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(Pictured: Ben Griffiths)

Institutional investors should revisit their approach to constructing equity portfolios in order to take advantage of innovations in the industry, according to a report in Towers Watson’s new publication: Equity investing: Insights into a better portfolio.

The report notes that investors have been diversifying away from equities in recent years, yet insists that the equity risk premium remains an important driver of returns.

According to Towers Watson, the building blocks of equity portfolios have evolved beyond market cap-weighted passive equity and active management. Now a third pillar, smart beta, targets systematic factors, non-market cap stock weighting or thematic investment opportunities, to capture particular premiums, typically at very low cost.

Ben Griffiths, head of Australian equity manager research at Towers Watson, said: “Developments in equity markets and the industry have added complexity and breadth, in terms of available products and portfolio construction tools. It is no longer sufficient to have an allocation to bulk beta and one or two active managers to construct an equity portfolio. The onus is now firmly on the asset owner to develop their own portfolio construction skills, or partner with someone to get access to these skills.”

Asset owners must be adept at manager selection, as well as portfolio construction, in order to identify skilled active managers from a universe of many thousands of competing products. A core principle is to make sure active managers are best in class and providing differentiated strategies which cannot be replicated more cheaply elsewhere using smart beta. Asset owners should introduce new channels for risk and reward, for instance through the implementation of long-short alongside the long-only portfolio, or more activist strategies.

Griffiths said: “We are open minded about where to look but often the best specialist equity managers are found in boutiques established to provide greater focus. In some cases, they may be managing money for high-net-worth individuals or running hedge funds. Often the mind-set or skill-set of these investors is different. For example, high-net-worth managers tend to think in terms of absolute return rather than relative to market indices.”

Investors targeting high levels of expected excess returns through active management may want to consider amplifying niche strategies through highly-concentrated (10-20 stock) mandates within an equity portfolio, comprised only of the active manager’s best ideas.

Studies have shown that portfolio managers often add value in their high conviction stock picks but destroy value with the unintended underweight positions in the portfolio. Having more concentrated portfolios with assets focused in the managers’ highest conviction ideas should offset unintended underweight positions and lead to better outcomes.

Griffiths said: “In a highly competitive world, we believe asset owners should simplify their strategy (for example, go passive) or raise their game, in order to deal with this complexity and benefit from it. Whilst there are greater expected rewards from the latter approach, it requires more internal governance and portfolio construction skill from the asset owner and therefore may not be suitable for everyone. Asset owners should determine what level of complexity is appropriate, given their requirements and their governance levels.”