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.

Portfolio Construction

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.