Model portfolios can provide many benefits to investment professionals. Perhaps the greatest benefit is a uniform set of portfolios that scales construction and maintenance across the client base. However, an underappreciated aspect of model portfolio uniformity is the ability to monitor performance and risk. One set of model portfolios implies return drivers, risks, and exposures are similar from client to client. Any portfolio gaps or deficiencies can be corrected, potentially avoiding a whack-a-mole approach to monitoring across custom portfolios.

Getting started with model portfolio monitoring

To fully leverage the performance and risk monitoring benefits of model portfolios, a sound and repeatable process should be in place. Breaking down the investment process into discrete steps can allow for more granular portfolio monitoring. An investor can observe the contribution to performance and risk for each step of construction, with the total portfolio reflecting the aggregated risks and performance.

The dangers of not monitoring model portfolio risk and performance include an unforeseen exposure derailing performance or increasing risk without the practitioner’s knowledge. Identifying this unintended risk becomes a near impossibility. Untangling the web of exposures embedded in each portfolio helps dial up the intended risks and reduce unintended or uncompensated risks. Applying a monitoring process to each portfolio construction step ensures each step is adding value. After all, if it’s not adding value, why keep it?

Choosing the right benchmark

The most straightforward form of portfolio monitoring is measuring performance. Performance measurement acts as a foundational element from which to build additional processes. However, before performance can be measured, there must be a suitable benchmark. There are several definitions of a benchmark, but the two most important elements are that it must be representative of the portfolio’s investment universe and the best passive implementation of the portfolio.

Working with a strong benchmark ensures that adding value over the benchmark is due to skill, rather than taking advantage of suboptimal implementation. Once the benchmark is established, the practitioner can walk through each step of the portfolio construction process to determine the most effective way to measure performance. For a portfolio that relies solely on a strategic allocation, the process is shown in Figure 1.

Figure 1: Strategic allocation

Source: Natixis Investment Managers Solutions. For illustrative purposes only.

Strategic vs. tactical allocation methods

Taking the asset allocation weight differences of each step in the investment process can give an idea of the allocation adjustments made from the benchmark weights to strategic, strategic weights to tactical, and finally, the tactical weights back to the benchmark.

Why would an investor tactically overweight an asset class that is strategically underweight the benchmark? The answer is time horizon. Shorter, tactical views often differ from longer, strategic views, and positioning can offset as these views are implemented. However, if you find that your tactical views are often offsetting the strategic views, then a revisit of the investment process may be in order. More often than not, both strategic and tactical views should be aligned.

Measuring the contribution to performance

Measuring the contribution to performance allows an investor to assess the added value of each leg of the investment process and reevaluate underperformance. Traditional attribution includes:

• Asset allocation effect: excess return via overweighting/underweighting asset classes vs. the benchmark
• Style effect: excess return via style selection within each asset class (think growth/value tilts, for example)
• Manager selection: excess return via manager outperformance/underperformance vs. its benchmark

While these buckets give a nuanced view on the drivers of performance at the total portfolio level, it still leaves the question of whether each step of the process adds value. 

For more granular views, there are software packages that perform detailed attribution analysis. The trick is inputting the correct benchmarks and portfolios to accurately measure the contribution of each step in the investment process. For instance, by including the strategic allocation as a secondary benchmark, investment practitioners can measure the contribution of each step of the investment process using attribution.

Risk driver identification

Adding a complementary perspective to portfolio performance, risk monitoring can help tease out the drivers of risk and ultimately performance. Risk analysis software has increased in popularity over the years, with both holdings-based and returns-based packages allowing the decomposition of portfolio exposures into factors.

These factors are explanatory variables that help describe what risks the portfolios’ underlying holdings are exposed to. Factors can be style driven (e.g., momentum or value); industry driven; regional, credit or interest rates; currency; and commodity. Risk factor models go beyond the traditional holdings-based regional and sector breakdowns and look at underlying drivers of risk.

Information to guide decisions

The final step in the process is using the information to make decisions. With performance measurement, this is more straightforward. Is each step in the investment process adding value? If not, is that a feature of the market environment or the result of a faulty process? To make this determination, ensuring the track record is long enough (at least five years) creates a large enough sample size to draw conclusions. To have some confidence in the process, backtesting is also an important feature.

Risk management decisions center on the dominant risk exposures in the portfolio and whether they are intended. With portfolios of active managers, the aggregated buy-and-sell decisions can create unintended concentrations in certain securities. A good risk-monitoring process should tease that out. The next decision becomes what to do about any unintended exposures. One possible solution is the introduction of a complementary strategy or manager, or a shift in the asset allocation.

No matter what the investment process looks like, a solid framework measuring drivers of performance and contributions to risk is essential. If the asset allocation is the foundation, then performance and risk monitoring compose the roof, preventing any leaks from storms that may arise.

Explore our model portfolios

Our multi-asset hybrid models combine strategic investments and active mutual funds with tactical positions and passive ETFs.