Designing a Shariah Global Equity Multi-manager Portfolio

Client-Specific Concerns

A Middle-Eastern financial institution was seeking to create a new public equities product for its clients with a multi-manager, Shariah-compliant approach. The objective was to design a multi-manager portfolio and provide an implementation plan for available seed assets as well as further inflows of subsequent assets.

The client was concerned about generating long-term excess returns in a robust manner, with improved risk-adjusted return, and were willing to consider portfolio configurations incorporating any active or passive management styles – from conservative approaches (core, low volatility et al) through to strategies such as high growth and deep value. They were also keen to understand the potential impact of Shariah compliance on both the availability of strategies and on the risk/return profile. bfinance was engaged to provide highly tailored advice to fit the institution’s specific strategic parameters, informed by institutional experience with portfolio design and fund selection.

Adding more asset managers leads to convergence of Tracking Error (the central limit theorum)

Outcome

• Creating an Investment Policy Statement: With the aim of populating a hypothetical investment policy statement for the public equity portfolio, the project considered the most suitable structure of objectives, quantifying those objectives and showing how to achieve those via global equity manager building blocks.
  
  
• Building the portfolio using complementary equity styles: Researchers advocated a focus on a set of style ‘building blocks’ that are complementary to each other, i.e. those that capitalise on the negative excess return correlations between investment styles. Analysis showed that this greatly increased chances for robust long-term relative performance. It was suggested to rule out investment styles that were less fit for the client’s purpose, such as income and low volatility.
  
  
• Considering the appropriate number of managers: Quantitative analysis showed that metrics like tracking error converge quickly once active managers are combined into a portfolio. Multi-manager portfolio construction should therefore carefully balance the number of managers and achieving appropriate diversification while not unduly constraining the potential to generate excess returns. For this client, it was argued that a 3-manager portfolio would be appropriate.
  
  
• Impact of Shariah-compliance: Analysis demonstrated that Shariah-compliance should not hinder the portfolio from generating attractive returns. However, the definition of Shariah-compliance could affect risk/return characteristics; for example, it was shown that MSCI’s conventional definition of Shariah-compliance would lead to a value-tilt. Comparing the client’s definition of Shariah to those used by index vendors, it was decided that S&P Developed Broad Market Index Shariah was the most appropriate benchmark for the portfolio. Shariah-compliance will be achieved by implementing via segregated mandates in which the client can dictate how Shariah restrictions may be implemented, e.g. via an exclusion list.