Wealth Creation Strategies: Part 3 – Portfolio Construction Process

Investment objective

Each portfolio has a specific investment objective, which it is expected to meet with a reasonable degree of certainty. To reliably deliver investment objectives over time we use portfolio theory in the construction of our portfolios.

Asset allocation

Choosing the strategic asset allocation is the most important investment decision. Returns from the market will determine the majority of the returns from a portfolio. This is known as the market return. Additional returns come from the ability of the manager to add value relative to the market return. They must do this so that the investor is compensated for any extra risk the manager takes in the portfolio on an after fees basis.

In determining the appropriate strategic asset allocation for the portfolios, AXA Financial Planning [ASFL 234663] considers the following:

• The contribution to the return of a particular asset class or security to a portfolio is equal to its proportion in the portfolio. Therefore, if Australian equities returns 10% and they make up 30% of the portfolio, then the contribution to the total return will be 3%.
• The contribution of a particular asset class to the total risk or volatility of a portfolio is not directly proportional to its weighting in the portfolio. The volatility contributed to the portfolio is dependent on the relationship between the returns of that asset class or security with the returns of other asset classes or securities in the portfolio.

Diversification

In this chart below, AXA Financial Planning [ASFL 234663]  have combined the expected returns from each asset class and combined them with the historical 20-year volatility of each asset class. The thick black line connects the five diversified portfolios used. The expected returns of the portfolios are made up of the expected returns of the contributing asset classes. Note how the diversified portfolios are to the left of the individual asset classes. This means that for the same expected return the diversified portfolio has had lower volatility.

This is what diversification is all about. It is not the cure-all but it is an important tool used to reduce risk for client portfolios.

Below are the five portfolios recommended by AXA Financial Planning [ASFL 234663]:

Sector	Defensive	Moderately Defensive	Balanced	Growth	High Growth
	30 / 70	50 / 50	70 / 30	85 / 15	99 / 1
Australian shares	14%	22%	34%	43%	45%
International shares	8%	18%	26%	32%	49%
Property	8%	10%	10%	10%	5%
Australian fixed interest	30%	23%	15%	8%	0%
International fixed interest	20%	17%	11%	5%	0%
Cash	20%	10%	4%	2%	1%
Total	100%	100%	100%	100%	100%

In the next table AXA Financial Planning [ASFL 234663] show the appropriate investment objectives for each of the portfolios. Importantly, these objectives are realistic, measurable and achievable.

	Defensive	Moderate Defensive	Balanced	Growth	High Growth
Projected nominal rate of return after wholesale fees and out performance (pa)	6. 3%	7.0%	7.8%	8.5%	9.1%
Assumed future inflation rate (pa)	2.5%	2.5%	2.5%	2.5%	2.5%
Projected real rate of return after fees and tax	3.8%	4.5%	5.3%	6.0%	6.6%
Minimum suggested investment horizon	2 years	3 years	4 years	5 years	9 years
Main investment objective over investment horizon	CPI + 1%	CPI + 2%	CPI + 3%	CPI + 4%	CPI + 5%
Probability of meeting main objective	98%	97%	61%	61%	59%
Secondary investment objective over minimum investment period	CPI + 0%	CPI + 0%	CPI + 0%	CPI + 0%	CPI + 0%
Probability of meeting secondary objective	100%	100%	75%	81%	83%
Probability of positive return over one year	93%	90%	84%	81%	78%
Normal range over one year periods*	2% to 11%	1% to 13%	0% to 16%	-1% to 18%	-3% to 21%
Extreme range over one year periods**	-7% to 19%	-10% to 24%	-16% to 32%	-20% to 37%	-26% to 44%

Based on after wholesale fees returns and 1% active outperformance in equities and before administration costs

* One standard deviation; 2/3 of annual results expected to fall in this range

** Three standard deviations; 99% of annual results expected to fall in this range

Objectives represent constraints or a target band of desirable outcomes. In the above example, the prime objective of ‘CPI plus X’ has a reasonable chance of being achieved over the desired time frame.

The downside is the higher the returns target the greater the variation in outcome.

Returns

Forecasting expected asset class returns is certainly an inexact science, but to make it simpler the process uses a building blocks approach. A point to note is that returns are additive.

The first block is inflation. This is the minimum any purchaser of an asset class expects, and is embedded in the cash rate. An asset class must achieve a positive real return over time.

The second block is the risk free rate. This is the time value of money and represents the ‘cost’ of deferring consumption until some future date. It is risk free because it is backed by a high credit rating Government (such as the US or Australia) which has taxing power so that it cannot default.

The third block is the risk premium. This is the additional earnings that investors demand in order to invest in risky assets where cash flows are uncertain.

Finally, manager alpha represents the return managers earn through their skill.  This is a measure of the investment management skill of the manager. Note that the proportion of return attributable to alpha is larger in more inefficient markets.

Putting returns into perspective

An arbitrary example may help to put investment returns into long-term context. Let’s assume you have a portfolio of $250,000 and you need an income of $25,000, this requires a net return of 10% per annum. That return is based on what you will need this year, whereas next year you will need that same return plus an increase for inflation to buy the same products and services. Or in other words, each year you will need inflation plus 10% as a return. Such a return is not reliably achievable in today’s economic climate. This calculation does not allow for future capital withdrawals as per your plans.

However, if you were prepared to have less capital in your later years you would need a lower return and therefore could take less risk. This is because you could take a small amount of capital each year to help fund your spending needs. Under this scenario you may only need to average a 5% return or inflation plus 5% per annum.

The notion about ‘averaging’ a return after five years as opposed to actually getting it each year is crucial to understand. You won’t actually get inflation plus 5% each year. Some years it will be higher or lower, but averaged over a minimum of five years it is likely to meet your target and get you where you want to go.

Fund manager selection process

Basically, portfolio construction has two inputs: Strategic asset allocation and manager selection.

Strategic asset allocation is based on:

• Expected return of individual asset classes.
• Diversification benefits of each asset class.
• Business risk (what are competitors doing?).
• Implementation costs. Can it be put together so that costs do not outweigh benefits?

Manager selection: What managers in what combination provide the best outcome with a high degree of certainty.

The theory behind choosing multiple managers to manage a single asset class is that together they increase the probability of achieving reliable out performance of the benchmark on an after fees basis. The following is a description of the types of managers considered in the investment process.

Index manager – Delivers a return that is consistently in line with index returns (before fund manager fees), with minimal tracking error (risk of under performing index).

Enhanced index manager – Delivers a return that is consistently above index by a margin of at least the fund managers’ fees, with low tracking error.

Core active manager – A core active manager is basically an active manager with a largely neutral approach to investing.  These managers do not have any material or systematic portfolio biases, and are likely to generate very consistent (albeit modest) out-performance in most market conditions.  These managers have strong risk management disciplines, including processes for identifying and managing ‘unintended’ risks.

Specialised active manager – An active manager with specific ‘style’ characteristics is likely to have a higher tracking error and to generate less consistent returns over time.  However, investors should be compensated with higher long-term returns.  We prefer that these managers also have strong risk management disciplines and avoid the extremes often associated with individual ‘styles’.

Manager combinations – The process is influenced by a number of considerations, including:

• Structural and style biases of the aggregate portfolio.
• The contribution from each individual fund manager to portfolio risk and return.
• The nature of the local business environment in which fund managers operate.
• Tax and legal considerations.

The following framework guides the manager combination process. The process anchors each sector portfolio with a largely ‘neutral’ approach to investing. This may include index managers, enhanced index managers and/or core active managers. The performance objective of the core of each of our sector portfolios is to fully capture (and hopefully add to) the underlying returns of each market sector index with a high degree of consistency.

Managers with specific style characteristics (‘specialised active managers’) may add diversity to a portfolio’s structure and improve returns, but can only be included if the overall portfolio does not exhibit a large systematic bias and their individual returns avoid the extremes often associated with individual ‘styles’. As a consequence, the process typically combines two or more specialised active managers based on their complementary styles.

Overall, portfolios may have a slight bias at different stages of the market cycle. This bias is only accepted if there is a full appreciation of the likely performance impact and with a view to adding to longer-term returns, and will typically be driven by high conviction manager decisions.

Manage and review

Just as important as knowing what managers to put in a portfolio is to know when their time is up. Just how does a manager get sacked?

• Short-term performance is inconsistent with the manager’s stated investment process.
• Longer-term performance is inconsistent with the manager’s performance objectives (usually expressed on a rolling 3 year basis).
• Concern about the implementation of a manager’s investment process.
• The emergence of another factor (eg. staff change) erodes the manager’s competitive edge.
• Identification of a compelling alternative.

Managed to a strategic asset allocation and reviewed periodically, our research shows that timing in and out of markets is not a reliable source of added value over time.

Investment portfolio benefits are derived from:

• Diversification across sectors, managers, and individual securities.
• Disciplined re-balancing to ensure strategic asset allocations and manager allocations are enduring throughout market movements.
• Active funds management.

Asset descriptions

Investors purchase assets, whether directly or indirectly, for the returns they provide. Each asset class has its own return attributes of income and/or capital growth and taxation treatment. Some assets may provide tax benefits such as tax-free and tax-deferred income or franking credits. They all have risk profiles, expected holding periods and expected long-term returns.

Cash - Cash investments provide maximum security of capital, however returns will vary depending upon prevailing interest rates.  While cash is very low risk, the impacts of inflation eroding the buying value of money and taxation should not be forgotten when using assessing real, after tax cash returns.  Cash assets can usually be accessed immediately, however superannuation and pension regulations must also be considered.  Cash assets offer no growth.

Fixed interest – Fixed interest securities are debt (loan) instruments, whereby the investor lends money with the expectation of a full return of capital (principal) and a payment of interest. They are usually defined by the:

• Length of the loan period.
• Interest payment.
• Type of issuer.
• Security that backs the debt.

The general principle is the longer the period and the less secure the lender, the higher the interest rate.

Fixed interest investments include, but are not limited to:

• Mortgage trusts provide regular interest income at variable rates and a high level of capital security. Investors’ funds are pooled and invested mainly in registered first mortgages secured against a spread of freehold property. Usually only 66% to 75% of valuation is lent.
• Bond trusts provide regular interest income through pooled investment in Government and corporate bonds. These funds offer high long-term capital security and the potential for some capital growth in addition to interest income.
• Term deposits provide a regular and secure income at a fixed rate for a fixed term.

Australian equities – Equities or shares offer investors the opportunity to participate in the growth and profitability of companies. In so doing, investors also take on the risks associated with owning a business. Many of the largest companies have their shares listed on the Australian stock exchange. This means there is a public market where brokers stand in for their clients to buy and sell shares.

While the Australian share market is dominated by the large institutions and significantly, large overseas institutions, an increasing number of smaller investors are being attracted to the market. There are many reasons for this, including:

• Market value has been increasing in value over a long period of time.
• Greater press coverage on the market and share ownership.
• The float of semi-Government corporations (such as the Commonwealth bank and Telstra) and the demutualisation and listing of large insurance companies.
• Hybrid products, such as instalment warrants.
• Self managed superannuation funds are providing investors with the structures and money to invest in the share market.
• The dividend imputation system is attractive for managing tax liabilities.
• Administration systems, including master trusts and wrap accounts, are making share holding easier as they provide custodial and reporting services.

International equities – International equities provide the same type of corporate ownership as do domestic shares, but may offer investment opportunities that are not available within the domestic (Australian) share market. They also offer diversification against holdings in domestic shares since different countries’ economies grow at different rates.

For Australian investors, the natural volatility of the internationalised share market is increased by the volatility of currency exchange rates. Thus, while the returns possible from international investing are high, the risks are also higher. In addition, the costs of researching, investing, monitoring and selling are high.

The Australian share market, by capitalisation, represents about 1% to 2% of the world share markets. However, most Australians would have limited exposure to world share markets. While the purchase and sale of domestic equities is relatively easy and the cost of entry into the market relatively low, investing directly into international equities is difficult for the general investor. Most investors gain exposure to international equities through pooled investment structures. As world markets continue to make news and are, in some cases, providing significant growth returns, individuals and institutional investors are tending to invest more of their money overseas.

Property – Property investment should be regarded as an important part of any growth-oriented portfolio. Well-selected and managed property investments should provide long-term capital growth in excess of inflation, combined with rental income.

The inclusion of property in your portfolio can help reduce overall volatility by providing a counter to your share market investments, as property values tend to move independently of share prices.

For many Australians, property is their first and most important investment. While they do not buy their home in order to resell in a trading sense, many people will move several times throughout their lifetime and thus experience the joys of property transactions.

Once the home is financially secured, many people look to purchase an income-producing property, often through a gearing package. Aside from the fact that the investor’s portfolio is now weighted 100% towards one asset class, property is an illiquid asset. It takes time to sell and time to settle. In addition, interest rates may rise, or the property may remain vacant for a period or be damaged by tenants. Care should be taken over property’s weighting in the total portfolio.

Commercial and industrial properties are projected to have higher real returns, however, most investors cannot afford to invest in these properties directly. Australia has more ways for investors to gain property exposure through pooled investments than any other country – reflecting investors’ continuing interest in the asset class.

Returns on property are generally capital growth and rental income. The two together form the total return. While different in nature, the capital growth, which is the increase in the potential sale value, is linked to the rental income. The value of the property is a function of the level, certainty and continuation of the income stream.

For assistance in helping you create your own wealth creation strategy to help you realise your goals and achieve financial freedom contact us today by either telephone 03 9542 3200 or email blog@freedomfinancialplanning.com.au

WARNING: The information contained on this website is provided in good faith. While the contents are obtained from various sources that are deemed reliable, it is not guaranteed as accurate or complete and should not be relied upon as such. It is recommended that you seek independent, professional advice before implementing any of the suggestions to ensure that it is appropriate to your needs and circumstances.