Six Steps to Portfolio ConstructionHermes, Sanlam, Investec, Coronation, Allan Gray, Cadiz, 36ONE, Ankh. We currently have well over a hundred different Unit Trust companiesin South Africa. They in turn provide us with hundreds of different choices for funds. In fact, there are currently more Unit Trust funds on themarket than there are stocks on the JSE. Constructing a portfolio can therefore be a complex and sometimes daunting experience, which if youget it wrong, can have unfortunate consequences.At Glacier we recommend a formulaic approach to portfolio construction that should help the investor to navigate his way through this complexlabyrinth. It includes several steps to guide the investor and to help order his thoughts.STEP ONE: DETERMINING THE RISK PROFILEThe first step in portfolio construction is determining the clients risk profile. This is a very important part of the process. All the other aspects ofportfolio construction feed off it. It is also important at this point to explain the risk-return tradeoff. Investors often want complete capitalprotection in market downturns and complete participation in market performance during upswings. This is not a realistic expectation and theirmisconceptions should be corrected.At Glacier we use 5 Risk Profiles: Conservative Cautious Moderate Moderately Aggressive AggressiveWhere clients fall on this scale is one of the main determinants of their portfolios final characteristics and performance. Investors have wildlydiffering attitudes toward risk and risk tolerance. While we might laugh at a 20-year old with a conservative risk profile or frown concerning a70-year old with an aggressive profile, risk attitudes are not due solely to personal circumstance. Inherent psychological differences also play abig role in risk tolerance and should be considered.At Glacier we have a questionnaire called RiTA that determines a clients risk profile. It is important to consider the questions carefully andanswer honestly.STEP TWO: STRATEGIC ASSET ALLOCATIONArmed with a risk profile, the next step is strategic asset allocation. Simply put, this is your long term asset allocation. Research has shown thatup to 90% of a portfolios performance can be explained by the composition of asset classes. There are five main asset classes to consider: Equities (Local South African) Property Bonds Foreign (Includes equities and fixed interest) Money Market (Short term cash instruments)Risk profile of client Money Market Bonds Property Equity ForeignConservative 40% - 60% 15% - 35% 5% - 25% 0% - 20% 0% - 10%Cautious 30% - 45% 15% - 35% 5% - 20% 15% - 35% 5% - 15%Moderate 15% - 30% 15% - 30% 5% - 15% 30% - 50% 10% - 20%Assertive 10% - 25% 10% - 25% 0% - 10% 45% - 60% 15% - 35%Aggressive 5% - 10% 10% - 20% 0% - 10% 60% - 75% 20% - 40%The amount of exposure a client should have to each asset class depends almost solelyon his risk profile. The table above details the asset allocation of the various riskprofiles. In order to populate the asset bands we suggest using a building blockapproach.This involves appointing specialist investment managers to each manage a part of theasset allocation. In other words, an assertive investor could invest his money asfollows. Equity exposure could be split between two general equity funds. Select one or two offshore funds to make up the foreign portion of the assets
A Property manager to manage the property portion A bond manager for the bond portion A money market fund for the cash portionThis is just one way to populate the asset bands. Instead of using a pure propertyfund, you could use a fixed interest varied specialist fund to take care of bonds, cashand property exposure and then only allocate a small portion to a money market fund.Another option is to use a core-satellite approach. Select a single core fund that hasan asset allocation mandate to make up the largest part of the portfolio. Then add oneor two other funds as satellites in keeping with the risk profile.STEP THREE: TACTICAL ASSET ALLOCATIONWhere strategic asset allocation determines the basic construction of the investmentover the long term, tactical asset allocation has a much shorter focus. It involvesactively over-or underweighting asset classes to take advantage of short term marketmovements. For example an Assertive investor who is bullish on foreign assets andbearish on property, would allocate assets closer to the top of the band (35%) inforeign and the bottom of the band in property (0%). If the investor is neutral towardsan asset class he will be somewhere in the middle.There is a big chance of getting tactical asset allocation wrong, so instead of addingvalue you reduce it. That is why we recommend you restrict the changes in assetallocation to within the bounds of the specified asset bands. If the investor feelsneutral towards an asset class or doesnt want to use tactical asset allocation, stayingin the middle of the bands will still enable him to reach his goals.STEP FOUR: FUND SELECTIONFund selection is the next step in the process. How do you choose funds from thehundreds in the market? "Shopping List", one of Glaciers proprietary researchdocuments, is a good starting place. Its goal is to highlight funds in each ACI categorywhich have demonstrated consistent performance and good capital protection.When selecting funds from the Shopping List it is important to remember what riskprofile your client has. This will play a large role in determining which funds youselect. Choosing three equity funds for the 20% equity exposure of a Conservativeclient, or two Money Market funds for an Assertive investor is unnecessary. Apart fromcomplicating the portfolio it doesnt really add any value.STEP FIVE: CONSTRUCTING THE PORTFOLIOOnce you have selected the funds its time you place them into a portfolio. Rememberthat the total risk of the portfolio is less than the average risk of the separate
funds. This is due to the benefits of diversification. By combining asset classes anddifferent management styles you significantly reduce risk.Let us use the following hypothetical portfolio as an example. Risk# Fund Name Fund Class % Rating1. Sanlam Value Fund Equity Value Funds 25% 8.502. Hermes Equity Fund Equity General Funds 25% 7.423. Ned group Flexible Income Fund Fixed Interest Varied Specialist Funds 20% 1.82 Foreign Asset Allocation Flexible4. Allan Gray Orbis Global FoF 20% 7.35 Fund5. Glacier Money Market Fund Fixed Interest Money Market Funds 10% 0.34The weighted average of the risk of this fund is 6.59. At that level of risk the portfoliois classified as Moderately-Aggressive. Remember that funds often dont movetogether in the same magnitude or even in the same direction.A measure of how funds move together is called the correlation. Correlations varyanywhere between -100% and 100%; with 100% meaning funds movements matchperfectly and -100% meaning funds movements are total opposites. Below is a tableshowing how the above funds correlate with each other.As you can see Fund 1 (Sanlam Value) correlates perfectly with itself. Fund 2 (HermesEquity) and Fund 1 correlate 92.7%. This is to be expected as both are equityfunds. You can also see that Fund 1 has a -49.8% correlation with Fund 4 (Allan GrayOrbis Global FoF). This means that these two funds often move in oppositedirections. This translates into a portfolio that has less risk than the sum of itsparts. The total risk on this portfolio is 5.00, which is a 24% improvement on just theweighted average.It is important to realise that you get the benefits of diversification whether you planfor it or not, but a process of selecting funds and specifically changing them to
maximise performance and minimise risk can be optimized if you understand thecorrelations.STEP SIX: REBALANCING THE PORTFOLIOThe portfolio must be rebalanced at least every 6 months. Due to market movementsand the inherent differences in the funds, they will grow at different rates. This couldchange the weightings in the portfolio, moving it out of its specified risk profile orasset bands. For this reason we advocate that you look at the asset and fundallocations on at least a half yearly basis, to keep the portfolios true to their originalrisk profile.Following these 6 steps will ensure that your clients receive a portfolio that matchestheir risk profile and will meet the requisite investment goals. This will give you, thefinancial advisor and the client, peace of mind.