The hidden keys to portfolio construction success

In today's rapidly changing financial markets, marked by economic uncertainty and volatility, the construction of a diversified and well-balanced portfolio is more crucial than ever for achieving investment success.

This article delves into the insights from Dan James, Head of Asset Management, as he unveils his three foundational principles for effective portfolio management. By adhering to these principles, advisers can navigate the complexities of the market and enhance their chances of long-term success for their clients.

1. Risk-adjusted returns matter

One of the fundamental principles in portfolio management is the pursuit of risk-adjusted returns.

This involves evaluating the full investing universe without being constrained by a "home bias." By taking a globally unconstrained approach to asset allocation, advisers can identify the best risk-adjusted returns for their clients. For example, advisers shouldn’t be constrained to holding a minimum investment in the UK simply because their clients like to hold investments which are familiar. If this means that they have zero exposure to the FTSE 100 because there are better risk-adjusted return to be had elsewhere, then advisers shouldn’t hesitate to implement that position.

Advisers also need to consider the impact of different time horizons. This is extremely important as there are multiple factors that can influence an investment decision across the spectrum, both short and long term. The cost of transacting is also something that advisers should carefully consider when implementing ideas. The point here is that one has to be confident that the cost of executing both the purchase and the sale of an idea will not erode the expected return.

Read more: Unleashing the benefits of unconstrained asset allocation

2. Having an idea is one thing, fitting it into a portfolio is another

Diversification remains a cornerstone of effective portfolio management. However, the marginal benefit of diversification diminishes as more ideas are added to the portfolio. Advisers should be looking at the marginal contribution to the benefit of diversification, often referred to as “the only free lunch” in the investment world.

This relationship is exponential. The more ideas you place in the portfolio, the lower the marginal diversification benefit of adding an additional idea becomes as they become similar in nature and therefore correlated. What we want to look for is the optimal number of ideas.

There is no magic formula for this. It is a function of numerous things and driven by the constraints of the opportunity set, be that geographically or by instrument type. One of the most important considerations is to ensure that one has the full opportunity set or toolbox available from which we can seek the optimal implementation of our ideas.

The success of a portfolio hinges on the quality of investment ideas and their implementation. Whether through simple index products or specialised funds, the focus should be on capturing market direction and specific investment themes.

3. Volatility isn’t your friend

Volatility is a significant concern for portfolio managers. Historical data from the global financial crisis (GFC) and the COVID-19 pandemic illustrates the impact of market fluctuations on clients’ portfolios and their long-term investment outcomes.

The total return of the S&P 500 across the GFC, from the highs in 2007 to the trough in 2008, the index fell by 60%. The recovery, back to positive, took three years – and it wasn’t until 2012 that it returned to the lofty levels of 2007. During Covid-19, the total return of the S&P 500 from peak to trough was around 30%, but this time the recovery back into positive return territory was four months – and the return to the previous highs only a month later.

The point here is that volatility hurts. It does not stay elevated for protracted periods as that is not how it works mathematically, but the impact can be felt for a long time and client returns can be materially compromised. Advisers must be vigilant about how changes in structural volatility might affect their clients' specific outcomes.

When comparing one portfolio to another, it’s important to avoid simply looking at the performance. As an example, there might be occasions when marginal outperformance of peers has been at the expense of exponentially larger amounts of risk to achieve these small excess returns. You need to ask yourself, are we happy with the amount of risk? If yes, could I get better rewarded for taking it? On the other hand, if I am not comfortable with the level of risk to deliver the return, I should be looking for a solution that delivers the risk adjusted return parameters that I need.

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