Has your Portfolio been Designed – or Cobbled together?
At Analytics all sorts of portfolios cross our desks. Portfolios that have been well-designed with funds playing clearly-defined roles and blending beautifully together…and then also portfolios where funds have been selected haphazardly over time due to their good past performance and the aim of the total portfolio has been lost in translation.
There is no excuse for not designing portfolios scientifically anymore. After all, the blueprint for designing portfolios was developed ages ago when Harry Markowitz wrote his seminal paper entitled “Portfolio Selection” in the Journal of Finance March 1952 edition. His article showed that diversifying across uncorrelated assets was a way to invest optimally while reducing risk. Consider the following quote by the Father of Modern Portfolio Theory, Harry Markowitz:
“A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies.”
At Analytics we design portfolios with the above quote in mind – ensuring that investment portfolios are constructed that include uncorrelated funds – an optimal combination of conservative satellite, core and aggressive satellite funds which should provide a consistent return profile in different market environments.
Figure 1 below depicts a typical combination of funds in a well-designed portfolio. A conservative satellite fund is defined as a fund that will perform well in a bear or volatile market, and will lag somewhat in a bull market. A core fund is defined as a fund that does not follow a specific style and performs relatively well in both bear and bull markets. An aggressive satellite fund is defined as a fund that will perform well in a bull market, but may lag in a bear market.
Market phases – bull, bear and flat markets
The market goes through different phases – periods of bull, bear and flat markets can be identified in hindsight. As investors, we would like to design portfolios that will withstand different market environments and produce consistent long-term returns.Figure 2 below indicates examples of bear, bull and flat markets we will use in the ensuing examples to illustrate simple principles in designing portfolios.