Shifting views on portfolio construction

The modern portfolio theory framework is now well over 50 years old. As the industry shifts from client-centric to consumer-centric portfolios, this personalisation is likely to align portfolios with investor’s goals, increasingly reflect their life preferences and serve as a gateway to rewards and benefits.

Though deemed to be 'Modern' portfolio theory (MPT), the primary framework used to construct diversified portfolios and deliver risk-adjusted investment returns is now well over 50 years old. Enhancements have helped keep MPT’s 60 per cent equity and 40 per cent bond allocation formula relevant for decades.

First, there were improvements around how to achieve diversification. There was a pivot from a top-down allocation targeting opportunistic equity and bond investments to a bottom-up style-box and then more broadly driven factor approach. For a period, a third 'alternatives' asset class joined the mix, but in recent years strategies disaggregated alternative allocations back into equities and bonds with more allocators now defining those categories as incorporating both public and private offerings.

Along the way, variations have developed in the portfolio template. Rather than allocating percentages of the portfolio across equity and bond exposures, by the early 2000s there was an emphasis on separating liquid from illiquid strategies to capture an 'illiquidity premium'. 

This was followed by “portable” alpha approaches that separated alpha-seeking strategies from broader market return-seeking strategies. Growth in passive funds and ETFs allowed for the emergence of today’s “core-satellite” approach that fully separates out beta and alpha.

VIEW ALL

View all

All these changes iterated the way that the portfolio was configured, and the types of investments chosen for it, but the purpose and nature of the portfolio itself was never questioned. The investment portfolio existed to capture the benefits of diversification and compounding to produce long-term risk-adjusted returns. This singular view of the portfolio’s purpose is beginning to change.

Shifting views on portfolio purpose

By the mid-2010s, a new view of investment portfolios was emerging. Thinking evolved in line with better computing and data-processing technologies that allowed for more flexible consideration of an investor’s goals. An investment portfolio did not need to be a singular thing that solely sought long-term risk-adjusted returns.

There could be many types of investment portfolios that could deliver an entire array of outcomes. Asset and wealth managers could deliver an entire suite of investment 'solutions' that might expand on accumulation strategies to offer income generation, capital protection or inflation protection as other options.

This idea of making the portfolio 'client-centric' as opposed to 'product-centric' continued to evolve as improved technologies allowed for democratised access to separately managed accounts, which once had been the domain of only institutions and the very wealthy. These offerings are now viable at much lower dollar thresholds. 

Investment and wealth managers can assemble a targeted solution for an investor, choosing from an expansive set of model portfolios that deliver the 'formula' for creating a portfolio—achieving its desired outcome and providing access to not just a set of funds, but the individual constituents of those funds.

Moving away from standard products to more tailored portfolios with direct access to individual securities allows for new types of client-centric optimisations. Such benefits include better managing individual tax exposures, reducing personal concentration risks and embedding new offerings such as annuity income streams. 

Market-leading technologies enable this approach and have shifted the industry engagement model so that the assembly and oversight of the portfolio is now a shared function between an asset and wealth manager.

Beyond becoming more aligned to the client, further evolution occurred in the late 2010s and into the early 2020s. Thinking about the portfolio’s purpose extended, centering on a belief that the investment portfolio could be a vehicle for achieving both financial and non-financial returns. Many of these non-financial returns were originally tied to environmental, social and governance (ESG) factors. 

Investors could use their portfolio allocations to reward companies that sought out transitions to reduce climate risk or pursued policies to improve equality and diversity. The investment portfolio could be a vehicle to help achieve 'impact', and it became possible to measure impact using new benchmarks for carbon capture or minority representation.

This view remains an important driver of portfolio construction in many regions, though enthusiasm for such goals has waned in some markets, particularly in the United States However, the concept of achieving both financial and non-financial goals by means of an investment portfolio could become ever more important in coming years.

From client-centric to consumer-centric portfolios

Today’s world is increasingly centered on the consumer. Streaming companies push series and movies based on a viewer’s demonstrated selections and preferences. Social media companies push content based on user interactions. Credit card providers and banks provide cash-back or redeemable rewards based on an individual’s spending. Companies offer loyalty points on purchases. Shopping sites use search queries and clicks to refine the goods displayed to potential buyers. Ads are personalised to reflect viewed-but-not-bought items.

Artificial intelligence (AI) is likely to accelerate this personalisation. Individuals leave sufficient data “trails” to enable AI to track and optimise interactions and content for a specific person. Most people have now experienced some version of their phone eavesdropping on their conversations and delivering information or search results that they never even requested. Personalised AI agents will make such auto-fulfillment more common. These offerings are on the near horizon and will become an individual’s unique interface to the world helping to orchestrate the content they see, items they buy, actions they take and more.

Attracting interest, getting a consumer’s attention and encouraging them to stick with you as a provider are going to become ever more important to businesses as these technologies take hold. This trend will necessitate an increased emphasis on incentives. New models are already emerging that provide clues about how such incentives may become part of an individual’s investment portfolio. 

Some examples include:

• Stock rewards: Micro-savings apps like Stash that round up the pennies on individual’s debit card and credit card purchases and invest those proceeds are already providing incremental stock-back rewards to an investor based on their shopping patterns, awarding stock from the companies where the individual shops the most.
• Token drops: Web3 decentralised apps and protocols—that require users to purchase their tokens to interact—pay rewards by means of incremental new token issuance dropped directly into the wallets of those participants that are the most active users of their offerings.
• Product access: Nike issues special non-fungible tokens (NFTs) that give owners the right to either trade the token or submit it to receive a unique pair of collectible sneakers.
• Community & event access: Ticketmaster now has a tool where event sponsors can mint their own NFTs to create exclusive communities and experiences for fans, allowing artists to offer perks like presales or backstage access to token holders.

In each of these instances, there is a direct link between the way that an individual lives their day-to-day life and their ability to benefit from the money they spend or invest.

The portfolio of the future and role of the adviser

These new models provide clues about the investment portfolio’s future purpose and composition. Just as a person might expect to earn rewards from their credit or debit card or get loyalty points from the companies where they shop, individuals are likely to come to view their investment portfolio as a reflection of their life and a gateway to rewards and benefits.

This positions the portfolio to provide not only long-term financial and non-financial returns, but short-term day-to-day benefits as well in terms of convenience, enjoyment, access and experiences. Portfolios would be increasingly aligned to both an individual’s goals and to the way that they live their lives.

Putting such a portfolio together profoundly changes the role of a wealth advisor. At one point, advisors were just brokers that highlighted stocks and bonds. Today, they are increasingly focused on a client’s overall financial health and plan, including their investment portfolio, estate plan, insurance coverage, tax management and more. If this vision for the future portfolio pans out, the adviser will become a true concierge helping clients plan, access and manage their entire lifestyle.

Nothing would create a deeper and more sticky relationship, but to get from here to that optimistic future advisors will need to adjust their approach to be not just client-centric, but consumer-centric also. This may require new types of partnerships, a broader understanding of cohorts and individual profiles and new technologies that can dynamically track and adjust offerings based on observed behaviors. If assembly remains a shared function across asset and wealth managers, this is a journey that both sets of participants will have to take together.

The challenge is hard, but the payoff would be transformational. We may truly be entering an era where we not only have more secure retirements, but better lives because of investing.

Sandy Kaul is head of innovation at Franklin Templeton.