Capturing ‘operational alpha’ within a multi-asset portfolio 

What is ‘operational alpha’?

Operational alpha is essentially the value a wealth manager adds by adopting more efficient processes and procedures, which is unrelated to the actual investment decision. A wealth manager's operational alpha is essential for taking full advantage of opportunistic investments as and when they arise, as well as managing costs and client servicing. In the absence of operational alpha, wealth managers may be unable to implement the right investment governance framework or optimise their own people, processes and technology for the most effective portfolio management. Among the primary methods wealth managers use to enhance the total alpha of a multi-asset portfolio are asset allocation and manager selection. Due to this, operational alpha has received less attention than it should, but we are confident that it will become an increasingly important source of returns over the next decade, as market returns are expected to be lower and macro volatility higher.

Hubris calls for Nemesis 

There is no doubt that avoiding hubris should be a top priority for wealth managers. One way to accomplish this is by having robust, high-quality investment governance procedures. While clear communication channels allow a wealth manager to respond to time-sensitive market opportunities, unhindered governance frameworks increase the investment opportunity set.

If wealth managers wish to avoid hubris calling to Nemesis, they must be prepared. This will help enable them to recognise and take advantage of opportunities, which usually occur when markets are volatile and in a state of crisis. To help ensure they are well prepared for opportunistic investments, wealth managers should focus on capturing operational alpha within the following areas:

• When making investments, balance speed with caution
• Change funding decisions from ex-post to ex-ante
• Streamline investment decision-making

When making investments, balance speed with caution

Wealth managers can balance speed with caution in several ways:

Plan ahead – As some opportunities are cyclical, you can assess their merits in advance.

Delegate responsibilities – Agility in investment decision-making can be enhanced by delegating to a subcommittee, investment manager or consultant. Consider active management decisions carefully, as they require accountability, performance measurement and clear risk limits.

Optimise execution and implementation – Derivatives, as an example and if appropriate, offer a low-cost way to execute short-term allocations quickly. 

Plan your exit – It is essential to consider how any opportunity will be unwound before investing. 

Change funding decisions from ex-post to ex-ante

By preparing ex-ante rather than ex-post, efficient funding can be achieved. Wealth managers usually raise cash to fund time-sensitive market opportunities by rebalancing portfolios, selling assets or deploying cash flows. In times of market stress, raising cash may require selling investments at a loss. Furthermore, some portfolios containing alternative investments may be affected by collateral and capital calls. 

Wealth managers can move from ex-post to ex-ante in several ways:

Opportunistic investment sleeve – Create a dedicated allocation to investment opportunities in the investment policy statement. The size of this allocation naturally limits active risk, and performance measurement can be simplified. An allocation to cash would carry an opportunity cost.

Rebalancing trades – To navigate rebalancing more effectively in different markets, use a dynamic rebalancing strategy that covers both concave and convex strategies.

Develop a liquidity budget – Identify the specific amount required over a period of 6-18 months in order to provide some level of operational certainty.

Streamline investment decision-making

The transition from opportunity to investment is complex and can take a significant amount of time if several decision-makers are involved. Typically, investment decisions are made in six stages: (1) market opportunity emerges, (2) opportunity is identified, (3) merits of the opportunity are discussed, (4) implementation approaches are considered, (5) due diligence, and (6) implementation.

Wealth managers can streamline the decision-making process in several ways:

Delegate decisions to a subgroup – In the case of investment subcommittees, these subgroups consist of individuals with a high degree of investment expertise who are willing to meet regularly (and in between when necessary). For this action to succeed, clear guidelines, objectives and constraints must be established as part of the committee's terms of reference.

Delegate some decisions to a third-party specialist provider – Within this approach, some of the governance burdens can be reduced, while novel ideas and dynamic asset allocation can be captured.

Increase the degree of freedom given to investment managers – A flexible investment strategy can take advantage of short-term investment opportunities in response to evolving market conditions and emerging trends. Multi-asset strategies – such as systematic asset allocation, which aims to reduce drawdown in falling markets and benefit from market uptrends, or multi-asset credit strategies, which dynamically rotate between different credit betas – can be useful ways for wealth managers with low governance to access opportunistic investments.

Beware an Icarus fall from opportunistic investing

While opportunistic investing seeks to improve investment returns, success is not guaranteed, and potential risks can be substantial if not properly considered. When market volatility is high and asset-class returns are highly dispersed, trading across asset classes can be risky. Additionally, market dislocations and valuation mispricing can persist for extended periods; the risks are further increased if wealth managers must sell their positions to cut their losses or maintain liquidity. In times of market volatility, wealth managers may be tempted to reduce the extent of due diligence or underestimate the sophistication of an investment and misjudge the level of operational and complexity risk. 

Therefore, in order to avoid the Icarus fall, it is imperative to ensure accountability for decision-makers, assess the impact of allocation decisions on performance and impose strict limitations on the size of opportunistic trades.

An emerging trend

In times of heightened market volatility, investment managers must be able to communicate with clients using reliable and up-to-date portfolio information and have in place a robust and dynamic governance framework. We believe those who have an accurate picture of portfolio positions are more likely to be in a position to demonstrate ‘operational alpha’ and be ready to capture opportunistic investments as and when they arise. We see this in Europe in particular, as regulators and clients are seeking enhanced transparency on ESG issues to demonstrate compliance with policies, regulations and marketing collateral. We believe that having this transparency and insight fundamentally improves the investment process, client interactions and outcomes.

Key Takeaways

• With volatile equity markets and rising interest rates, wealth managers will need to embrace a greater degree of opportunism in the future in order to generate the required returns.  
• Becoming a provider of liquidity in stressed or dislocated situations is an important instance of capturing operational alpha. 
• Wealth managers should consider the merits of specialist multi-asset managers or hedge fund strategies, which are inherently dynamic.