Our first two articles reviewed the definitions and importance of including “alternative investments” as part of a portfolio to provide an adequate balance of different asset classes. These included the use of guaranteed capital investments.
Many readers have asked us to give broader considerations to the equity (stock and fixed interest) side of the portfolio to gain a fuller understanding of how portfolio managers select their stocks and funds.
A portfolio provides the means of fulfilling a client’s investment objectives. There are many critical issues that need to be agreed upon up front, before a portfolio can be established.
• What are the client’s investment objectives?
• Is the preference for capital growth or income or a combination?
• What is the attitude to risk?
• What is the time horizon for investment to achieve objectives?
• What are the client’s expectations of returns?
The risk profile of a portfolio may be viewed at a sector or stock level. A low risk strategy would necessitate a high exposure to equity markets and possibly the emerging markets. There is a mathematical tradeoff between risk and return. For example, at a stock level, short-term bonds are clearly low risk while higher exposure to stocks in the emerging markets are higher risk. The expectation of higher returns will raise the risk profile of the portfolio. Once the portfolio is in place, sufficient time must be given for it to bear fruit.
Historically, the highest returns come from equity markets over the longer term rather than from fixed interest and cash. Also noticeable is the positive effect that re-investing income has on the over return against the capital return if income is removed.
Understanding the Objectives
At the initial stage, it is important to discuss how the portfolio’s performance is to be assessed. This may be done by comparing performance against benchmark. This gives both the client and portfolio manager a clear target against which performance can be assessed. A benchmark may be an index such as the S&P 500 or FTSE 100 or a composite covering the relevant asset classes. The benchmark should reflect the entire portfolio and should be reasonable, realistic and reviewed on a regular basis to ensure it remains relevant.
Focusing on the investment objectives, the portfolio manager will look to add value in the construction of the portfolio. The manager is selected because of his/her investment style. This may be a “top down” approach taking macro-economic factors into account, or a “bottom up” approach whereby individual stocks’ merits compared to fundamental analysis is the determining factor.
Fund performance is derived from two sources:
• Sector weighting against the asset allocation of the benchmark.
• Stock selection.
Weighting is the industry term given to what percentage of an index is represented in your portfolio. It is vital that the composition of the benchmark is kept in focus at all times. The U.S. and Canada make up approximately 50 percent of the FT/S&P World Index. If a portfolio manager, for example, severely underweights the U.S. and this market performs extremely well (as it has done), it will be difficult for the manager to outperform the Index and produce good returns. The weighting of the asset classes against the weighting of the benchmark is the end product of the portfolio manager’s macro-economic analysis.
At a more detailed level, weightings may also be applied to the sectors within equity markets. For example, the bull market in London has been led by the financial, pharmaceutical and oil sectors. Over-weighting in these sectors would guarantee outperformance, as would under-weighting the laggard paper and engineering sectors.
Stock selection has a more dramatic effect on the performance as a portfolio than that of sector weighting. The divergence of the performance of individual stocks can be very wide, even between those in the same sector. There is no set formula for picking stocks, but the portfolio manager is responsible for fundamental analysis when determining the relative value of a stock against various criteria. An example would be the quality of the management. Companies with weaker management rarely outperform unless they are taken over. Another vital component of performance is timing of purchases and sales.
Getting the Weightings Right
As the portfolio’s performance is assessed against that of the benchmark, the portfolio manager must be mindful of the effect the size of the individual stock has on the underlying index. Clearly, large capitalization stocks have a greater effect on the performance of the index than do small and medium capitalization stocks. Large company stocks can underperform as AT&T and BTR have against the Dow Jones and the FTSE 100 respectively.
Although large capitalization stocks are important, portfolio managers should not ignore the tremendous growth potential of the smaller companies. However, these companies do bring a higher risk profile to the portfolio.
The risk profile can be reduced if it is well diversified. Modern portfolio theory suggests that adequate diversification may be obtained only if in excess of 30 stocks are held. Clearly this may be difficult with a small portfolio, in which case collective funds, such as unit trusts and mutual funds, should be included.
Portfolios may be managed on a discretionary or advisory basis, depending on the client’s level of involvement. A discretionary service, comprising of efficient administration, secure safe custody/nominees and cash management, will provide the client with periodic reports and peace of mind. This enables the client to monitor at leisure the portfolio’s structure and underlying performance.
Magellan Tresidder Tuohy has access to several types of portfolio management services. Please call Alison Pockett or David Spratley at 3582-3773 for further information.