constructs his models, he said his responsibility is to make sure that the portfolio is transparent and that funds remain within the range clients thought they were getting. Particularly, he said, he looks at the amount of active risk investors have in their portfolios, including the higher fees that typically come from active managers.

The role of mathematical optimization – choosing the proportion of assets to achieve the best risk-adjusted return – is also a critical tool in constructing a portfolio, but it’s a dynamic process, said Wilson.

Frequently, fund managers spend a lot of time looking forward and what they believe the markets will do in the future. Some styles, he said, do better in certain environments. He gave the example that small-cap funds tend to do better when resources are in great demand, but managers need to keep in mind that if that situation reverses, managers then have to cut back on small caps.

Gates called optimization a “puzzle” and said that at the end of the day, optimization is not the ultimate way his managers choose a portfolio.

Judgment call

“That said, it is a useful tool in helping us understand the risk-return trade-offs. It helps us understand the implications of our own assumptions. But when it comes to actually picking the portfolio I think there is still going to be a judgment call” that investors will accept.

While many Canadians have a home-country bias when it comes to investing, it’s a reality that there is a heavy representation of financials and energy on the S&P/TSX Composite Index especially when compared with the S&P500, which is a highly diversified index, said Wilson. It’s important to look at what each investor needs in a portfolio overall, but he said he is also sensitive to the fact that there are an increasing number of global companies that can contribute positively to a portfolio.

Global diversification

BlackRock did a study of large asset allocation mutual funds in the U.S. and found that on average, they contain 80% U.S. equities, a number Gates said is much higher than the 50%-or-so found in the MSCI all-country world index. He said many financial advisors are concerned about allocating too many global funds to investors’ portfolios. “It’s kind of a fiscal rejection people have for a portfolio if you don’t acknowledge home bias.” However, Gates said global investing can be accomplished through a number of U.S. companies that have offices and plants outside of the U.S. and are considered global in nature.

Value creation

Wilson agreed that diversification by geography can be challenging and managers and advisors need to ask themselves whether going through with this kind of asset allocation will present opportunities or risk, noting that value creation should be the key to any portfolio.

Advisors who are moving towards fee-based practices will see that asset allocation is critical to portfolios and will need to look at any risk that stems from global diversification, the sources for these risks and the timing for the strategies, said Gates.

As well, asset allocation isn’t a one-time-only practice, said Wilson. His firm looks at where it can achieve benefits from diversification to help clients meet their long-term needs. But these requirements can change over time, so asset allocation has to be just as dynamic – by adjusting classes on a short-term basis perhaps.

Not surprisingly, he said many of TDAM’s clients want his company to better manage their portfolios so they don’t go down as much as the markets nearly as much as they want to go up when markets rise.

“They’ve always asked for that, but they want us to manage that experience more, which is really the focus of what we’re trying to do.” Wilson said managers are now looking at risks related to broader demographics, especially for retirees and how best they can weather downturns.

The biggest risk

Despite all of these added factors to alpha and beta, Kaplan said the biggest risk for fund managers is that something will happen that fund managers haven’t even contemplated.

“Could there be another financial crisis? Could there be inflation? There are a number of things that we want to be prepared for, but of course there could be something that we didn’t prepare for because we hadn’t thought about it.”