In a traditional approach to investing, commonly referred to as strategic asset allocation, Boards select a policy asset mix and asset class benchmarks. Investment managers then put together asset class portfolios that aim to add value by beating their benchmark. 

This reinforces siloed behaviour and a focus on line items versus the big picture investment objective. Further, beating a benchmark at the asset class level may contribute to, but does not define, investment success. As pension investors, investment success must be defined as being able to pay the pension promise to members as reflected by funded status.

So what alternatives exist to strategic asset allocation? A total portfolio approach. 

While a total portfolio approach may take different forms depending on the pension plan, its focus is on aligning the objectives of investment teams with stakeholder interests by incentivizing them to generate total returns at a level of risk consistent with meeting Plan liabilities. This prioritizes paying pensions over beating benchmarks. 

A total portfolio approach encourages the investment team to allocate scarce resources like risk and liquidity, in totality, to earn the returns that are needed to meet the pension promise. While the three dimensions of return, risk and liquidity are also considered in a more traditional investment approach, the investment team is constrained in respect of the policy asset mix benchmark. In a total portfolio approach, however, the Board sets the investment objective, risk tolerance, and broad asset class ranges, while management owns the asset allocation. Thus, management can move beyond just managing tracking error and have more flexibility to allocate liquidity and risk to where the best investment opportunities are, given the prevailing investment environment. A total portfolio approach is less static.

Here are some thoughts on how we are implementing our own take on the total portfolio approach at OPTrust. Some of this is in practice already, and some is where we are aiming to go:

1. Our primary objective is not to match or beat the return on a traditional policy asset mix, but instead to design the total portfolio to deliver on our pension funding objectives at an acceptable level of risk. We construct the asset mix with our liabilities in mind and have the flexibility to adjust it as our Plan position and market conditions evolve.
2. The focus of portfolio construction is to efficiently allocate scarce resources, namely liquidity and risk, to assets and strategies that, when combined all together, provide the best possibility of achieving our investment objective. We begin with illiquid assets – where we believe we have the best potential for value creation – and augment these exposures with liquid assets and strategies to achieve our desired total portfolio risk-return profile. 
3. Each asset or strategy is assigned to a specific sub-portfolio that has a well-defined purpose, allowing investment teams to see how their decisions contribute to our total fund objectives.  For example, we manage the sensitivity of our liabilities to interest rates using a customized Liability-Hedging Portfolio. It is designed to perform well against our own liabilities, not a generic bond index benchmark, and its success is measured accordingly. Our Return-Seeking and Risk-Mitigation Portfolios also have customized design objectives that contribute to our overall goal of delivering the returns we need to pay pensions in a risk-efficient fashion. 
4. We look at a variety of metrics to gauge our performance and, while index benchmarks can be helpful references in some cases, we place a greater focus on total fund metrics like our funded status and performance compared to a simple, passive, low-cost reference portfolio of comparable risk. We develop customized metrics that are fit for purpose and align with the specific objectives of our sub-portfolios, i.e., liability-hedging, return-seeking and risk-mitigation, and believe these are much more relevant and insightful performance indicators than asset class benchmarks.  
5. Risk factors, the underlying drivers of risk-return across asset classes, can help us see where risks may be concentrated. Real estate, for example, has both equity risk and interest rate risk, in addition to its own idiosyncratic factors. It’s important to look-through our asset classes, in a total portfolio context, to assess their underlying return drivers and manage them appropriately. A total portfolio approach enables us to better manage risk factor exposures across the fund in response to market conditions without being distracted by tracking error constraints. 
6. A total portfolio approach helps us break down silos and encourages collaboration across teams. There is less of a tendency to hoard allocations. Further, with a total portfolio approach, good investment opportunities that don’t fit neatly into traditional asset class buckets are less likely to be overlooked, as would often be the case in a traditional strategic asset allocation framework.  

We believe that Plan members are best served with a total portfolio approach that closely links the objectives and incentives of our management team with their interests: delivering Plan sustainability. Ownership of total portfolio returns and risk – instead of relative performance against a policy mix – changes the behaviour of an investment team in ways we believe are accretive to the long-term funding success of the Plan, and in service of our members’ interests.