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PORTFOLIO CONSTRUCTION

PUTTING IT ALL TOGETHER... Portfolio construction is where the 10% of investment that is creative and inspired meets the hard work and perspiration.

Portfolio construction is the combination of the Investment Philosophy; the research that has gone into the Investment Process; the macro-analysis of the top down Asset Allocation; and the micro-research of the bottom up Investment Selection.

Portfolio Construction is the most under-regarded of all of the investment stages as so many investors think of investment as one product, strategy or sub-asset class; but it is one of the most important.  It is like the first note of a travelling orchestra.  There is so much energy expended to get the instruments tuned and assembled in one place; all to start at the first wave of the conductor’s baton.

Creativity A creative Portfolio is constructed in such a way that it is different ….. should it be 60% net short? Long Japan or financial stocks? Include a weighting in
distressed debt?

The most critical portfolio construction decision in terms of mitigating risk for the maximum return is determining the weighting of each holding in the portfolio.  The weightings of each investment / asset-class / strategy are critical to the overall performance.  Should investments be based on equal weightings or conviction?  How much more of an investment can you have while maintaining the same risk levels?  How much more of a holding can you add or take from the portfolio, while maintaining the same risk levels?

Creativity can also be injected through a high degree of segmentation between various markets, sectors, themes, strategies and currencies, all with particular tilts to suit the desired risk-return exposures).  For instance, Asia ex-Japan portion be broken down in to five sub-regions; ASEAN markets, Australasia, Greater China, India and Korea.  A specific investment bet can then be taken in a particular area without severely impacting the overall risk of the portfolio.

Investment is 90% perspiration and 10% inspiration – dependent on the creativity of the investor.   Sometimes you have to suspend disbelief in the light of a good story; sometimes you feel you will be wrong but you should do it anyway because you know it is the right thing to do.  Investment is not about being comfortable; it is often about being uncomfortable.

Complete Portfolio So a typical portfolio might be the one attached here which is a Global (Asian-tilt) Portfolio.  The portfolio percentage allocations are clear and we have added specific products designed to do a particular role in the risk area determined by the asset allocation.   The products are not identified but they are all real investment funds.  We could easily have made the investment selections using directly invested bonds or shares or other assets.

Post-Construction A very important part of the Portfolio Construction process is:

  • Execution – making sure the portfolio is invested as designed.  This means not only buying the right investment in the right proportion that the Strategic Asset Allocation requires but also in making sure the portfolio is doing what is intended.
  • It is critical to back-analyse our investment portfolios to ensure that we are taking risk where we want and seeing returns to match our views.  When you back-analyse the portfolio, does it make sense?  Is the portfolio set to take on the risks that you actually want, and not the risks that you don’t want? There is nothing more pathetic than having an investment view and not exposing the portfolio to that investment. 
  • We also need to monitor our individual investments and if we are not happy put them on a watch list for even further scrutiny.  Investment portfolios need rebalancing and reworking from time to time as the Tactical Asset Allocation changes and as different assets perform the portfolio could end up being exposed against the tactical view.
  • And we should feedback our information back into the Investment Philosophy and the Process mechanism to ensure that we are always moving with the times. In no industry is the Maoist principle of continual revolution more critical in that portfolios continually have to be de-constructed to ensure that they are likely to lead to planned consequences rather than unintended consequences.

Other Portfolio Construction issues include:

TRADING Many are uncomfortable with short term trading – we don’t have the conviction, we are too cynical, too afraid of losing money by being whiplashed to buy and sell unthinkingly by the markets.  But many do see short term trading as a way that they can make money.  We like the visibility of long cycles that we can see and analyse, determined by expected economic, financial, political and sentimental factors.  We don’t watch every tick on prices. But there is always a time to sell and always a time to buy. History has taught us that there are always times to be out of the market.

TIMING Sir John Templeton used to say that timing is less important than time.  When I open up some research on a market the first thing I look at is the historical price chart.  I am not an expert in charting or technical analysis – most charts to me forecast that the market will definitely go up, or down or perhaps sideways.  However contained within the charts are all the struggles of human nature; all those hopes dashed, all those fears allayed.  Looking at a historical chart is the quickest way to understand where a market came from and to use as an important input into where it might be going. It summarises the weight of money – moved by all of those individual investment decisions, rather like a stock market version of Adam Smith’s Invisible Hand.

We have a further number of Investment Mantras for your reference:

  • Buy a market for its special (best of breed) factors.  For instance buy Japan for autos not consumer goods, buy France for consumer goods not heavy industry.
  • In a volatile market, be conservative.  You can always play again; you do not have to roll the dice in every game.  If the game is getting hard to discern, then use your discretion to stay out of it.
  • In a volatile sub-asset class, be conservative.  If the sub-asset class is volatile, such as emerging market equities or early stage private equity, there are no prizes for being brave.  Stay conservative within a risky sub-asset class as there is no point piling volatility on volatility.
  • Always have about 10% deeply contrarian.  When something moves it is usually too late – keep something unfashionable in your back pocket.
  • Asset performance rotates.  Rotation, rotation, rotation.
  • The answer lies in the field, go out to do investment research (company visits, country visits)
  • If you have a big winner start by taking your cost out, leaving the profits – never let one position get too large.