Introduction
The aim of portfolio construction at Partners Capital is to eke out every ounce of investment return possible for our clients while adding the least amount of risk to the overall portfolio as a result. There is no such thing as "absolute returns" if this means returns without risk. Investing is about being paid for taking risk, but not all risk pays the same returns. At different points in time, we will get paid different amounts for providing equity capital to companies (equity risk), lending to governments, companies and individuals who may default (credit risk), lending long term for a fixed nominal return while real returns may be at risk (duration or interest rate risk) and for holding assets that deliver real returns while running the risk of low returns in a deflationary environment (inflation hedging risk). The most critical decision in portfolio construction is budgeting allocations to these different risks based on expected future payments for taking those risks. A keen understanding of macroeconomic circumstances and their impact on these risk premiums is required as the starting point for portfolio construction.
This is referred to as asset allocation by more traditional investment models or "risk budgeting" by more contemporary models. The so-called endowment model may lock into a long term asset allocation and ignore short term pricing of risk in recognition of the difficulty of timing market price moves in the short term, creating a limitation in the model. We sympathize with the degree of difficulty, but we have strived to put processes in place with client portfolios that we believe give us the agility to exploit extreme moves where pricing falls well out of line with historical price and risk relationships, as we saw with credit in early 2009, for example. Such opportunities are rare, but often define portfolio performance.
Another potential weakness in the endowment approach to investing is that it starts with asset allocation and slavishly seeks to fill each asset class bucket with what they hope to be the best relevant asset managers to be found. We turn the process on its head and start by building the portfolio with what we believe are the best performing asset managers in absolute terms regardless of asset class, and then achieve our asset allocation targets by filling in the gaps (or decreasing the excesses) with low fee passive instruments, such as ETFs and futures. Absolute performance is defined as performance not generated from simply taking market risk, but rather skill based performance (so-called "manager alpha").
Manager sizing is another critical decision in portfolio construction. We generally seek to substitute market risk for manager concentration risk in the belief that Partners Capital can identify and access some of the best asset managers, including those, in particular, whose returns are not dependent upon market direction.
Asset Classes
We engage in passive and active fund or manager investments. Low cost passive exposures are deployed in the most efficient asset classes where we believe manager outperformance is unlikely to occur on a sustainable basis, including fixed income, large-cap developed market public equities, commodities and inflation-linked bonds. Over the years, we have built up a strong community of over 100 outperforming active asset managers across the following asset classes to complement our client's passive investments:
- Public Equity: This includes specialist managers who manage their portfolios to have 100% equity exposure, who vary between 0% and 100% exposure or who have a variable bias and so can be short the market. Most specialize in a geographic region and many have sector focused strategies as well.
- Active Fixed Income & Credit: This includes specialist managers who employ strategies in the corporate debt or credit markets including investment grade bonds, convertible and high yield debt, bank loans and mortgages. Most government bond exposure is passive.
- Absolute Return: This includes specialist managers who employ strategies which are not dependent upon taking market risk (whether it is equity, credit, interest rate or other market risks). Strategies tend to exploit relative mispricing opportunities including market neutral equities, fixed income relative value, managed futures, macro, multi-strategy, dynamic credit and merger arbitrage strategies.
- Private Equity: This includes generally illiquid investments with specialist managers who are experts in, for example, small/midcap buyouts, specialist sectors, distressed opportunities (including debt for control), turnarounds, growth capital in emerging markets, venture capital and secondary opportunities. We generally do not invest in large or mega-cap buyout funds.
- Real Assets: This includes specialist managers who are experts in, for example, core, value added and opportunistic real estate investing, land aggregation, zoning and development, distressed real estate, real estate debt related opportunities (including mortgages), commodities and inflation linked bonds. Most commodity and inflation linked bond exposure is passive.
Risk Management
The overall process of portfolio construction constitutes "risk management" in Partners Capital parlance, but the essence of risk management is knowing what risks are being taken at any point in time. The greatest risk associated with multi-asset class, multi-manager models is the potential for suprises in the underlying components. At Partners Capital, the assembled portfolio of what we believe to be best of breed active asset managers and low-cost passive market exposures are closely monitored on a look-through basis to the underlying manager positions to the extent possible. This enables us to closely monitor total-portfolio look-through exposure to various risks including specific geographic markets, sectors, and instrument types. Through various portfolio overlay strategies, we seek to mitigate any risk excesses or shortfalls identified. Through close asset manager strategy monitoring, we seek to identify when managers deviate from past areas of strength or otherwise alter their strategies, team or processes, and we redeem where we judge appropriate.
Risk & Return Targets
Different clients seek different levels of risk. The bulk of the capital we advise is focused on long term capital appreciation and is able to accept risk to achieve growth. In practice, this generally sees our client portfolios embedding risk similar to that of a portfolio that is 50-60% equities and 40-50% government bonds; in other words, relatively moderate risk by institutional investing standards. Against this moderate level of risk, we aim to achieve equity market levels of returns over the long term.
Investment returns will fluctuate with market conditions and every investment has the potential for loss as well as profit. The value of investments may fall as well as rise and investors may not get back the amount invested.
