The big picture: holistic portfolio planning

In managing money for their clients, an increasing number of advisers talk of viewing the portfolio as a whole and implementing holistic portfolio design.

A holistic approach is subtly different from the traditional view of asset allocation, which tends to place most of the emphasis on the separate pieces of a portfolio.

For instance, a discussion about asset allocation might focus on the degree to which the client wants to be exposed to, say, large caps and small caps.

Under the holistic approach, though, the adviser can emphasise the total risk/return structure of the portfolio, based upon its exposure to units of size (small cap versus large cap) and cost (value versus growth).

In other words, holistic portfolio planning treats the whole as greater than the sum of the parts.

Regardless of the individual vehicles you eventually use to implement your strategy, you should treat the overall portfolio as one huge set of securities with a single overall risk/return characteristic.

The point of this is that advisers who take a holistic approach can both add value to their clients’ financial lives and differentiate themselves from the pack.

Designing a holistic portfolio

The common approach to portfolio management is to buy individual products for their individual returns. But this methodology can put significant limits on your ability to design superior portfolios.

A holistic approach gives you more flexibility and expands your options by shifting your initial focus toward the bigger picture.

Essentially, you start by considering the portfolio’s total risk and return characteristic before thinking about individual product targets.

In this way, portfolio management is like drawing. Instead of first trying to sketch out a perfect nose or eyes, you start with a broad layout of the subject; the overview, form or structure. This achieves a better final result and prevents you from wasting time labouring over minutiae.

But just as an artist must understand the colours on their palette and how they mix together, so must an adviser understand the sources of risk and return.

This means determining how you want to position the portfolio relative to the overall market in terms of size. That is, should the portfolio be smaller than average market capitalisation or larger? And it means looking at to what extent the portfolio should be tilted more toward value stocks or growth shares.

Approximately five decades of financial research into historical asset prices has shown that small cap and value stocks offer a return premium relative to their peers, large and growth companies.

These are the abiding parameters of risk and return, and overall portfolio structure should be dictated by them.

Portfolio theory

The theory behind this approach came from a ground-breaking paper published in 1992 by US academics Gene Fama and Ken French. Their ‘three-factor model’ found that three elements: the market, firm size and book-to-market ratio determined about 95 per cent of the variation in stock returns.

Prior to this, most academics and investors believed a single factor model — the market factor — did the best job of explaining returns.

The Fama-French paper was hugely influential. Their conclusion, now implicit in the investment offerings of thousands of fund managers, was that there were three independent sources of risk in stock market returns.

What’s more, the small cap and value effects were found to be observable around the world, not just in the US market.

Portfolio construction

So what does this mean for the individual adviser in constructing a portfolio for a client?

The first decision, and always the most important, is the appropriate mix of defensive assets on the one hand and growth assets on the other.

The second decision is the allocation within these broad parameters of individual asset classes — cash and fixed interest in the defensive arena and property, Australian and global equities and emerging markets in the growth area.

It is the third decision that many advisers fail to make — the decision on the further division of these broad asset classes into sub-asset classes. In the case of equities, this means the allocation toward large cap, small cap and value.

This is an important decision, because the research shows that exposure to these risk factors is the principal determinant of differences in equity return.

Tailoring the tilts

Of course, the extent of any tilt toward small cap or value will depend on each client’s goals and tolerance for risk. That is something you will learn by taking a comprehensive approach to client relationship management and learning all you can about your clients.

What’s more, any tilt toward value, small caps or both should be reassessed as a client’s personal risk profile changes over time and with age.

Remember, there is no single optimum portfolio. Rather, the emphasis should be on satisfying the risk appetite of each individual investor.

Once you’ve created an overall structure for the portfolio, it’s time to fill in the detail of the picture by choosing specific investments. Your choices should be based on two main factors: efficacy (the power to produce the effect you desire, for example, a value tilt,) and cost.

A few guidelines here can help. The more you tilt a portfolio toward small company shares, the more expensive it will be to implement and maintain. That’s because small stocks are illiquid and relatively expensive to trade. By contrast, large cap stocks are cost-efficient.

When it comes to implementation, your focus should be on accessing as many parts of the market as possible, targeting exposure towards the mix of asset classes (large, value and small) that accomplish your client’s risk/return objectives.

Diversification benefits

There is an additional advantage to this holistic approach that is hugely important to you and your clients: greater diversification.

The more asset classes your clients invest in, the more protected they will be from the wild swings of the markets. Greater diversification means reduced volatility. And experience shows investors are more likely to stay disciplined when they hold a variety of assets and view their portfolios as a singular unit instead of a collection of parts. This may prevent them from selling an asset class when it’s suffering or loading up on a hot investment that has soared in price.

The danger of trying to time the market by shifting between various asset classes can be seen in chart 1 (page 26 of Money Management, June 28), showing the best-to-worst performing asset classes each year going back to the early 1990s.

As can be seen in chart 1 (page 26 of Money Management , June 28), there is little pattern in the performance of asset classes from one year to the next. For instance, emerging markets were the standout performer in 1999, delivering a 63.69 per cent return. The following year they were the single worst performer, losing 31 per cent.

Global value stocks were the number one asset class in 2000, but fell well out of favour in the following three years as Australian value, property and small caps came back to the fore.

If there is any discernible pattern, it is that returns from fixed interest strategies tend to cluster around the bottom half of the table.

However, that is what you would expect if you believe that risk and return are related.

What can you the adviser do about this? The simple answer is diversification, a process that both washes away the random fortunes and positions of the client’s portfolio to capture the returns of broad economic forces.

Tables 1 and 2 and chart 2 (page 26 of Money Management , June 28), compare the annualised compound returns and standard deviations (a measure of volatility) of three individual portfolios.

The first portfolio is a simple split of fixed interest, and Australian and global equities, 30 per cent S&P/ASX 300 index, 30 per cent MSCI World Index and 40 per cent 90-day bank bills. The second diversifies the equity component by size splitting it evenly between large and small cap stocks.

The third portfolio completes the story, halving the small cap exposure to include value stocks.

Now compare the returns and volatility of the most broadly diversified strategy with the more concentrated portfolios. You can see that the returns are greater, and for portfolio 3, the standard deviation lower. This is the power of diversification. The whole is greater than the sum of the parts.

The lesson from all this is that instead of viewing investments as products, advisers should look at them as tools for designing a portfolio’s overall structure.

This holistic approach can create stronger and more cost-effective solutions for your clients, who will repay you with their loyalty for years to come.

Vanessa Bennett is regional director of financial adviser services for DimensionalFund Advisors in Sydney.