https://api.vanguard.com/rs/gre/gls/1.3.0/documents/dddd/gb
WELCOME

Uncovering hidden biases in an investment portfolio

27 October 2020 | Portfolio construction

 Print

 Remove  Save

Joshua Woodruff, Head of Portfolio Analytics & Consulting, Vanguard Europe

A strong investment proposition is critical to the success of any adviser. It is the foundation on which good client relationships develop and flourish. But how can you be sure that you’ve got it right?

The path to building an optimal portfolio in line with a client’s goals and risk tolerance is fraught with risk and complexity. A portfolio that is simple on the outside can harbour biases, gaps and concentrations that may only become apparent when it fails to behave as expected. This has the potential to lead to some very uncomfortable conversations.

In many cases, the clues are there in respect of suboptimal portfolio construction. These are likely to include persistent underperformance relative to a benchmark, failure to behave as expected in given market conditions, or high relative costs. Other issues may be less obvious. For example, the choice of benchmark can distort performance measurement.

Let’s take Portfolio ZZZ, an example of how unintended consequences can significantly alter portfolio performance. The objective of the portfolio is long-term capital growth with relatively low volatility and limited potential for drawdown. The portfolio is measured against the Investment Association’s (IA) Mixed 20-60% peer group, meaning 20-60% of the total portfolio must be invested in equities at any time.

Looking at the performance of Portfolio ZZZ compared to the peer group in the table below, we can see it has outperformed over the past five years – a strong track record. It is less risky than the peer group, with a lower maximum drawdown over the five-year time period.

Benchmark comparison

% July 2015 to July 2020

Return

Standard deviation

Cumulative return

Sharpe ratio

Max drawdown

Portfolio ZZZ

6.18

7.13

34.99

0.81

-10.13

IA Mixed Investment 20-60% Shares

3.70

7.47

19.93

0.46

-13.02

Source: Vanguard. Data is for illustrative purposes only

It’s also low cost with an ongoing charges figure (OCF) of 0.09%. Outwardly, it appears to be a well-constructed portfolio that is meeting its objectives. But before making a decision, let’s see how it compares to an alternative, Portfolio AAA, shown in the table below. As we can see, Portfolio AAA is more expensive than Portfolio ZZZ, although at 0.15% OCF it is still low cost. But Portfolio AAA is simpler, with only six funds compared to ZZZ’s nine, making it easier to maintain and more transparent.

Fund allocations and costs

Portfolio ZZZ

Weighting %

OCF

Equities

UK

31.50

0.06

US

9.12

0.06

Europe

4.03

0.08

Japan

2.82

0.10

Pacific ex Japan

1.95

0.13

Bonds

UK investment grade

12.85

0.12

Global corporate

12.84

0.12

Gilts

12.69

0.11

Overseas governments

12.21

0.11

Portfolio

100.00

0.09


Portfolio AAA

Weighting %

OCF

Equities

UK

2.91

0.06

Developed ex UK

36.45

0.14

Emerging markets

5.12

0.23

Global small cap

4.90

0.29

Bonds

Global bonds

45.62

0.15

Gilts

5.01

0.11

Portfolio

100.00

0.15

 Source: Vanguard. Data is for illustrative purposes only

The next step is to take a closer look at how the funds compare to the given benchmark. We have also compared them to LifeStrategy 60% Equity, which stands as a representation of a whole-market portfolio from a UK investor’s point of view. In the table below, we get a clue as to why Portfolio ZZZ may have been outperforming. Relative to the IA sector it has a substantially greater weighting to equities, while its allocation to cash is much smaller and its allocation to alternatives is negligible compared to the 10% in the peer group.

Asset allocation

Weighting %

Cash

Equity

Bond

Other

Portfolio ZZZ

1

48

50

1

Portfolio AAA

0

49

50

1

Vanguard LifeStrategy 60% Equity A Acc

0

59

40

1

IA Mixed Investment 20-60% Shares

10

38

41

10

Source: Vanguard. Data is for illustrative purposes only

This raises important questions about benchmarking. A good portfolio needs an appropriate comparator if its key characteristics, costs, risk and returns – the characteristics that most influence its long-term behaviour – are to be clearly identified and understood.

Hidden biases

When we dig still deeper and look at exposures on a regional basis, Portfolio ZZZ is significantly overweight the UK compared to either Portfolio AAA or to LifeStrategy 60% Equity. This overweight comes at the expense of emerging market (EM) and North American equities. As a result, looking at the sector breakdown, Portfolio ZZZ is also underweight in technology, owing to the dominance of the sector in the US and some Asian markets. By being overweight UK equities, Portfolio ZZZ has significant exposures to basic materials and consumer defensives, which are substantial constituents of the UK market.

Source: Vanguard. Data is for illustrative purposes only

There is nothing inherently wrong with these positions, if they reflect the investor’s intentions. What we should also understand, though, is that there is likely to be a cascade of further consequences that may, or may not be intended. For example, in the UK, two-thirds of the basic materials sector is chemical companies, within which two companies account for about 66% of the market. By the same token, most of the UK’s consumer defensive sector is made up of only a handful of companies. If we look at ZZZ’s overweight to financials – albeit a marginal overweight relative to AAA and LifeStrategy 60% Equity  – we know that most of these financials will be UK companies, again meaning the portfolio is significantly exposed to a handful of large UK financials.

A further bias is evident in Portfolio ZZZ’s style exposure, a product of it sector weightings. Its value exposure is 42%, compared to 35.1% for Portfolio AAA and 38% for LifeStrategy 60% Equity.

Source: Vanguard. Data is for illustrative purposes only

To conclude the analysis, let’s revisit the five-year performance of Portfolio ZZZ and this time compare it to LifeStrategy 60% Equity and Portfolio AAA, as well as the IA Mixed 20-60 peer group. As we can see, while Portfolio ZZZ outperformed its peer group, it underperformed LifeStrategy 60% Equity and Portfolio AAA for most of the period.  More strikingly, Portfolio ZZZ’s recovery from the late February Covid-19 sell-off has been poor in comparison to LifeStrategy 60% Equity and Portfolio AAA, though ahead of the designated peer group.

Portfolio ZZZ is low cost and a functional investment vehicle by any standard. But its geographic biases, which translate across to sector and style biases, are driving its performance in ways that may not be fully appreciated. Comparing the fund to the IA Mixed 20—60 peer group is disguising its true performance, as the average asset allocation in the peer group is very different to that of the fund.

This is an example of a portfolio that looks good on the surface but whose hidden biases may bring surprises – not least in times of crisis – that can lead to the kind of awkward client conversations that everyone wants to avoid.

 

 


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 and simulated past performance are not reliable indicators of future results.

Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.

Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.

Investments in smaller companies may be more volatile than investments in well-established blue chip companies.

The funds may use derivatives in order to reduce risk or cost and/or generate extra income or growth. The use of derivatives could increase or reduce exposure to underlying assets and result in greater fluctuations of the funds’ net asset value. A derivative is a financial contract whose value is based on the value of a financial asset (such as a share, bond, or currency) or a market index.

ETF shares can be bought or sold only through a broker. Investing in ETFs entails stockbroker commission and a bid-offer spread which should be considered fully before investing. The Vanguard LifeStrategy® Funds may invest in Exchange Traded Fund (ETF) shares.

Please also read the risk factors section in the prospectus which is available on the Vanguard website.

Important information

This document is directed at investment professionals only and should not be distributed to, or relied upon by retail investors.

This document is designed for use by, and is directed only at persons resident in the UK.

The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this document is general in nature and does not constitute legal, tax, or investment advice. Potential investors are urged to consult their professional advisers on the implications of making an investment in, holding or disposing of [units/shares], and the receipt of distribution from any investment.

The Authorised Corporate Director for Vanguard LifeStrategy®  Funds ICVC is Vanguard Investments UK, Limited. Vanguard Asset Management, Limited is a distributor of Vanguard LifeStrategy®  Funds ICVC.

For further information on the funds’ investment policy, please refer to the key investor information document (“KIID”). The KIID and the Prospectus for the funds are available from Vanguard Asset Management, Limited via our website https://global.vanguard.com/.

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

© 2020 Vanguard Asset Management, Limited. All rights reserved.

Vanguard Asset Management, Limited. All rights reserved.

 Print

 Remove  Save