Best Practices for Portfolio Construction

At the core of portfolio construction are the investor’s underlying objectives, risk tolerance and timeframe for investing. Good portfolio construction strategies reflect the investor’s objectives and constraints, whereas bad portfolio construction does not match an investor’s behavioral tendencies.

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.

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As a general rule, there’s no one-size-fits-all method for optimizing portfolio construction. Best practices will often depend on many factors, including the risk profile and objectives of the investor.

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.

Advisors need to take a strategic approach when helping clients decide on the appropriate mix of active or passive strategies. As Vanguard notes, this often requires a quantitative framework. Such a model includes evaluating four key variables:

• 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.

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Advisors who are well versed in specialized software and the investment selection process can coach clients into making better investment decisions. Advisors have powerful tools at their disposal that can help clients understand whether or not they are truly diversified.

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.

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As the CBOE VIX has clearly shown recently, volatility is becoming a mainstay in today’s markets. Advisors should have a plan in place to help their clients deal with choppy market cycles.

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.

As history has shown, making currency-hedging decisions at the asset level rather than at the portfolio level can have disastrous consequences.

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.

In today’s investment climate, the costs of poor portfolio construction can be very high. Investors should seek out the advice of qualified financial advisors anytime they are employing an active portfolio strategy. An advisor can help you construct a portfolio that protects against volatility, employs proper hedging strategies and ensures proper diversification.

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