Considerations for implementing the total portfolio approach to portfolio construction

More large asset owners—including sovereign wealth funds, pension plans, and diversified growth funds using multi‑asset strategies—are exploring the total portfolio approach (TPA) for asset allocation decisions.¹ In contrast to the more traditionally used strategic asset allocation (SAA) framework, which more heavily relies on setting a portfolio policy and fixed asset class benchmarks, the TPA emphasizes flexible, objective‑driven allocation managed by integrated teams. This philosophy aims to align portfolios more directly with an investor’s objectives and may offer increased adaptability to changing market conditions.

The SAA framework has long been the foundation for portfolio construction, offering clear accountability, prespecified benchmarks, and strong governance through asset class silos. However, the post‑COVID era—marked by rapid changes in inflation, interest rates, and geopolitics—has revealed some possible limitations in the SAA framework’s responsiveness; limitations that investors believe a TPA could possibly solve. Is that true?

What is the the total portfolio approach?

The TPA is a holistic, objective‑based investment framework that evaluates an investment portfolio relative to a desired outcome rather than against traditional asset class benchmarks. It emphasizes a more integrated and flexible approach to asset allocation and risk management, potentially allowing for dynamic adjustments in response to changing market conditions and investor objectives. While there are various forms of TPAs, generally they have the following characteristics:

• Focus on outcome‑based objectives from a total portfolio perspective
• Dynamic, flexible allocation
• Integrated decision‑making across the portfolio
• Independence from specific benchmarks and asset classes for portfolio evaluation

When might a TPA appeal to investors?

A TPA may be considered by investors whose objectives cannot easily be represented by a policy benchmark. For example, U.S. foundations with a 5% payout mandate may seek to preserve real portfolio value, which is difficult to identify through market benchmarks. In this example, an investor implementing a TPA may reference consumer price index (CPI) + 5% as the investment guideline. An investor adhering to an SAA framework would likely also consider CPI + 5% in the portfolio evaluation but would make some assumptions about the capital markets—hypothetically, a long‑term inflation rate of 2%, nominal equity return expectation of 10%, and a bond return expectation of 4%—to arrive at a policy portfolio of 50% stocks and 50% bonds. A TPA may be of interest to investors who prefer not to use that type of neutral portfolio as a starting point for their investment decisions.

A TPA may also be considered by investors with the skill and governance flexibility to dynamically reallocate capital in response to changing opportunities. In theory, an investor with a high tracking error budget could pursue similar strategies with a combined SAA + tactical asset allocation (TAA) framework. However, in practice, many SAA‑oriented processes often lack this nimbleness due to asset class governance silos and continue to own assets that have an unpromising outlook. A TPA process is often designed to support regular evaluation of each asset’s role within the portfolio in pursuit of the desired outcome.

What are the key implementation considerations of a TPA?

Belief: For the governance model and decision framework to add incremental value over an SAA‑based process, investors adopting a TPA may need a strong belief in the merits of a more dynamic asset allocation process. TPA investors must believe that the combination of the statements below holds true.

• Market environments change significantly, and rigid asset class structures are not well positioned to adapt to these dynamics.
• Such changes in market environment may be identifiable by well‑informed investment decision‑makers.
• Investors (internal and external managers) have the skills to make these assessments well.

The TPA as an investment framework may support intended outcomes if the above beliefs do materialize within the investment organization. However, on the flip side, the framework is unlikely to improve portfolio outcomes materially should any of these assumptions turn out to be incorrect.

Governance: Due to the unanchored nature of decision‑making and execution, TPA investors need substantially different governance and organizational structures than SAA investors. Traditionally, investment boards set the SAA framework objectives and delegate their implementation to specialized asset class teams. Under the TPA, the authority to dynamically allocate capital shifts to the chief investment officer (CIO) and/or an integrated investment team, who are responsible for both asset selection and allocation at the total portfolio level and are empowered to act more nimbly when investment regimes change. The role of the board then also changes from focusing less on asset class decisions and performance monitoring to focusing more on setting overarching portfolio objectives (e.g., return targets, risk appetite, liquidity needs) and monitoring portfolio adherence to these goals. In other words, the different levels of authority/flexibility in tactical adjustment could be viewed as the key difference between an SAA framework and a TPA.

Potential different governance structures between an SAA framework and a TPA lead naturally to decisions regarding investment team setup and the skill sets required. For a TPA, as the portfolio‑level objective is only defined at the highest level, its outcome depends on breaking down asset class silos. This requires reconfiguring teams to work collaboratively—often around risk factors like credit, duration, and liquidity, rather than around asset classes.

Implementation and liquidity: Given the adaptive nature of a TPA, it is important for assets in the TPA universe to be liquid and easily tradable to allow for timely reallocation. Otherwise, prolonged divestment periods may cause potential new opportunities to reprice prior to reinvestment. This is the theory, though. In practice, some TPA strategies nevertheless make allocations to private assets. This creates a challenge for TPA implementation where liquidity mismatch across assets may limit the reactive feature of the TPA. A key question for investors looking to implement a TPA is how to incorporate investments with long capital commitments and payback periods, such as those with a J‑curve effect or potentially value-destructive transaction costs. While choosing liquid or passive investments might seem like a quick solution, that could restrict the investment universe and undermine the TPA’s ability to meet its desired objectives.

"...a TPA investor could allow for more granular risk management...."
Thomas Poullaouec, Regional Head of Global Investment Solutions, APAC

On the other hand, a TPA could potentially aggregate assets with different liquidity profiles through the same lens. Instead of evaluating public and private assets separately, as an SAA framework investor would typically do, a TPA investor could allow for more granular risk management and risk premium distribution across public and private investments, even if the overall allocation stays static.

Accountability and performance attribution: One of the key strengths of an SAA framework over a TPA is that its hierarchy structure allows performance measurement and attribution more easily. If an investor accepts an SAA framework, attribution becomes mostly an exercise of evaluating performance against the relative benchmark. This same process can occur at the asset class level as well. This helps determine and attribute performance from a TAA framework or active management at the underlying asset class level. With a TPA, the performance evaluation focuses on whether the portfolio achieved its overarching objective with a less clear process for determining the point in the investment process that caused outperformance or underperformance. There are two essential challenges in this regard:

• Longer evaluation periods needed: The impact of the TPA may be more observable over multiyear cycles, which can make it challenging for boards and stakeholders to assess skill or outcome in the short term.
• Managing stakeholder expectations: Communicating why short‑term underperformance relative to the objective may not signal failure is essential, yet may be politically challenging within large organizations.

In practice, to measure the performance properly for a TPA, investors should at least consider:

• Clear, measurable objectives: A TPA requires explicit portfolio‑level objectives (e.g., CPI + x%, liability matching, funding ratio maintenance, etc.), which must be set and approved by the investment board. These portfoliowide objectives replace traditional asset class benchmarks as the primary yardstick for success. This requires boards to accept more nuanced attribution frameworks, including qualitative investor or manager evaluation, incorporating collaboration, implementation costs, client service, and reliability.
• Complex attribution: Attribution analysis becomes more challenging, as sources of return and risk are less easily determined. Boards may need educational support to shift away from more traditional performance reporting.

Does a TPA differ meaningfully from an SAA framework?

Despite the notable differences in governance and accountability between an SAA framework and a TPA, there are many areas that the TPA and SAA framework have in common. Some have argued that one of the main benefits of a TPA is a focus on making investment decisions while considering the entire portfolio. However, a properly instituted SAA framework requires this as well. One common misunderstanding about an SAA framework is that investment decisions are only made relative to the benchmark. However, the initial design of the SAA framework should consider the entire portfolio perspective. In a well‑executed SAA framework investment process, each asset and portfolio construction decision should be made in terms of total‑portfolio contribution to risk and return, incorporating correlations with other investments in the portfolio.

Another area of supposed difference between a TPA and an SAA framework is the idea that a TPA focuses more on factors and risk premia in asset allocation decisions. However, an SAA approach can leverage the same framework. For example, mapping asset class exposures to different factor exposures and constructing the SAA framework based on factor exposures is a common practice.

Conclusion

The total portfolio approach is often characterized as a more holistic, adaptive framework for managing institutional portfolios. However, its implementation depends on an investor’s willingness to adopt a new governance model, the belief that the market investment opportunity set changes constantly and materially, and that the investment team/CIO has the skill necessary to identify and implement portfolio changes to capture these opportunities. For many investors, the investment framework lies not in choosing between a TPA and an SAA approach, but in combining elements of both to balance flexibility, accountability, and long‑term objectives. An SAA framework and a TPA aren’t inherently opposites, and both can incorporate additional portfolio construction decisions such as active/passive, public/private implementation, or factor‑based investing. Many individual investment institutions adopt hybrid models, taking elements from each to suit their circumstances and capabilities. Similarly, many asset managers, including T. Rowe Price, have experience applying both approaches in support of client investment objectives.