Portfolio construction today faces new structural challenges. The evolution of the regulatory framework, the increasing concentration of indices, the rise of smart beta strategies, the integration of ESG criteria, and the questioning of the American dollar’s supremacy are making it necessary to partially rethink traditional approaches.
Regulatory requirements for transparency on fees (such as the Markets in Financial Instruments Directive II) and the issue of value for money are prompting a review of asset allocation, including that of diversified strategies. Traditionally, asset allocation is based on indices that do not explicitly take into account the fees of different asset classes. For example, emerging debt has a total cost of ownership of around 120 basis points compared to 40 for Eurozone government bonds. Integrating these costs means redefining the ‘efficient frontier’. Assets that appear attractive at first glance may lose all or part of their appeal once these fees are taken into account. Our research shows that an expensive asset class only finds its place when it provides a significant diversification benefit.
Furthermore, in recent years, the concentration of performance on a small number of securities has greatly penalised active management: portfolio diversification and ESG criteria have led active managers to underweight the famous ‘Batmaan’ ( Broadcom, Apple, Tesla, Microsoft, Meta Platforms, Alphabet, Amazon and Nvidia stocks) in the US and ‘Granolas’ ( GSK, Roche, ASML, Nestlé, Novartis, Novo Nordisk, L’Oreal, LVMH, AstraZeneca, Sanofi and SAP stocks) in Europe. An approach that combines low-cost passive management to gain exposure to these securities, and conviction-based active management in areas benefiting from greater dispersion and greater alpha prospects, is proving to be a profitable strategy. This strategy applies perfectly to universes such as emerging equities or small caps, for example. Passive and active management can thus prove complementary in the implementation of multi-management portfolios offering the best ‘risk-adjusted performance/cost ratios.
Portfolio construction is undergoing a fundamental shift, driven by evolving regulations, rising index concentration, ESG integration, and changing cost dynamics.
Smart beta strategies that combine the advantages of passive management (low costs, transparency) with an ‘active selection logic’ based on factors have gained widespread popularity. Although attractive on paper, their performance is reduced by high transaction costs due to factor rotations, but also from a timing effect: investment flows often follow periods of outperformance, then withdraw during downturns, eroding the return obtained compared to a buy-and-hold strategy. The robustness of certain strategies is questionable due to backtests carried out over a relatively limited past period, which biases the results. More fundamentally, some factors can experience long periods of underperformance. For example, the value premium did not pay off for nearly a decade before 2020, penalised by a low interest rate environment. To limit this cyclical effect, some so-called ‘Barbell management strategies’ seek to combine several factors, such as value and growth, in order to benefit from complementary performance drivers. However, even this approach has its limits. High market concentration, driven by a few large technology stocks, has significantly undermined this type of strategy, which by design does not have a marked bias and therefore does not excessively overweight certain stocks.
Passive and active management can thus prove complementary in the implementation of multi-management portfolios offering the best ‘risk-adjusted performance/cost ratios.
The geographical allocation of portfolios, long marked by a domestic bias due to better knowledge of local markets, has also become a dilemma. The United States now represents 65 to 70% of global indices following a very strong outperformance of US large caps. The weight of the US in portfolios was thus the main contributor to the relative performance of diversified portfolios in 2024. However, as US tariffs have caused a resurgence in volatility, investors are realising that an allocation based on global indices is now generating too much regional risk. The solution is potentially to rely on alternative indices: equally weighted or customised indices reflecting a long-term strategic allocation.
This recalibration of strategic allocation is all the more important as ESG investment, which has been growing strongly in recent years, particularly in Europe, tends to increase concentration around developed countries which often display better ESG standards. The exclusions implemented in sustainable management can also lead to sector and style biases, in favour of the growth style, quality factor, and large caps. These biases, if not controlled, lead to under-diversification of portfolios. To limit these effects, it is possible to use a sector-neutral approach known as ‘best in class’. A transitional approach aimed at no longer excluding a company, but instead keeping it in the portfolio while defining a tangible engagement plan, also proves to be an effective strategy, offering financial leverage on valuations.
Finally, for investors who are not constrained by currency risk, the issue of exchange rate risk deserves analysis. For a long time, it made sense for a European investor not to hedge their exposure to the dollar, as it played a role as a safe haven. But now, the United States’ foreign policy and the weight of US debt could call this approach into question. Furthermore, the cost of hedging currency risk has significantly increased due to the interest rate differential between the US and the Eurozone. As a result, systematic hedging has become costly and potentially destructive of performance. It is therefore advisable to adopt more refined approaches, such as hedging only certain pockets of the portfolio or adopting dynamic currency management, depending on macroeconomic conditions and relative valuation levels.
