Insights, Updates and News

The art of portfolio construction

By Jannie Leach, Head of Core Investments

An investment strategy starts with a clearly defined goal and an action plan on how to achieve this goal with a reasonable probability of success. This can be difficult as there are many distractions along the investment journey, e.g. there are regular articles on the next great investment opportunities; whether it be individual shares or the latest top performing unit trust. These opportunities may very well be good investments but may not be suitable within your investment strategy. In order to understand why this is the case we need to look at a topic that has not received as much attention as stock ideas but can have a significant impact on achieving your investment goals, namely, portfolio construction.

Portfolio construction, at the fund management level, has to deal with the complexities of the markets and needs to ensure that the portfolio can achieve the set investment goals while staying on track during turbulent and uncertain times. Constructing a portfolio that can withstand uncertainty is quite often described as an art, meaning that the real world is too complex to articulate in simple mathematical equations and therefore requires judgement and experience.

Investment risk and duration
A key consideration in achieving the investment goal of a portfolio, is the risks taken by investors and the time required to navigate them. There are two types of risks to consider when investing into a fund; the risk of a permanent loss of capital and the risk of losing purchasing power. The graph below illustrates the trade-off between the two types of risks for the traditional asset classes (green squares) and two balanced funds which use these asset classes.

We can use duration1 to illustrate the relationship between time and risk as it illustrates that the investment horizon is important because it allows you to withstand the ups and downs of markets while the income produced by your investment can compound and thereby protect your purchasing power.

Diversification and capital protection
Time, however, cannot protect you from a permanent loss of capital. For this you need to diversify your income sources so that you can bear some of these loses. Furthermore, although parts of most investors’ portfolios will be invested for long periods, it may not be continuously with the same investment provider or in the same strategy. This means that investors can quite easily turn a temporary market drop into a permanent loss when they disinvest after a major market fall, whether it be due to panic or for an emergency. Sufficient diversification across asset classes and regions can greatly reduce the impact of a permanent loss of capital while protecting purchasing power.

Portfolio construction over practical investment time frames (10 years and less) is therefore a careful balance between maintaining purchasing power while protecting capital. The measurement period shifts from the investment’s duration, where the impact of market fluctuations is reduced, to a minimum investment period over which you can avoid negative returns and possible losses.

Setting an appropriate long-term strategic asset allocation
The investment universe is first established by looking at all suitable and allowable (in terms of regulations and investment strategies) asset classes for the specific mandate which may be used to achieve the investment goal. A sensible long term strategic asset allocation can then be set with the aim of maximising the probability of achieving the investment goal - after all costs - over the required time frame. Some of the factors which determine the asset allocation are:

  • Normalised risk premiums for the relevant asset classes and their behaviour through different market cycles. 
  • Correlation between asset classes over various market cycles to understand their true diversification benefits, especially during market drawdowns when correlation across some asset classes increases. 
  • Structural and regulatory environment.

In the table below, we have summarised three portfolios with different return objectives and time frames. The portfolios are able to meet their objectives around two thirds of all the relevant rolling periods (as highlighted in the green blocks). Even when they don’t achieve their stated objectives, normally following a severe market correction, they are able to produce inflation beating returns in more than 80% of these rolling periods. They have also been able to produce positive returns over the appropriate timeframes under all market conditions.

Stock selection and tactical asset allocation 
You can enhance the purchasing power protection of a fund through stock selection and tactical asset allocation. These do however add a layer of complexity to the portfolio construction process as risks need to be assessed at an instrument level and aligned to the portfolio’s investment objective. These risk measures may include:

  • Building in a margin of safety on the valuations of securities to reduce the chances of a permanent loss of capital. 
  • Carefully assessing the duration of the investment idea to align it to the portfolio’s objective and time horizon. For example, quality of earnings would be more of a concern in a conservative balanced portfolio compared to an equity portfolio due to the shorter investment horizon. 
  • Ensuring diversification through careful assessment of the economic drivers behind each investment. For example you may select shares and credit instruments that are both highly sensitive to interest rate changes and therefore not necessarily getting any benefit from investing across different asset classes.

Monitoring your strategy and the importance of rebalancing
Over time asset classes produce different returns which inevitably lead to a change in the original weightings allocated to each asset class in the portfolio, and ultimately the risk profile of the portfolio. In order to ensure that a portfolio’s risk and return characteristics remain the same over time, the portfolio must be rebalanced to its original asset allocation. Similarly, when active stock selection is employed, weightings to investment instruments need to be carefully monitored.

Tax efficiency and keeping costs low
When looking at the returns on any given portfolio, it is important to consider the effect of costs and taxes on returns over time. Fees and taxes can erode a significant part of an investor’s returns. The table below illustrates the effect of fees on the probability of successfully meeting your investment objectives.

Securities transaction tax (STT), income tax, dividend withholding tax and capital gains tax (CGT) can also have material impact on your long-term investment returns. Investment vehicles such as unit trusts are for example more CGT efficient than a stock portfolio, while investment wrappers such as retirement annuities or a tax-free investments are exempt from most of the taxes mentioned above (see articles in previous newsletters2).

In practise portfolio construction occurs at two levels: The first is normally where an investor, in many cases with the assistance of a financial advisor, defines his unique set of financial goals and selects a range of suitable funds to meet these goals. The second level occurs within the selected funds; which are managed by portfolio managers, and aims to achieve the investment objective set out in the fund’s mandate. In all these mandates portfolio construction plays a pivotal role, whether they are actively managed or use low cost rules-based strategies.

1 Duration is a term normally used to describe the price sensitivity of fixed interest instruments like bonds and cash. We can however use it for illustrative purposes as it gives a sense of how long you need to invest in an asset class for it to deliver the required risk premium assuming a constant long term average yield and range of capital drawdowns. For equities this will loosely translate into the period over which 90% of the total return comes from dividends and earnings and only a small part from P/E re-ratings.
2 Seugnet van der Merwe, “Are you making the most of your tax-free investment?”, Q1 2016 and “The new tax-free savings account: how much will you actually save?”, Q1 2015.

Related content

Offshore investments: Open for business

By Trevor Garvin, Head of Multi-Management

Several journalists and commentators forecast global doom and gloom while others sketch a scenario that this is...

Read article

Where advisors really add value

By Nic Andrew, Head of Nedgroup Investments

Good advisors should first make sure that they are adding this value (whether it is true and sustainable) and secondly present...

Read article

You have been subscribed to our newsletter