The portfolio approach to investing
An investment portfolio can be defined as a collection of financial instruments such as equities, bonds, exchange-traded funds (ETFs), cash, and cash equivalents. The portfolio perspective on investing highlights that the risk an investor takes by holding only a single security is not rewarded by higher returns. On the other hand, modern portfolio theory concludes that holding a diversified investment portfolio reduces the risk for a given level of expected return. Diversification allows an investor to reduce portfolio risk without necessarily reducing the portfolio’s expected return.
Evaluating how individual investments shape this risk-return profile is one of portfolio management’s core functions. Yet, constructing well-diversified portfolios that are conscious of investors’ unique circumstances is only one of the characteristics of portfolio management.
We recently sat down with a handful of Anchor’s senior portfolio managers to better understand the portfolio management process and its value proposition within our private client business.
The portfolio management process
The first step within the portfolio management process involves establishing the investor’s return objective given their personal risk profile, time horizon, tax exposure, income, and liquidity needs. Of course, this will differ for each investor depending on their unique circumstances, financial position, or preference, and once established, an appropriate risk profile can be assigned to the client.
The next step within the portfolio management process involves determining how funds will be allocated to the various asset classes, given their risk-return characteristics. Portfolio managers must be able to justify the proportion of a portfolio most appropriate to allocate to each asset class. Once asset class allocations have been determined, the portfolio manager is tasked with identifying the most attractive securities within each asset class that are best positioned to meet the investor’s return objectives, given the abovementioned constraints.
The final step within the process involves providing feedback to the client in the form of periodic reporting, in which the portfolio manager measures the portfolio’s performance and evaluates it relative to the return on the benchmark established upon the inception of the portfolio. The benchmark is the standard against which an investor can measure the relative performance of their portfolio.
As an investor’s circumstances change, asset classes and risk-return characteristics will also change. As a result, the actual weights of the securities within investment portfolios will also change as asset prices move. The portfolio manager is therefore tasked with transition management which involves monitoring these changes and rebalancing the portfolio periodically in response to these changes while adjusting security weights back to their desired allocations.
Active vs passive management
Investment portfolios can typically be managed by applying active or passive management strategies. Active investment management strategies attempt to outperform a chosen benchmark through a portfolio manager’s various analysis techniques. In addition, a dynamic research complement typically supports portfolio managers that follow an active strategy and tend to construct portfolios around a specific theme, such as value, growth, or momentum-oriented investing. In contrast, passive investment management strategies attempt to replicate the sector of the market they represent.
Portfolio managers that apply a passive approach typically use unit trusts or ETFs that replicate the performance of a chosen benchmark index, such as the FTSE JSE All Share Index Top 40 (ALSI 40) or the S&P 500. It has been interesting to note how rapidly the market share for passive management has grown. This is partly due to the lower fees passive managers charge investors and, in part, to questions about whether active managers can add value over time on a risk-adjusted basis, especially in DMs that are believed to be relatively efficient. While the active vs passive debate continues, our senior portfolio managers were content to conclude that although each strategy requires a unique skill set, there is room for both strategies within a portfolio manager’s arsenal and, when applied appropriately, in considering the unique circumstances of individual investors.
Portfolio managers as market strategists
Portfolio managers are tasked with more than just understanding how different securities, asset classes, funds, and weightings impact each other; they are also responsible for being strategic around the timing of the portfolio. The portfolio manager takes on the role of market strategist. The value they offer to investors is that they can identify favourable entry points into and out of the market through their access to timely macroeconomic, industry, and company-specific information. Here portfolio managers must be able to sift through a daily blizzard of information to identify anything that could materially change the fundamental backdrop of the securities held within their clients’ respective investment portfolios. Equity research reports and insights from our investment team support Anchor’s investment process. The analysts, fund managers and investment managers deliberate this research and the assets in our portfolios at our weekly local and offshore investment meetings, providing the portfolio managers with more than one perspective of the fundamental underpinnings of each security and thereby enriching the decision-making process.
Portfolio managers must have a sense of the key drivers of the movements in security prices, which in the near term are far more influenced by swings in investor psychology than by changes in companies’ long-term prospects. Herein lies another role that portfolio managers play on behalf of individual investors as wealth psychologists. Before we discuss this, it is important to establish an investor’s risk tolerance. While an investor’s risk capacity is determined by their ability to take on additional risk, their risk tolerance is how comfortable a client is with changes in investment returns or an investor’s appetite or willingness to take on more risk in pursuing a return objective.
Portfolio managers as wealth psychologists
Behavioural finance, pioneered by the results of Kahneman and Tversky in the early 1970s, highlights that human decision-making has systematic biases that lead to irrational decisions. When faced with complex decision-making, individuals often lack the time or ability to derive the optimal course of action prescribed by traditional finance. Nowhere do these biases arise more prevalently than in an investor’s attempt to manage their own funds, where cognitive limitations and emotional responses lead to decisions that result in less favourable outcomes for investors.
In this regard, portfolio managers are responsible for identifying these errors and emotional biases and guiding investors through them while conveying investment information in a way that instils confidence. Portfolio managers may, from time to time, fall victim to these cognitive errors and emotional biases themselves. Here the collective calm of deliberating investment decisions within a wider, experienced management team ensures that the potential impact of these decisions on clients’ investment portfolios is carefully considered. Macro events and the ebbs and flows of companies’ near-term fortunes are unpredictable and not necessarily indicative of, or relevant to, their long-term prospects. The role of portfolio managers here is to steer clients’ portfolios through the soap opera that plays out daily in local and global markets.
Conclusion
It would be a dramatic understatement to say that 2022 was a challenging year for global investors. Perhaps more unnerving was the extent and persistence of the negative market performance and how widespread it was across most geographies and asset classes. Research shows that even for investors that adopted the most balanced and well-diversified approaches across equities and bonds, last year was still one of the worst years to be an investor in the past 150 years. Though challenging for portfolio managers, this has presented an opportunity to pause and reflect on many aspects within the discipline of portfolio management, such as effectively identifying and managing client and portfolio risk. It has offered a chance to relook at the construction of client portfolios through the lens of their preparedness and reinforce their resilience to future uncertainties. This has also highlighted how a robust investment process that allows for healthy deliberation across disciplines only enriches the asset allocation and decision-making process for portfolio managers. The adage of too many cooks spoiling the broth proves woefully false when considering the merits of investment prospects within a wider investment team.
When considering the portfolio management value proposition, the analogy of a travel agent vs a tour guide comes to mind. A travel agent sells you a holiday package to a city or a destination that they have often not been to themselves. However, tour guides, through their knowledge and experience, walk you through the cities themselves, pointing out the historical and cultural significance of the destination while ensuring that you stay within the intended path. Likewise, portfolio managers are called to do more than sell a ‘house view’. Portfolio managers use their expertise to chart the best possible investment course for their clients’ unique, individual requirements and oversee the daily management of their clients’ investment portfolios so that investors can achieve their desired return objectives. This is the essence of portfolio management.
At Anchor, our clients come first. Our dedicated Anchor team of investment professionals are experts in devising investment strategies and generating financial wealth for our clients by offering a broad range of local and global investment solutions and structures to build your financial portfolio. These investment solutions also include asset management, access to hedge funds, personal share portfolios, unit trusts, and pension fund products. In addition, our skillset provides our clients with access to various local and global investment solutions. Please provide your contact details here, and one of our trusted financial advisors will contact you.
