Why constructing an investment portfolio is not so simple

Jan 21 2016 08:00
Greg Flash

Serious investors and professional financial advisors understand that it is critical to research funds exhaustively.

Having identified the “good” ones on the basis of their past performance, they usually feel safe in spreading their investments across the selected funds.

While we agree that this exercise is necessary and worthwhile, it is only a first step and does not lead to a robust and diversified portfolio. Here’s why.

The first point to make is the definition of “good”. While the funds you identify may have excellent track records, they might not be best suited for current economic conditions.

For example, we have been living through a protracted bull run since 2009. Many of the funds that did well during that period are those that are focused on growth and momentum.

More conservative funds that look for value have performed less well. But now that the bull has run out of steam, we seem to have entered into a new period of volatility, the ability to pick undervalued stocks becomes much more important.

To put it simply, funds perform differently in different economic conditions not because one is necessary better than the other, but because each is looking for different things.

In order to be properly diversified, a portfolio should have a range of funds that have different criteria and aims, and thus investment styles.

It is thus necessary to assess each fund’s risk metrics to understand when they will do best—having different types of funds will act as a “shock absorber”, whereas a portfolio comprised of the same kind of fund will be less able to weather changing economic cycles.

When the going is good, they will all go up, but when conditions change, they will all go down together.

Another complication could be that the manager of a particular fund has only been in the job for two years—thus the 10-year record you are looking at is not really indicative of the fund’s current trajectory.

One has to be aware of these fund manager changes and account for them in any research.

When it comes to diversification, one needs to realise that the 2008 financial crisis taught us that the financial world is now very interconnected.

Thus achieving diversification between asset classes is very much more difficult because no clear boundaries exist anymore.

In the wake of the crisis, too, many funds changed style in order to find the liquidity they needed to meet their commitments—thus judging a fund’s style by its name can be dangerous.

Our key message is that constructing a portfolio requires a robust and formal process that looks at the risk profile of each fund, plus the investment style of the individual running the fund.

In the end, and especially as markets continue to be exceptionally volatile, constructing a robust and shock-resistant portfolio has never been more important—or more difficult.

*Greg Flash, chief investment officer at GCI Asset Management