Belief 5: Portfolio construction
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Belief 5: Portfolio construction

We believe that taking an active approach to portfolio construction and the management of risk and return in our clients’ portfolios adds value in many situations.

The main objective for portfolio construction is to build a suite of investments, from a range of asset classes, that balances the needs for cash, protection from market downturns and consistency in returns with your long-term growth objectives.

We believe this is best done through via a rigorous systematic, dynamic process, represented in the diagram below.



Diversification & asset allocation

Because it is extremely difficult to pick cycles, a less risky way of investing is to diversify your investments across a range of asset classes, both in Australia and globally, generally over the medium to long term. This is better than trying to pick cycles and jump from one asset class to another. This is often called the ‘don’t put all your eggs in one basket’ rule.

What are the key asset classes we invest in?

In Building a portfolio, the major asset types utilised are:

Defensive Assets
Cash Bank accounts, cash fund
Fixed Interest Term deposits, Australian and international government bonds, corporate bonds
Growth Assets
Property and Infrastructure Australian and international listed and direct
Shares (Equities) Australian and international large and small companies, with a mixture of hedged and unhedged currency exposures
Alternative Investments* Managed futures, real return, currency, derivatives, and market neutral

*A note on Alternative Investments: “alternative” investments are typically highly specialised investments used specifically to diversify returns and risk in a way that is unrelated to market cycles. Their ability to invest in many different financial and commodity markets around the world, in a manner that allows them to profit in both rising and falling markets makes them suitable vehicles to take advantage of shorter-term market trends. They can also exploit opportunities in financial markets not available to traditional portfolios.

The key to diversification is accessing a sufficiently wide variety of investments across a range of asset classes that enables a “smoothing” of returns at a portfolio level through various market cycles. This process is called “asset allocation”.

What is Asset Allocation?

Asset Allocation is simply defined as the approach taken and process of determining the mix of asset classes that make up your Investment portfolio.

It is the role of the Portfolio Constructor and/or Investment Manager, to determine which are the best investments to fill your asset allocations with. For diversification benefits, a range of investments are combined to provide the optimum risk verses return result for you. This usually comprises a range of managed funds and/or direct investments. Again, to diversify, this may be a combination of some low-risk funds, such as fixed interest and cash funds, and some higher risk share funds, both from Australia and internationally.

We believe that unless you are professionally qualified with significant experience in portfolio construction and Investment Management, then Portfolio Construction and Asset Allocation decisions when building your portfolios should be undertaken by independent, specialist and experienced Investment Professionals.


Approaches to Asset Allocation

We believe that building an investment portfolio shouldn’t be a set and forget proposition and that a more active approach to Asset Allocation can add significant value over time, by actively being able to tilt portfolio allocations to either manage risk (smoothing returns), or by taking advantage of market opportunities when they present themselves, thus increasing the probability our clients will achieve their goals.

The main Asset Allocation approaches we consider when building a portfolio are outlined below:

Strategic Asset Allocation

Strategic Asset Allocation (SAA) is a strategy where portfolio managers set their target allocations for various asset classes and rebalances the portfolio periodically (at least annually) to the original allocations when they deviate significantly from the initial settings, due to differing returns from the various assets.

In SAA, the target allocations depend on several factors: the investor’s risk tolerance, time horizon, and investment objectives. Also, the allocations may change over time as the parameters change.

Strategic Asset Allocation is compatible with a buy-and-hold strategy as opposed to Tactical Asset Allocation, which is more suited to an active trading approach. Strategic and Tactical Asset Allocation styles are based on modern portfolio theories, which emphasizes diversification to reduce risk and improve portfolio returns.

An SAA approach is often more cost effective than a Tactical or Dynamic approach to Asset Allocation and given its buy-and-hold nature requires less monitoring than other forms of Asset Allocation.

Investor suitability

An SAA approach is more suited to those who:

    • Prefer a buy-and-hold approach to investing,
    • Would like a simple solution that requires little ongoing monitoring,
    • Are more cost-conscious and thus more focused on fees, rather than risk and return outcomes,
    • For cost concerns and/or other reasons do not wish to engage regularly with an adviser, and
    • Do not wish to constantly personally monitor their investments. [1]

Tactical and Dynamic Asset Allocation

Tactical and Dynamic Asset Allocation Approaches are Active Management portfolio strategies where an Investment Manager is engaged take a more Active Approach to Portfolio Construction, in order to enhance either risk and/or return outcomes by taking advantage of market opportunities where they believe there is value to do so.

Tactical Asset Allocation

Tactical Asset Allocation (TAA) is an active management portfolio strategy, that starts with an SAA,  and actively shifts the percentage of assets held in various categories to take advantage of market pricing anomalies or strong market sectors. This strategy allows portfolio managers to create extra value (either through risk minimization or return maximization) by taking advantage of certain situations in the marketplace. It is considered a moderately active strategy since managers return to the portfolio’s original strategic asset mix once reaching the desired short-term profits.

The Usefulness of Tactical Asset Allocation

Tactical Asset Allocation is the process of taking an active stance on the strategic asset allocation itself and adjusting long-term target weights for a short period, to capitalize on the market or economic opportunities.

Usually, tactical shifts range from 5% to 10%, though they may be lower. In practice, it is unusual to adjust any asset class by more than 10% tactically. This large adjustment would show a fundamental problem with the construction of the strategic asset allocation[2]

Dynamic Asset Allocation

Dynamic Asset Allocation (DAA) is an active portfolio management strategy that frequently adjusts the mix of asset classes to suit market conditions. Adjustments usually involve reducing positions in the worst performing asset classes, while adding to positions in the best performing assets.

The general premise of DAA is to respond to current risks and downturns and take advantage of trends to achieve returns that exceed a targeted benchmark. There is typically no target asset mix, as investment managers can adjust portfolio allocations as they see fit. The success of dynamic asset allocation depends on the portfolio manager making good investment decisions at the right time.

Advantages of Dynamic Asset Allocation

  • Performance: Investing in the best performing asset classes ensures investors’ portfolios have the highest exposure to momentum and reap returns if the trend continues. Conversely, portfolios that use DAA reduce asset classes that are trending lower, to help minimize losses.
  • Diversification: DAA exposes a portfolio to multiple asset classes to help manage risk. Portfolio managers may make investments in; equities, fixed interest, mutual funds, index funds, currencies and derivatives. Top performing asset classes can help offset underperforming assets, if the manager makes a bad call.

Limitations of Dynamic Asset Allocation

  • Active Management: Actively adjusting portfolio allocations to meet changing market conditions takes time and resources. Investment managers need to keep up-to-date with breaking macro- and company-specific news, to determine its impact on various asset classes. Additional research analysts may need to be hired to help ensure the correct investment decisions get made.
  • Transaction Costs: DAA involves frequently buying and selling different assets. This increases transaction costs that reduce the portfolio’s overall return. If most holdings in the portfolio are trending higher, a management strategy that favours buy-and-hold investing, such as, may outperform dynamic asset allocation over certain periods due to fewer transaction costs.[3]

Both TAA and DAA approaches require more frequent monitoring and adjustment than a more static SAA approach.

Investor suitability

Active Approaches to Asset Allocation (TAA and DAA) are more suited to investors who:

    • Would like their Investment Manager to actively adjust the of mix of asset classes as they see fit, with the intent of increasing returns or reducing risk, when compared to a more static approach.
    • Believe that high quality Investment Managers have the skills and expertise to do this effectively,
    • Are more focused on risk and return outcomes than cost,
    • Are willing to engage regularly with an adviser to select, monitor and review their Investment Managers


Our philosophy about Asset Allocation

Given the highly active nature of dynamic asset allocation and the ability for risk and return outcomes to vary significantly, potentially outside of a client’s risk profile, we believe that a dynamic approach should only be used for a portion of a client’s portfolio and that the overall portfolio should still be built and regularly monitored to fit within relevant strategic and tactical asset allocation weightings.

As outlined above, Tactical and Dynamic Asset Allocation approaches are often more expensive and require significant skill and experience to implement, in order to gain the benefits (when compared to a strategic asset allocation approach).

Therefore, our philosophies of transparency, research and ongoing monitoring are critical when utilising these approaches.  Since these approaches require more active oversight, we believe they are best used in consultation with an Adviser so that strategies, allocations and managers can be monitored to ensure they are adding value.

Where Tactical and/or Dynamic Asset Allocation can be provided by a high quality independent Investment Manager for a similar price to Strategic Asset Allocation and where it is suitable (as outlined above); , given the ability to actively manage risk and return, maximising the chance our clients will achieve their goals.


Strategic Asset Allocation Tactical & Dynamic Asset Allocation
Prefer a buy-and-hold approach to Investing Would like their Investment Manager to actively adjust the of mix of asset classes as they see fit, with the intent of increasing returns or reducing risk, when compared to a more static approach
Would like a simple solution that requires little ongoing monitoring Believe that high quality Investment Managers have the skills and expertise to do this effectively
Are more cost conscious and thus more focused on fees, rather than risk and return outcomes Are more focused on risk and return outcomes than cost
For cost concerns and/or other reasons do not wish to engage regularly with an adviser Are more concerned with set risk and return outcomes, then having their assets allocated within a set or range bound Asset Allocation framework
Do not wish to constantly monitor their investments themselves Are willing to engage regularly with an adviser to select, monitor and review their Investment Managers


Manager and stock selection

Once the asset allocation methodology has been determined, there are two main approaches that can be taken when selecting and monitoring the underlying investments, that will make up the portfolio in each asset class. These are active selection and passive (index) selection.

Active management

is a dynamic, hands-on approach to investing, typically managed by a professional money manager or investment firm. This approach means decisions are constantly made about the appropriateness and performance of the assets being held within the portfolio. This approach tends to attract higher fees as you are paying for expertise in asset selection and the effort required in keeping an eye on things day in and day out. Participants here value a custom approach to suit their personal values and goals and believe that the flexibility and adaptability add value over the long term.

Advantages of active management

An Investment Manager’s expertise, experience, skill and judgment is being utilized, when investing in an actively managed fund. Active Fund Managers have flexibility and freedom in the stock selection process, as performance is not tracked to an index. Actively managed funds also allow for benefits in tax and transaction fee management. The ability to buy and sell when deemed necessary, makes it possible to offset losing investments with wining investments, to produce better outcomes than a more static approach.

Additionally, by not being compelled to follow specific benchmarks, active Fund Managers can manage risk more proficiently by adjusting holdings to sectors, industries or stocks that they believe will underperform, due to economic, industry or stock specific issues (poor management, governance, benchmarks, targets, funds available, etc…). Active Managers can also mitigate risk by using various hedging strategies (such as short selling and using derivatives to protect portfolios.

An active approach relies on the skill of the Investment Manager, where the investor is paying for a manager and is essentially taking on the risk of the manager underperforming when compared to the benchmark, for the potential for enhanced risk and return outcomes specific to their needs.

Investor suitability

An Active approach would be more suited to someone who is focused more on risk and return outcomes than cost and who believes that managers can add value (either by reducing risk or enhancing returns) through active stock selection based on research and market insight.

We believe that an active approach should only be undertaken where either, the investor is willing to actively research the managers selected in their portfolio and monitor and assess their performance on a regular basis, or where the investor is willing to engage an Adviser to undertake these roles.

Passive management

Passive management is a style of management where a fund’s portfolio mirrors a market index, like the ASX 200 or Dow Jones Industrial Index, whereby the portfolio holds all stocks in the, in the same manner as the index. In this way, the Investor will receive the risk and return outcomes of the index and market being invested in, with no potential to outperform and with no risk (excluding fees and costs) of underperforming that market index.

Passive investment tends to be a more ‘set and forget’ approach to investing, and tends to involve more index-based funds. This approach tends to have lower fees but is less tailored to a person’s values and goals. Participants here are to the market’s movements.[4]

Advantages of Passive Investing

Passive management approaches tend to have lower management fees than active approaches. Many of these funds focus on index funds which use the guiding index philosophy to determine when to buy or sell underlying assets. For example, the ASX200 is a grouping of the top 200 companies listed on the Australian Stock Exchange. Buying into a fund that models that would give you a percentage holding in each of those 200 companies. At the end of the year, the list would be revised to determine the new top 200 and holdings would be sold or bought to keep up to date. Passive approaches tend to have fewer transactions and therefore lower investment-related taxes like capital gains. Investing under a passive model puts distance between you and the buy/sell decision, reducing the temptation to allow emotional responses to market variations influence your decisions.

Investor Suitability

A passive approach would suit an investor who either has a strong belief in market efficiency with a philosophical belief that active management doesn’t add value; or for investors who are solely focused on cost, wanting to achieve the market return at the lowest cost, with no consideration of after fee performance and no adjustment for the consideration of the risks inherent in the market.

Our philosophy about management

We believe that an active approach should only be undertaken where there is a clear benefit, when weighed against the cost. In certain markets or sectors, a passive approach may be best in order to gain the return of the market, at the lowest cost. As such, it is common for a portfolio to consist of a mix between active and passive investments.

We believe these decisions are best left to an Investment Manager building and maintaining the portfolio and where an adviser is not being engaged to assist with this, or where the Investor isn’t qualified to make these decisions, a Manager should be selected that can undertake these decisions within a single fund structure, in line with the investors risk profile.

Role of your adviser in taking an active approach to portfolio construction, asset allocation and stock selection

We believe that the role of the adviser in this stage is critical. As discussed previously, an Active Approach relies on the skill and expertise of a manager to deliver on its objectives throughout the Investment Cycle.

By taking a more active approach, the investor does take on the “human element” risks, should their Investment and/or fund manager not perform by way of lower market returns or Increased Risk, and thus the Investor ends up paying more for an inferior outcome, when compared to a cheaper “set and forget” strategy.

As such, we believe that where an investor is going to take a more active, it is important to engage an adviser to monitor the performance of the various managers on behalf of the clients, to ensure the client is receiving value for the cost.

What’s your philosophy?

You believe Investment Managers are unable to add value by taking an Active approach to the management and monitoring of your investment portfolio as you believe that the market ultimately provides the best return. You are not prepared to pay for an Active approach. You believe that by taking an Active approach to managing and monitoring your investment portfolio, Investment Managers can add value through enhanced risk and return outcomes. Taking an active approach is more important to you than seeking lower cost passive options.
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