Construction Methodology for Optimal Portfolios - Part Three
In previous articles, we have discussed some of the theoretical underpinnings supporting the importance of the asset allocation decision, however as yet we have not discussed the process followed to build portfolios using an asset class methodology.
Generally speaking, there are three sequential steps or decisions:
1. Firstly the allocation across growth (equity) and defensive (bond) investments needs to be determined. How much of the investors capital will be allocated towards growth investments such as stocks and property securities and defensive investments such as cash and fixed interest will depend on individual circumstances and their preference and tolerance to investment risk.
2. Next, the broad asset allocation needs to be identified. For example, within the allocation to growth assets, how much capital will be allocated towards Domestic Stocks, Property, Emerging Markets and Global Stocks.
3. Finally, how capital is allocated within each asset class needs to be identified based on the risk and return characteristics of the underlying securities.
The objective of the portfolio construction process is to build a portfolio which provides an expected return commensurate with its inherent risk. Importantly, the risk the investor is willing to bear is taken into consideration and generally, a range of portfolios can be developed to suit the risk tolerances of most investors.
The first two steps in the portfolio construction process determine growth and defensive allocations across each portfolio as well as the allocation of capital across the main asset classes. Typically, these splits are based on the risk profiles used by the firm building asset class portfolios. Some hypothetical risk profiles, together with the allocation across growth and defensive investments are detailed below:
Naturally the more aggressive the investor, the greater the allocation towards growth assets. An interesting aspect of building a portfolio under this methodology is the treatment of property securities within the portfolio.
Commonly, property is treated as a growth investment, primarily due to the growth generated. However, a reasonable argument can be made that property has both equity and bond like characteristics. That is, the capital growth potential of property can be associated with an equity investment, while the relatively fixed and continuous nature of rental income is akin to the regular interest paid on a bond investment.
In view of this (and dependent on the specifics of the underlying property investment chosen), it would be reasonable to allocate 50% of an investment in property securities to growth (i.e. equity) and the remaining 50% to the defensive part of the portfolio.
It is important to note that the allocation between growth and defensive investments, and across the main asset classes is determined based on what an investor, within each risk profile, would consider an appropriate allocation. For example, a defensive investor would likely be uncomfortable with an allocation to growth investments exceeding 20%, however a balanced investor is more risk tolerant and may be willing to accept an equity exposure of up to 60%.
The third step is in some respects the most important. Determining the sub-asset allocation, that is the type of securities purchased within each asset class. This is important as this essentially determines the risk and return characteristics of each portfolio. The selection of investments within the sub-asset allocation should also reflect as closely as possible the targeted allocation strategy. Importantly, the sub-asset allocation decision can be made without reference to the decisions made in the first two steps.
This step generally involves testing sub-asset class mixes across a spectrum of combinations over a pre-determined time period to identify the ideal weighting across each sub-asset class. The purpose of such an analysis is to identify the optimal risk exposure given the expected return of the specific asset class. Essentially, what we want to look for is the combination that provides the highest level of return compared to the risk involved.
This process has been illustrated in the table below:
Data for the period November 2000 to January 2023
Over this period, the Australian market (represented by the S&P/ASX 300 Index) produced an annualized return and standard deviation of 8.21% and 16.68% respectively.
The analysis highlights several issues:
- All the portfolios tested generated a greater return than the market, all at a comparatively lower risk to the market;
- Increasing exposure to small stocks over this period resulted in a marginal decrease in return; and
- Increasing exposure to value stocks, increases portfolio returns though there can be prolonged periods where no value premium is present.
The testing process provides valuable insight into the relationship between the sub-asset classes within the domestic equity market. For example, small stocks are considered higher risk than value or large stocks. However, given the differing risk and return characteristics, including small stocks in a portfolio is valuable as it provides additional diversification. More importantly, this provides a methodical approach to building portfolios.
For the purpose of this example, let us assume sample seven is chosen. We can see that over this period sample 7 has produced a return around .63% higher than the market (8.84% to 8.21%) at lower risk (14.37% to 16.68%).
Once a sub-asset allocation decision is made, this can be applied across all portfolios irrespective of the client’s risk profile. This is highlighted in table 3.
The above table lists the broad domestic equity exposure for each portfolio, together with the associate sub-asset allocation. The sub-asset allocation is based on a 60% allocation of the domestic equity to large stocks, 30% to value stocks and 10% to small stocks. As has been noted above, the testing outlined in Table 2 applies across each of the portfolios arising out of the decisions made in steps one and two.
A similar process is used to determine the sub-asset classes within the International Equity component of the portfolio. That is, a variety of sub-asset class mixes are tested to identify the combination which produces the optimal risk and return outcome. However, in addition to the large, small and value sub-asset classes, international equity also includes an emerging markets sub-asset class.
The process of selecting the optimal sub-asset class weighting for the international equity component of a portfolio has been illustrated in the table below:
Data Sourced from the period October 2000 to January 2023
Over this period, the international market (represented by the MSCI World Ex Aus Index, 50% hedged and 50% unhedged) produced an annualized return and standard deviation of 5.17% and 13.45% respectively.
The analysis highlights several issues:
- Many of the combinations tested generated a greater return than the market, most at a lower risk to the market.
- Increasing exposure to small and value stocks resulted in an increased return, for only a marginal increase in risk.
- Increasing exposure to emerging markets marginally increased risk over this time period.
For the purpose of this example, let us assume portfolio nine is chosen. We can see that this portfolio has produced a return .55% p.a. higher than the market (5.72% to 5.17%) with only a marginal increase in risk (13.48% to 13.45%).
Once a sub-asset allocation decision is made, this can be applied across all portfolios irrespective of the investors risk profile. This is highlighted in table 5.
It should be pointed out, however, that the information in tables 2 and 4 may represent a relatively small subset of the testing process. A more extensive process may be required, particularly where portfolios are being established for the first time. Subsequent data testing should be undertaken periodically to ensure the sub-asset allocations selected continue to provide expected returns consistent with the risk exposure.
This highlights the importance of the asset allocation decision. It effectively allows, in the above example, the ability to generate a return in excess of the market return at a lower or comparable rate of risk. This is possible due to the more efficient capturing of the returns available given the marginal increase in risk.
Once the asset allocation has been finalized across each of the identified risk profiles, then next step is to monitor portfolios over time to ensure they remain consistent with the philosophy of asset class investing.
Disclosure: Please note that all information provided is of a general nature and does not take into account your current financial situation, needs or objectives. Before acting on any of the information you should consider its appropriateness, having regard to your own objectives, financial situation and needs. The Prosperity Planners Pty Ltd t/a Prosperity Planners ABN 56 679 768 897 is an Authorised Representative No. 1289369 and Credit Representative No. 532716 of FYG Planners Pty Ltd Australian Financial Services Licensee and Australian Credit Licensee No. 224543 ABN 55 094 972 540 Level 2, 39-41 Alexander Street Burnie TAS 7320.