Best Practices for Portfolio Construction

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Best Practices

Portfolio Management

Best Practices for Portfolio Construction

Sam Bourgi Jun 18, 2019

This is where advisors can add value by helping their clients through behavioral coaching. Regardless of their expertise or level of sophistication, investors often need help navigating through complex market cycles or holding onto investments that have underperformed for any length of time. Through behavioral coaching, advisors can better suggest the right asset manager or actively managed fund for their clients.

Learn more about the portfolio management process here.

Best Practices for Portfolio Construction

That being said, there are at least four common threads that apply to portfolio construction and these will be relevant for the majority of investors.

Choosing Between Active-passive Strategies

  • Gross alpha expectation – Since actual future alpha is uncertain, “alpha expectation” frameworks essentially weigh the risks that active funds may underperform their benchmark.
  • Cost – Regardless of the strategy employed, factoring cost in the investment process is critical to building a profitable portfolio.
  • Active risk – Using a statistic called tracking error, advisors can measure a portfolio’s volatility relative to the underlying benchmark. Volatility plays a direct role in asset allocation.
  • Active-risk tolerance – Evaluating an investor’s risk tolerance is important even when employing an active portfolio strategy. While there’s no one-size-fits-all method to measuring active-risk tolerance, a focus on long-term investment goals should guide the strategy.

This framework is likely to work much better for investors who aren’t risk-averse. Investors who don’t fall into this camp may be better off with a simple indexing strategy, which has been shown to provide steady returns over the long haul.

Want to learn more about portfolio rebalancing? Click here.

Choosing Between a Concentrated or Diversified Portfolio

As Vanguard notes, not being fully diversified in today’s market carries significant risks. According to the widely cited study by Gary Brinson, et al. in 1986, asset allocation accounts for 90% of an investment’s variability. Since asset allocation largely determines how a portfolio performs, diversification across asset classes is critical to long-term success.

Learn about different portfolio management concepts here.

Making the Decision to Manage Overall Portfolio Volatility

This means constructing a portfolio that can cope with various market trends, while also taking into account the client’s investment goals, situation, and underlying risk tolerances. By working with an advisor, investors can employ active strategies to navigate through choppy market conditions. At the same time, there are several methods an advisor can employ to reduce portfolio volatility. These include asset diversification, reducing downside risks by evaluating how much a fund declines relative to its benchmark during bearish cycles and re-balancing when necessary to ensure original asset allocation is maintained. While this may come at the expense of higher returns, it addresses the concerns of investors who are overly worried about volatility.

Making the Currency Hedging Decision

Currency-hedging decisions should take into consideration factors such as investment time horizon, asset mix, and risk preference, among others. In other words, the hedging strategy must follow the portfolio’s strategic asset allocation. For example, fixed income portfolios should be hedged to local currency. Without this, the volatility of currencies in international bonds can offset the diversification benefits. On the other hand, when investing in foreign equities, adopting a systemic approach to currency hedging is necessary. This may include hedging with currency futures and, over longer-term horizons, passive hedging strategies that rely on currency trends, valuations and global interest-rate differentials.

The Bottom Line

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