It is one thing to have a good investment idea, but quite another to extract the maximum potential from that idea and combine it with others to create an optimal portfolio. This is where portfolio construction comes in.

Diversification may be the only free lunch in finance, yet even seemingly well-diversified portfolios can harbour hidden biases and correlations. These can lead to excessive weightings of certain strategies or a portfolio that expresses too many similar ideas, overexposing it to particular risks. In a difficult market environment, when traditional correlations break down, it can come as a nasty surprise. This is where good portfolio construction shows its worth.

“During good times, positioning strategies for the very worst-case scenarios might appear wasteful, and some might argue over-elaborate. But for events like the global financial crisis or COVID-19, the effort to make portfolios as watertight as possible bears out, especially when there is so much we don’t know,” explains Euan Munro, chief executive officer at Aviva Investors

Letting the best ideas shine and addressing inefficiencies

Effective portfolio construction aims to optimise risk-adjusted returns for a given set of constraints and to embed diversification and resilience into the investment process. The quality of investment ideas and strategies remain paramount, but portfolio construction identifies the best way to put them into practice.

Josh Lohmeier, head of US investment-grade credit at Aviva Investors, likens this to creating a framework that lets your best ideas shine. “Any great portfolio construction process needs strong idiosyncratic ideas. Portfolio construction is how you build a portfolio around those great ideas to provide resilience and downside protection.” 

A robust, repeatable portfolio construction process can help uncover and remove biases and correlations

A robust, repeatable portfolio construction process can also help uncover and remove biases and correlations, allowing investors to add return without taking additional risk. This is as true for funds that invest in publicly traded assets such as bonds and equities as it is for real assets like infrastructure and real estate. 

Active managers often follow a bottom up and simplistic approach to portfolio construction; purchasing the securities they like, avoiding those they dislike and determining whether they are happy with the resulting overall risk and tracking error. It is a good start, but more specific risk allocation techniques can help deliver more resilient investment returns.

“Tracking error is a very important tool for understanding how you are deviating from your preferred benchmark, but it is not necessarily a great tool for measuring risk,” explains Lohmeier. 

Similar inefficiencies can be found in real assets indices, as Chris Urwin, director of real assets research at Aviva Investors, highlighted in his analysis of MSCI commercial real estate indices. 1

Even the most comprehensive real estate indices provide incomplete coverage in terms of sectors and geographies. And like all indices, the coverage and weightings evolve as a function of holdings rather than real economic activity.

Changes to the way markets function can cause distortions, something that has been evident in recent years in the stock market. For investors who do not want to be at the mercy of volatility, the next step is to understand how to make their portfolio construction process more robust and capable of delivering resilient outcomes.

Diversification: Easier said than done

One benefit of not being too closely wedded to tracking error is the freedom to allocate to a variety of assets or asset classes. However, diversification is more than the sum of different assets; it requires an understanding and careful calibration of the underlying drivers of risk.

In real assets, a study by the Investment Property Forum looked at the volatility of returns on over 1,000 properties in the UK between 2002 and 2013. As the specific risks are so different from property to property, it found that diversification can be achieved rapidly – portfolios of 15 to 20 assets would, on average, have recorded volatility of returns close to that of the overall market.2

Figure 1: Tracking error can be misleading
10-year standard deviation of simulated real estate portfolios
Source: Individual Property Risk, Investment Property Forum, July 2015

In credit, there are multiple return drivers such as carry – how much yield investors are getting – and forward-looking views on how spreads could change in various markets or sectors.

Equity risk can also be broken down by the level of exposure to regions, sectors or factors; whether style factors like value, growth, quality and momentum, or macroeconomic factors like energy prices or interest rates. There is a degree of overlap, but a good risk approach can disaggregate the portfolio’s risks into these distinct categories. Investors need to assess whether they are exposed to these risks by design, via a non-consensus view and well-argued investment case, or unintentionally. 

Correlation Street

True diversification comes through constructing a portfolio of assets with low correlation to each other. Success or failure in achieving this will only really become apparent in a crisis.

“We closely monitor the correlation structure of portfolios – in other words, how correlated all the ideas are to each other – and by using metrics like marginal risk contribution. It tells us which positions are increasing risk in the portfolio, which are offsetting it, and which don’t add much risk but do enhance diversification,” says Wei-Jin Tan, investment risk and portfolio construction specialist at Aviva Investors.

Figure 2: Correlation schematic in AIMS portfolios: Market, opportunistic and risk-reducing strategies
Correlation schematic in AIMS portfolios: Market, opportunistic and risk-reducing strategies
Source: Aviva Investors, as of May 2020

It pays to constantly monitor correlations between assets, however, as these can change over time and in different conditions. One way to measure this is through a method called absorption. Using principal component analysis, investors can assess how much of a portfolio’s volatility can be explained by one factor.

To further assess diversification, investors should also pay attention to turbulence within a portfolio. Tan explains turbulence as being a measure of correlation ‘unusualness’. 

Figure 3: Turbulence
Source: Aviva Investors, as of May 13, 2020

Turbulence analysis looks at a portfolio over time, how it has evolved and how it maps onto what the expectations were. Investors can analyse whether individual strategies are exhibiting unexpected behaviour and identify internal stresses within the portfolio from a performance perspective.

Building efficient portfolios

These tools allow portfolio managers to target the efficient allocation of return drivers across a strategy; helping them determine which positions to add or ignore, but also providing guidance on how to size and structure the allocations to optimise returns for the same level of risk.

Incorporating investors’ broad views on the market can also add value when maximising portfolio efficiency

Incorporating investors’ broad views on the market – to introduce more traditional alpha through sector weightings or yield curves, for example – can also add value when maximising portfolio efficiency.

Just as diversification makes a portfolio more robust, Peter Fitzgerald, Aviva Investors’ chief investment officer, multi-asset and macro, believes fostering an inclusive culture of debate within investment teams aids the construction process.

Fitzgerald emphasises the fact people are encouraged to speak up when they disagree. “The whole point of the exercise is to understand what we might have missed and whether there are any risks we have failed to spot. When there is vigorous debate, the person who disagrees strongly may not see their view end up in the central case, but it will feature in one of the risk cases,” he adds. 

Beware behavioural bias and target resilience

“We tend to have a more optimistic view of the future, partly because we imagine we have more control over the outcome than we do. In other words, when it comes to our decision making, we tend to ignore the downside – it’s called the illusion of control,” says Annie Duke, World Series of Poker champion and author of Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts.

Not only is this important before implementing a new idea; it is also essential to monitor invested ideas on an ongoing basis, to track whether they are behaving in line with expectations and, if not, to understand why not.

Resilience targeting is about choosing the ‘efficient’ portfolio that best leverages the central investment thesis but will not be materially affected should the thesis fail to deliver. This can be further enhanced by incorporating sensitivity analysis of investment ideas or portfolios under multiple scenarios. These scenario analyses illustrate the level of risk taken in pursuit of returns and what can happen to a portfolio when the central thesis does not play out.

"Cinderella, you will go to the ball”

For much of the past decade, preaching the virtues of portfolio construction would have fallen on deaf ears as ultra-loose monetary policy has made it easy to generate decent returns through simple (and cheap) exposure to a variety of asset classes. But COVID-19 – the impact of which has severely damaged companies, sectors and entire economies – has shifted the debate once more. 

Building portfolios that can hold up in the most testing of circumstances is a matter of design, not good fortune

Building portfolios that can hold up in the most testing of circumstances is a matter of design, not good fortune; it results from sound investment and risk management processes and good, old-fashioned skill and judgement. Unfairly miscast as an expensive ‘Cinderella science’ during the bull years, portfolio construction now has its chance to shine.


  1. Josh Lohmeier, ‘Tapping a misunderstood Alpha Source: Effective corporate bond portfolio construction’, Aviva Investors, 2019
  2. For this analysis, we created a benchmark index and multiple portfolios including just 10 credit issuers in 10 individual sectors. The issuers were chosen based on the size of the investment universe and their respective sectors. We selected a broad range of maturities of 2-, 5-, 10- and 30-years for each issuer or sector. Each sector/security within this hypothetical universe must hold exactly 10% market value in each issuer. The only flexibility available is which maturities can be purchased within each credit. These hypothetical portfolios must also keep key rate durations broadly neutral and total portfolio durations very close to the duration of the benchmark. For the comparison purposes, the sample benchmark index owns exactly 2.5% in each maturity – 2-year, 5-year, 10-year, 30-year – of each issuer in the 10 index sectors. The portfolio is also balanced so that it contains five higher volatility sectors (shown in red) and five lower volatility sectors (shown in green.) In our analysis of this hypothetical index, the duration is 7.6 years and annualised estimated portfolio volatility is 3.7%. For each sample portfolio, we calculated duration, base case returns, tracking error and portfolio volatility statistics. We also calculated excess returns for each sample portfolio against our custom benchmark in 15 different investment scenarios. Of the 15 different investment scenarios, there are three different interest rate environments: bull (lower yields), bear (higher yields) and flat. There are also five different credit spread scenarios for each interest rate environment: a base case to reflect general views on credit markets; a bull credit spread scenario; and three bear credit spread scenarios—baby bear, normal bear and big bear–which reflect gradually increasing levels of spread widening volatility

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