Portfolio construction needs overhaul

The traditional method of portfolio construction should be abandoned, as it has difficulty accounting for global equities, private equity and real estate, cannot handle some asset classes such as options, and is unsuitable for retirement strategies, leading portfolio strategist Randy Lert has asserted.

Lert, who is Russell Investment Group’s chief portfolio strategist, told delegates at the Portfolio Construction Forum in Sydney recently that the traditional method for choosing assets that maximise expected returns at a level of risk acceptable to the client was no longer appropriate in most cases.

“The traditional model continues to be stretched with implementation issues,” Lert said.

“Changes in the way investors thought about global investing had challenged the model.

“There has been a shift of paradigm from ‘How much do I invest outside my home market?’ to ‘How do I get the best stock portfolio irrespective of company domicile?’”

Lert warned selecting the best assets in each national market would not necessarily produce the best global portfolio, and few current products were based on true global research.

He said asset classes such as private equity and real estate were also difficult to include in the model because their volatility could not easily be assessed, as they were traded infrequently.

Assets with absolute-return oriented strategies and options were also difficult to incorporate, he said.

Another key shortcoming of the model Lert highlighted was its focus on accumulating wealth, and inability to cater for the ‘decumulation’ of assets that occurred in retirement strategies.

He suggested a better alternative for retirees was “dynamic hedging”, with the cost of a lifetime annuity modelled as the “fail safe” wealth level that has to be maintained. He said this would change the portfolio construction problem to an “asset/annuity optimisation” problem.