After the success of our series of articles detailing the benefits of being a wholesale client, we have decided to run another series of articles, this time looking at the various inputs that go into our way of thinking about portfolio construction.
Hopefully this series will also add value to our current and prospective clients who haven’t been able to get to a seminar where we discuss the subject or attend webinar of the same.
Where to start?
The first place to go to when looking at a portfolio is probably not necessarily one that is much considered – usually one jumps right to the security selection and misses this important step altogether.
Firstly, you should always ask yourself what the objectives of the portfolio are – in other words, what style of portfolio are you looking to build?
Will it be one that delivers a consistent return year on year, or will it track a benchmark and deliver the volatility of that benchmark while hopefully outperforming?
These are fundamental questions of what type of return you are looking for, and often drive the allocation decisions and return profile of the portfolio, regardless of what ends up being in it.
The below chart shows the two main types of portfolio – one which delivers consistently year in and year out, and one which gets there in the end but by a more winding road.
Absolute return portfolios look to deliver a consistent return every year, with minimal deviation from the target. They typically try to offer a lower volatility of return away from the target as the strategy is designed to be robust through all parts of the cycle.
In terms of management, they are typically more actively managed than benchmarked portfolios as benchmarks tend not to change very much over time, and the buying and selling look to smooth out returns.
Relative return or benchmarked
Benchmarked returns styles look to follow a market standard measurement and outperform it by a specified margin. Examples include Consumer Price Index (CPI) + 3% or the ASX200 + 3% for example.
The benchmarked portfolio tends to closely resemble the composition of its underlying benchmark, and attempts to achieve outperformance by weighting the individual securities differently to the index, or by allocating to it when it is ‘cheap’ and away from it when it is ‘expensive’.
Of course, these kinds of timing allocation decisions can be (and have been shown to be) exceedingly difficult to get right in practice, potentially increasing the volatility of the portfolio.
Deciding between these two, and potentially other styles, can have consequences for the application of decisions relating to the further risk factors that we will examine in subsequent articles.
Diversification is probably the single best tool in an investor’s armoury when it comes to preserving capital.
The simple underlying premise here being that if you spread your risk over many different investments, something bad is unlikely to happen to a lot of them all at the same time. Therefore the portfolio is more able to withstand a shock than if it is concentrated in fewer, larger positions where if something bad happens to one, it will have an outsize effect on the portfolio.
Given our asset class is one which is used to secure income and preserve capital, rather than grow capital, our natural assumption is that our investors are looking for the same thing. We therefore always try to maximise diversification within the boundaries of satisfying demand for yield and maintaining the value offered by individual bonds.
Concentration of investments is historically the way to generate wealth (with the caveat that of course the investment has to go well). If you think of some of Australia’s wealthiest people, they have typically concentrated their assets in one investment or business – think the Lowy family in Westfield or the Pratt family in Visy.
The Lowy family offers a good case study in the change from accumulation to preservation. Over time their family office has built up a very diversified suite of investments, to preserve the capital that their concentrated single asset of Westfield has grown, and this has continued apace since they sold their stake in Westfield a few years ago. Preservation of their capital, not growth, has now become their main focus.
In the next few articles we will delve a little deeper into the risks that we consider when we construct portfolios. This is a relatively novel approach – to consider risk before return – and we hope that the discussion of these risks will educate and allow our current and prospective clients a better understanding of how their own portfolios are and can be constructed to achieve their goals.