Planning the portfolio construction process

The main objective of successful portfolio construction is to deliver the best possible solution for the client.

Our clients are retail investors at all stages of life. The portfolios that they need vary. Some want a portfolio to deliver growth, some want income portfolios, others focus on capital preservation, and then there are aggressive investors who want to use leverage to increase wealth.

This means our advisers need to tailor the portfolios to each client. In tailoring, the advisers will consider, among other things:

~ the risk profile of the client — this is established using questionnaires and interviews;

~ the time horizon — sometimes part of a portfolio needs to be invested in very low capital risk assets against short-term cash requirements;

~ the return requirements; and

~ the special needs of each client — a client may want leverage or to preserve capital.

This must then be translated into a portfolio of investments.

Asset allocation

Because of the mix of clients, several asset allocation mixes are needed. These map to the client’s risk profiles and the results of the adviser/client interview process. There is flexibility built in for tailoring to a particular client request, for example overweight international shares.

The various asset allocation mixes vary from capital preservation portfolios, through balanced to aggressive portfolios.

Typically, a capital preservation portfolio will invest in cash or enhanced cash only. At the other end of the spectrum, an aggressive portfolio will invest in growth assets only.

In addition to the traditional asset classes, portfolios can include hedge funds and/or tactical asset allocation funds.

The asset allocation mixes are regularly tested against current return and risk expectations for each market. This is not a tactical exercise; it is built on medium to long-term market expectations.

Portfolio construction

For retail clients there are three main streams for portfolio construction. Advisers will often mix these in a portfolio.

Multi-manager funds: Use of these funds effectively outsources the manager selection and monitoring. This is very useful for the many clients who want a robust ‘set-and-forget’ portfolio. Some multi-manager diversified portfolios have tactical asset allocation and alternative investments. This is also a good way to tap into smaller boutique managers and wholesale managers that do not have separate retail products.

Diversified funds: These have always been popular because they often combine benchmark allocations to traditional asset classes with fairly active tactical asset allocation. This limits risk for clients and can add alpha. The other advantage of diversified funds is that they can invest in smaller asset classes like emerging countries and private equity. The client can get a lot of value add in terms of diversification and alternate sources of alpha from investment in single diversified funds. The downside to the use of diversified funds is that sometimes the fund is a relatively weak manager in one asset class. This is often balanced in portfolios by the addition of a strong single sector manager. Our advisers call this the ‘core plus satellite’ approach.

Single sector fund portfolios: The use of single sector funds allows advisers to select the best managers in each asset class. It is also possible to add tactical asset allocation with a special TAA fund.

In addition to the three streams for typical managed fund portfolios, advisers look at client requirements for direct equities, income, property and cash. Obviously technical and tax factors play a large part in the components of the portfolio.

Investment fund selection

Investment funds are selected by advisers from a list of recommended funds. Our research process is rigorous. Australia’s regulators dictate that investments that are recommended must be well researched. The dealer group must be able to demonstrate that it has met with the obligations of section 912A and 945A of the Corporations Act and ASIC policy Statements 175 and 164.

To support this regulatory requirement and to contribute to the desire of advisers to only be recommending the best products, our research division has a rigorous and structured review process for existing products on the recommended list and products considered for addition to the list.

Investments are reviewed using the following process steps:

1. Identification of the ‘universe’ of funds for the review.

2. Quantitative testing

3. Questionnaires

4. Formal Review

The qualitative factors that we look at are:

~ corporate strength;

~ investment process/philosophy;

~ risk management;

~ investment team;

~ administration and client services; and

~ systems and technology;

The quantitative factors we typically look at are:

Return:

~ how the manager has performed relative to a benchmark;

~ has the manager added value through security selection or tactical allocation?; and

~ how have the manager’s returns varied in line with movements in the market?

Risk:

~ what has been the manager’s downside volatility of returns?

~ how much risk has the manager taken to achieve the excess returns?

~ how successful (in terms of returns) has the manager been in tilting the portfolio away from the benchmark?

The wide variety of clients means that investment products of all levels of risk may be needed. The important thing is to use investments that give good returns for the risks.

When the review is complete, the recommendations are taken to the adviser group clients. Both RetireInvest and Tandem have an Investment Selection Committee, the members of which are charged with scrutinising and debating the recommendations and deciding whether the recommendations should go through to the recommended list.

Combining investments

If this part of the process is done well, significant risk reduction benefits can be achieved. Our advisers take into account many investment characteristics to ensure that the portfolio is well diversified and that it meets clients’ objectives. Some factors taken into account when combining investment products are:

~ investment style (value, growth, growth at a reasonable price, style rotational, index);

~ market cap (small, medium and large cap);

~ turnover and franking credits;

~ risk characteristics for fixed interest investments (duration, investment grade credit, high yield, default risk); and

~ currency management (active, passive, unhedged).

For the example portfolios that our research division produces, the factors above are taken into account and, in addition, the following analysis is performed:

~ historical correlations, portfolio returns against benchmark;

~ portfolio risk measurement with volatility measures and downside risk measures; and

~ absolute returns throughout different market cycles.

While past performance is not necessarily a good indicator of future performance, it can give insight into appropriate combinations of investments and expected alpha.

Maggie Callinan is research manager at ING Advice Research.