12 MODEL PORTFOLIO CONSTRUCTION
Imagine a moderately cautious investor who had identified the need for a 20% exposure to UK equities. A likely outcome would be a cautiously minded, defensive fund, possibly in the UK Equity Income sector that offered access to the asset class but fitted the risk profile of the investor. But a better solution exists. Within the spectrum of UK equity funds available that meet the required standard for excellence, there will be a superior solution. Assume there are two alterna- tives: a fund with an aggressively minded fund manager, with a bullish outlook on the economy and who believes in the growth prospects of the technology sector; and a fund that relies on pure stock picking to iden- tify undervalued companies and has a bias towards only the most stable and financially secure firms. These two funds invest in the same asset class but will behave dif- ferently, the conditions for one to excel are different to the optimal con- ditions for the other. The same prin- ciples of diversification apply; the combined returns are available for much less risk than average. The tables show just how much diversification it is possible to add through fund selection.
The first table shows the correla- tion between four main sectors, UK All Companies, Global, UK Gilt and Property. These represent the core asset classes most investors hold in their portfolios, and are considered to be diverse. The correlation statistics say otherwise however, with only property showing any significant behavioural differences.
The second table shows how dra- matically the situation can be improved by selecting active funds and considering the relationships between them.
An equally weighted portfolio con- sisting of the four sector averages would have had a volatility of 9.26% over the past three years, whereas the comparable fund portfolio would have had a volatility of 8.44% over the same period, despite the individ- ual constituents being much more volatile individually. The fund port- folio would have outperformed the other by 19.5% as well.
If we expand this principle across all asset classes, it is possible to use the active element of funds to add fur- ther diversification benefits and obtain the same asset class exposure for a much lower level of risk than expected. Alternatively, the same level of risk can be achieved while having greater exposure to risky, higher returning assets.
MODEL PORTFOLIO Name
UT Global TR in GB UT Property TR in GB
UT UK All Comps TR in GB UT UK Gilts in GB
UT Global TR in GB
0.92PC 0.96PC -0.39NC
UT Property TR in GB 0.92PC
0.89PC -0.28LC
UT UK All Comps TR in GB 0.96PC 0.89PC
-0.34NC
Two line description Two line description Two line description Two line description Two line description Two line descript Two line descript Two linelinelie * PC - Positive Correlation. LC - Low Correlation. NC - Negative Correlation
Source: FE
UT UK Gilt TR in GB -0.39NC -0.28LC -0.34NC
MAY 2012
MODEL PORTFOLIO Name
Alpha Real Cap -
Freehold Ex Trst Acc in GB Cazenove -
UK Opps B in GB Henderson -
UK Gilt A TR in GB
McInroy & Wood - Smaller Comps TR in GB
0.11LC -0.32NC 0.25LC -0.29LC 0.84PC -0.36NC
Two line description Two line description Two line description Two line description Two line description Two line descripttion Two line description Two line * PC - Positive Correlation. LC - Low Correlation. NC - Negative Correlation
An example of how this works in the real world is seen above: a portfo- lio following the same asset alloca- tion strategy using active funds is able to have a much lower risk profile than the same strategy implemented with index tracking funds, over a six- month period.
This seems quite obvious, and most advisers will no doubt try to get a broad range of styles and charac- teristics when picking funds for a portfolio.
The problem, though, is how to objectively assess which funds offer the best mix and interaction. While it is possible to understand how two funds react quite easily, and even three funds, the multitude of interre- lationships within a larger portfolio are far too many and complex. The only way to truly maximise the diversification benefits within funds is to try to analyse every possi- ble combination, then select the mix that offers the greatest reduction in portfolio volatility relative to the volatility of the individual funds. This requires some considerable number crunching.
Accessing the risk profiles of 17 trillion possible portfolios is a task that is beyond even the most avid Excel user, and is the main reason diversification has traditionally stopped at the asset class level. To complete the task successfully
Source: FE ‘ ‘
Selecting the optimal
portfolio from the near
infinite range available is much like looking for a needle in a haystack
investors would need a database of fund information and past perfor- mance; the expertise to calculate and interpret volatility; the ability to cre- ate, store and analyse all the portfolios and the computing power to prevent this from taking several lifetimes. Selecting the optimal portfolio from the near infinite range available is like looking for a needle in a haystack. However, by modelling the character- istics of each portfolio, it is possible to create an efficient frontier of portfolios that contain the optimal combination of funds at every level of risk. Developments by leading acade- mics and fund research house FE have made great strides in this area. Having the required technological infrastructure and quantity of fund data at their disposal, they have man- aged to perfect this process. Diversification has been the dri- ving force enhancing investors’ returns for more than a generation and now, thanks to recent break- throughs, is poised to offer more ben- efit than ever before.
For too long funds have been viewed in isolation, merely as vehi- cles providing access to an asset class. The importance of viewing a portfolio as a whole, something that has been understood for more than 60 years, is finally possible for the majority of investors – not just a few privileged institutions.
0.11LC -0.32NC -0.29LC 0.25LC 0.84PC -0.36NC
Alpha Real Capital
Freehold Exempt Trust Acc in GB
Cazenove UK Opps B in GB
Henderson UK Gilt
A TR in GB
McInroy & Wood Smaller Comps TR in GB
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