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Portfolio Construction: A Systematic Approach

 

Investopedia defines a portfolio as a “collection of financial investments like stocks, bonds, commodities, cash, and cash equivalents….” If we use this definition then we would want to construct a portfolio by combining the asset classes from around the world in a way that maximizes the return for a given amount of risk. (In the coming weeks we will be discussing the three elements of risk and how they should be measured appropriately.)

Our portfolio construction process is one part of a holistic financial planning endeavor. We do not create portfolios and allow clients to select them off the shelf any more than your doctor would allow you to write your own prescription. Instead, we work with clients to understand their life goals, financial objectives, limitations, and biases so that we can construct an appropriate investment portfolio. This portfolio is designed to work within the greater financial plan that has been developed for each client. However, every portfolio that we design follows the principles outlined below.

WE ARE GROUNDED IN SCIENCE: Our portfolio construction process is grounded in academic science using generations of historical data. We invest in historically profitable asset classes. In other words, when certain asset classes are cheap (on a historical basis) we are more likely to include them in our portfolio. While some investment managers are attempting to see the future based on “breaking news,” we are looking for long-term historical patterns. These “factors” represent the long term “drivers of returns” for each of our portfolios. We work to implement these historical drivers of returns into your portfolios.¹

WE DIVERSIFY: We diversify across asset classes, geographies, and other spectrums to reduce historical volatility. We thoughtfully diversify your portfolio instead of simply having multiple investments. For instance, we may have multiple investments that seem to share investment goals or attributes. You may see two funds that are both “Short Term Fixed Income” and wonder why they are both necessary. However, a careful examination would reveal a low correlation between the two funds.² In other words, while one fund may be more affected by changes in interest rates, the other fund may be more affected by changes in credit spreads.

WE FOCUS ON WHAT IS KNOWN: There are well-documented “Investment Factors” that are demonstrated across time, domains, geographies, and industries. For instance, companies that are not good at paying their debts (bad credit risks) have historically paid higher interest rates, whether they want to borrow money for one month or 20 years. They have to pay higher interest rates than good credit risks regardless of which country they operate in or which industry they operate in. All things being equal, you should expect companies with strong cash flows and good cash management to pay lower interest than companies that have poorer cash management practices. This means that when credit spreads “tighten,” investors are being compensated less than they have historically been compensated to take on the risk of lending to the borrower with a lower credit rating. We would work to eliminate those higher risk creditors out of our portfolios, since investors are not being compensated appropriately based on historical norms. This is just one example of the many factors that we evaluate based on historical and broad-based academic evidence.

WE IGNORE THE NOISE: Investors today have more information available to them than ever before. Instead of just having the nightly news, we now have a 24-hour news cycle augmented by social media where content creators are financially incentivized to compete for “clicks” and “views”. While the amount of information is ever-increasing, the quality of information may be questionable. You will also note that very few online prognosticators are actually managing your money, but rather they are needing you to view their content so that they can be paid. While much of this data is useful and can help us make informed decisions, we seek to look deeper into the long-term trends that have historically moved markets and made certain investments more attractive relative to their peers.

WE TEST TO ENSURE: We create portfolios based on factors that we believe will continue to be historically successful. Instead of trying to win the most recent time period, we create portfolios that would have been attractive over multiple historical market cycles. This results in stable and defensible portfolios that allow investors to achieve their objectives over their defined time horizon. Any portfolio construction has been evaluated based on where we are in today’s economic cycle, but also based on how the portfolio would perform over an entire economic cycle. This allows investors to have peace of mind knowing that their portfolio will be working for them regardless of market conditions.

1 https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/f-f_5_factors_2x3.html
2 https://www.dimensional.com/dfsmedia/f27f1cc5b9674653938eb84ff8006d8c/61063-source/smas-quantifying-the-tradeoffs-between-taxes-and-diversification.pdf

Michael French

Author: Michael French, Senior Vice President of Investments