Diversification may be the only free lunch in finance, yet even seemingly well-diversified portfolios can harbour hidden biases and correlations.
These can lead to excessive weightings of certain strategies or a portfolio that expresses too many similar ideas, over-exposing it to particular risks.
In a crisis, when traditional correlations break down, it can come as a nasty surprise. This is where good portfolio construction shows its worth.
Effective portfolio construction aims to optimise risk-adjusted returns for a given set of constraints and to embed diversification and resilience into the investment process.
The quality of investment ideas and strategies remains paramount, but portfolio construction identifies the best way to put them into practice.
A robust, repeatable portfolio construction process can also help uncover and remove biases and correlations, allowing investors to add return without taking additional risk.
- Diversified portfolios can have biases
- Volatility has an impact on portfolios
- It is useful to assess volatility in different situations
In particular, this is as true for funds that invest in publicly traded assets such as bonds and equities as it is for real assets such as infrastructure and real estate.
Instead of blindly following an inefficient benchmark index, investors can construct portfolios of well-understood assets that allow their expertise to add value – identifying and optimising return drivers, ensuring diversification and taking a forward-looking view to managing risk.
Active managers often follow a bottom-up and simplistic approach to portfolio construction; purchasing the securities they like, avoiding those they dislike and determining whether they are happy with the resulting overall risk and tracking error.
But while tracking error helps investors see how they are deviating from their preferred benchmark, it is not necessarily a great tool for measuring risk. These deviations need to be value-creating and risk-reducing.
Changes to the way markets function can cause distortions and this has been evident in recent years in the stock market. The rise of passive investing has led to many investors now getting exposure to big-picture trends through exchange-traded funds, rather than rigorous research of company fundamentals.
For example, when something dramatic happens, such as a sudden change in the macroeconomic environment, ETFs reallocate at a large scale, which affects a lot of companies, sectors and investors.
For investors who do not want to be at the mercy of volatility, the next step is to understand how to make their portfolio construction process more robust and capable of delivering resilient outcomes.
In credit, there are multiple return drivers such as carry – how much yield investors are getting – and forward-looking views on how spreads in different sectors might change depending on the market backdrop.
Managers should look to isolate the most efficient places to generate yield and carry relative to the benchmark, while simultaneously identifying idiosyncratic ideas, which are more focused on spread compression.
Humility is an underrated quality in the construction process. This is because investment managers tend to be optimistic about their ability to forecast performance, which creates a bias toward riskier allocations.