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Portfolio construction: A top-down approach

This video tutorial explains why it makes sense to start with a client's investment goals when building portfolios.

 

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There are two main approaches to portfolio construction, top down and bottom-up. A bottom-up approach is generally the most common way to construct a portfolio but it can result in unpredictable outcomes.

A “top-down” approach to portfolio construction can add value in two ways. It can help redefine the client-adviser relationship and is also suited to the post-RDR world of financial planning. This means mapping portfolios specifically to each client’s individual case.

When building a portfolio, selecting the right fund manager or fund only forms a small part of the portfolio-construction process. 

A top-down approach means starting with the asset allocation based on clients’ goals and risk tolerance for each goal. The next step is to populate the agreed asset allocation then manager selection.

As shown by several studies, asset allocation is the most important part of building a portfolio. 

This means finding the right mix of assets for your client’s individual circumstances, investment aims and attitude to risk. 

Here is where you can use traditional tools such as model portfolios to help determine the basic building blocks of the portfolio. The risk-return profile will determine this at very high levels, but don’t overlook the importance of diversification at asset allocation level.

Factors like changes in the overall economy and investment fashions can alter the best and worst performing asset and sub-asset classes. For example, growth funds might perform well compared with income funds during economic booms and vice-versa when the economy is slower.

Let’s take a look at how various equity sub-asset classes have performed since separate data for growth and value styles became available. Each year they’re ranked from best to worst.

Of course it’s difficult to tell which sub-asset class or classes will rank highly in the future. That’s why it makes sense to hold a spread, proportionate to a client’s risk/return profile, rather than trying to pick the next big thing.

You can help your clients avoid dangerous investment fads with an asset allocation strategy. It’s easy to get the timing wrong on ‘hot assets’ that peak and fall dramatically. It’s your job to coach your client into not making emotional decisions, keeping their portfolio balanced and in line with their risk return profile.

After deciding on overall asset allocation, you need to elect how to divide the portfolio between the sub-assets, or different kinds of asset within each asset class; or sub-asset allocation in short. A sub-asset class within equities could cover large companies, smaller companies, growth funds, income funds and global equities.

With regards to choosing sub-assets, diversification is crucial. It allows you to focus on a particular sub-asset class and thus avoid too much risk. What’s more, you can adjust the proportions of these sub classes to increase a portfolio’s potential for growth (while tolerating an extra degree of risk).

Generally, a portfolio’s sub-asset class allocation should be diversified and match the market-cap weightings of the broad market… unless overweighting a market segment or sector is part of your strategy of course.

Indexing and active management may seem like opposite sides in a debate, but taking a combination of the two approaches has its advantages.

Components from each can moderate between the extremes of relative performance. This kind of strategy can help avoid making the client feel regretful when one approach trumps the other.

Traditionally manager selection was the first and most important part of the process. However in a top-down approach it’s the final aspect to consider. No matter your choice of manager, index or active, your chance of outperformance increases by focusing on those with lower fund costs. This is because you get to keep more of any return the funds achieve.

Costs, like interest, also have a compounding long-term effect. It might not always be obvious but they can impact dramatically on returns. Look at the impact of different annual management charges (AMC’s) over time.

Here we’ve assumed neutral growth so that the total effect of costs is clear and not obscured by positive or negative investment returns.

The 4-P model acts as way to select a fund manager, as well as a fund comparison tool. 

Find out any detail on the experience and expertise of the fund managers – and see how long they’ve actually been running their fund.

Look for a genuine commitment to the long-term, and that you feel comfortable with the firm’s ‘Statement of Investment Principles’. With index managers, you will want to know how they intend to replicate the index returns.

If you’re considering index funds, process is an important factor to take into consideration. Examining the way a firm goes about implementing their index strategy and how successfully they do it will prove to be useful knowledge to have. With index managers you should also investigate their approach to stock lending.

Past performance is probably the least reliable indication of future results. Investors need to look at the fund’s context to see if recent success matches the firm’s general investment philosophy and process.

When choosing a fund manager remember to compare them to the actual benchmark for the fund not against other similar funds. It is possible for fund managers to fall behind their benchmarks, but still have a high ranking – a fact that’s true of both index and active managers.

So as we can see, a top-down approach means building client portfolios starting with asset allocation based on individual goals and the risk tolerance for each goal, then, populating the agreed asset allocation and finally, manager selection.

Investment risk information:

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.

Other important information:

This video was produced by Vanguard Asset Management, Ltd. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.

If this is to be used on third party websites for an audience of professional investors as the submission suggests I would also include the for professional investors disclaimer at the top.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

© 2018 Vanguard Asset Management, Limited. All rights reserved.