Sunday, Aug 16, 2009

Let's start with the title: "Portfolio planning and the importance of weight". It's got a boring ring to it, so I will start with the conclusion - because that's important - then meander into some really exciting relevance. Hang in there.

The most important thing in asset management is to manage an investment towards the expectations of the investor. The most important tool that we have is the "weight" tool.

Some will subconsciously predict that I will quote from the studies of Professor Brinson (and others) which show that over 95 per cent of a portfolio's performance over a period of over say five years is down to "asset allocation" (that is, weight, the amount you have in one egg-laden basket versus the amount of eggs in another basket). But I won't quote from him, but it increasingly looks like he was right.

It is critical then, for investors to accept that my doctor's description of my body as "overweight" is a criticism that has no silver lining, yet the description of a portfolio being "overweight" in "X" is dis-similar to the extent that the "overweight" should reflect where the biggest silver lining of a portfolio's performance will come from.

The important thing re-stated: That you have to be "overweight" on something to get the performance near to your benchmark target, and that something should clearly reflect three things: Your benchmark, base currency and attitude to risk.

So, here is the really exciting bit: Does it? Does your portfolio, really, truly, reflect an overweight position that would show a third-party viewer: your base currency; your benchmark and your attitude to risk? The "weight-is-an-issue" thing has been around for some time. But there is an emerging trend that leads us to a different response in terms of how much and where we go for our overweight positions. In a nutshell, we could put it down to those bulls and bears running around secularly. Or are they running cyclically?

A prominent issue among equity market managers in recent months relates to the quandary as to whether the equity market rise was a bear market rally or the beginning of a bull market. If the latter transpires, market historians will call it a secular rally.

So, whilst "weight-is-an-issue" has been around for some time, what is different is that if equity markets are running cyclically or secularly, the chances are that they are running more or less in the same direction. This is a massive change to how portfolios should be constructed.

I read the sales circular of a locally based IFA that seemed to suggest "effective performance" at over 70 per cent-plus recently from a lump sum into a Royal Skandia long term plan (November to now).

India gets most of the credit, but the portfolio was diversified into Chinese equities, plus oil and gas. The good news is that the investors' profit has been "booked" into cash.

I wouldn't know what Brinson would say to this, but amongst the reactions, he might wonder firstly, why a long term product with exit/entry charges is being used to "trade" from 100 per cent equity to 100 per cent cash (why didn't he just use a stock broker?); secondly, he would wonder what the benchmark for performance is (was it 101 per cent, or 76 per cent annualised?), if so, what took place in the original attitude-to-risk discussion?

Lets hope the investor was Indian (base currency bias), with a "don't care" performance attitude. As above all, Brinson would wonder: Where is the asset allocation logic behind the original selection?

Ultimately, here is the point. Your portfolio's overweight position can be highly rewarding if you know what is going up all the time (as Markowitz's Nobel Prize winning paper states).

The conclusion: Asset allocation is critical. The asset in which you are overweight will drive the performance.

Overweight positions should increasingly reflect a mix of management styles given that equity markets and other correlated assets are becoming more "same-way-directional".

It will only reflect specific assets or specific countries where the risk attitude is exceptionally high. Or, where advisers can prove that they can predict the future.

By Sean Kelleher, Special to Gulf News

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