The Key Pillars of Portfolio Construction

What should the objectives of the fund be?

What is the objective of a pool of available funds? Who is the Investor or Asset Owner? What is their investment horizon?

Once we have a good and clear understanding of the purpose of the investment as well as some underlying characteristics of the asset owner, then we can start putting together their broad risk/return profile which will help us identify the appropriate asset allocation strategy.

What is the strategic asset allocation (SAA)?

This is the core structure of a portfolio, it is put together based on the objectives of the fund, which should have already been established. 

It is a long-term decision, with adjustments made on the asset allocations every 3-5 years as underlying considerations change.

Traditionally, the SSA would follow a format of 40% bonds and 60% equities, the idea being that equities do well when the market rallies and bonds provide protection when the economy weakens. 

Due to current economic conditions, this traditional split of 60/40 has changed, with alternatives now typically being included in the SAA. 

What is the tactical asset allocation (TAA)?

The SAA establishes the long-term investment plan, however during the more medium term geopolitical, economic and business cycles impact financial markets and therefore the underlying asset classes. The purpose of the TAA is to capture some of those interim market moves and adjust the portfolio to reflect those views. 

What is the purpose of benchmarks?

A benchmark is a standard against which the performance of a security, fund or portfolio manager can be measured. They guide the portfolio manager and allow for sponsors to assess how well the PM has done. 

The portfolio is compared against its benchmark to assess the risk/return characteristics and differences between the two. 

There is a benchmark available for every type of investment strategy or asset class. For example, the S&P 500, the FTSE 100, or even cash indices such as SONIA.