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Webinar: Creating a successful investment portfolio

03 October 2017 | Webinars

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What does success look like? Is it all about performance? Is it return relative to risk? Is it about client needs?

Matthew Piro, head of product review at Vanguard Europe, has many years' experience selecting and monitoring fund managers.

Ankul Daga, senior investment strategist, is one of Vanguard's leading experts on portfolio construction.

Leo Schulz, senior investment writer, speaks to Matt and Ankul about creating a successful investment portfolio.

This is an edited transcript of their conversation.

Leo Schulz:  When an adviser creates an investment portfolio for a client, how should he or she measure success? What are the milestones, what are the signs to look for to indicate a portfolio is or is not going to be successful?

My name is Leo Schulz. I have with me Ankul Daga, senior investment strategist and Matt Piro, head of product at Vanguard Europe. Matt and Ankul, welcome, thank you for joining us today. To all our live listeners, you should now see a box appearing on your screen in which you can submit questions for Matt and Ankul. Submit them as you think of them in your own time and we'll work them into the discussion as we go along or deal with anything at the end that's left over.

Now clearly, creating a successful portfolio is a big topic and we're not going to come to definitive answers here today. What we do want to do is to cover some of the key points and to share some practical ideas on implementation. So the flow of the conversation today will be as set out here: where does success start, portfolio construction, selecting a great fund manager, what are the milestones and what does success look like?

So Matt and Ankul, not much pressure! I think some easy questions there to get you in the mood. Ankul, I'd like to start with you and where does success start, and we see here Vanguard's four investment principles - talk us through these please, Ankul.

Ankul Daga: So Leo, we find that for most investors, if they start with these four investment principles, they can look to maximise their chances of achieving investment success. So we start with goals. If investors focus on their investment goals and lay them out with clarity, that almost gives a certain clarity of thought to building portfolios from that point onward. The goal in itself would vary, you know, some goals will be essential; some goals will be more aspirational. So if you think of most real life things like planning for retirement or kids' education or buying a second home, that goal in itself dictates how much risk to take with their money or their assets.

And then along with that they have a time horizon, which they would plan for, so for instance retirement would tend to be a fairly long-term goal whereas kids' education would be much more defined in that format. So we suggest investors start with their goals, have a kind of purpose, a clarity of thought around what they're investing and saving for, and then from there execute it by designing their asset allocation, making sure they have a balanced asset allocation which has broadly diversified investment in there.

By diversification what we specifically mean is having a good blend of home assets and overseas assets, of UK assets in terms of equities and bonds, and international assets, again looking at equities and bonds. So at Vanguard we tend to start with a healthy respect for markets, and a lot of our thinking is inspired by a market cap approach, and we suggest investors look globally, rather than focus only on that home market.

So once investors have zeroed in on their goals, and they've got a balanced strategic allocation, the next thing to think about is minimising costs. At the end of the day, every penny paid in fees and charges is a penny taken out from the investor's return and that's where we feel that if investors focus on the routes to implementation while being quite focused on cost, they can maximise their chances of achieving their goals.

And this is where the decision between active and passive becomes very interesting. We can come back to that later, but the final principle, and again I think this is a very important one, is around discipline. Now as most listeners would expect, discipline is simply a good thing, whether it's in life or in investment, but what discipline really means here is if your goal was relevant when you set it, then it makes sense to bring your portfolio back to its original strategic allocation and focus it back to its original goal. Because at the end of the day, the strategic asset allocation of the portfolio is the most important decision an investor can make, and it's critical to keep your investment aligned to that at any given point in time.

Leo Schulz: Ankul, thank you for that introduction. You mentioned the risk return trade-off, you mentioned balance, you mentioned the strategic asset allocation and the importance of that and the importance in your view of thinking globally in terms of asset allocation. But I think what is there, and you did also mention you'd come back to it, is the balance between active and passive, or the choice between active and passive. I wonder if you could just talk us through that a little bit?

Ankul Daga: Sure, so once the investor has selected the right asset allocation for a particular goal, then they've got to execute it, they've got to convert it from a conceptual construct into a real portfolio. And I think at that point it's really important to make the decision on execution, on implementation. So if you think, look at this flow chart on the screen in front of you, we tend to think of this in three steps, and broadly we hope these three steps will provide some clarity.

The first element is, are advisers and their clients able to pick good managers, able to identify good asset managers who would advise you over and above a passive alternative? If the answer to that question is yes, then we move to the next piece. The next piece has to do with the return. When an adviser invests their clients' assets into an active fund, they're expecting a certain level of outperformance, let's call it alpha.

For that alpha, they are prepared to pay a certain cost to the fund managers. Now the costs are pretty explicit and pretty clearly known before the fact. I think the alpha expectation is a very critical piece and I think that's where the advisers need to have that discussion with the fund managers and come to a conclusion. Our view is that that decision has to be very deliberate and very explicit, so advisers typically know how much they're paying for every single fund, it's important for them to understand what kind of alpha, what level of alpha are they going to get from that particular fund.

So we've gone from step one, which is just identifying good, talented managers, to step two, which is understanding the return dynamics between cost and alpha. The third element to all of this is the risk. Now to get exposure to the market, it's pretty straightforward in today's world. So twenty years back an investor had to buy active funds to get exposure to the market; now with the rise of index funds and passive, you can get that exposure pretty easily and at relatively low cost.

To add active on top of that and have an opportunity to outperform, you also have an opportunity or potential to underperform, and that's what I'm going to refer to as the risk in all of this. When investors buy active funds, they're exposed to a certain level of active uncertainty or an uncertainty in the outcome of an active fund manager, relative to a benchmark. And it's important to capture that, and it's important to capture how the investor feels about it, because one of our keys to success in active is patience, and it's important that investors have the patience to let active succeed for them.

Leo Schulz: So this is the last of the circles along the bottom row there, isn't it, under three risk, the tolerance to active risk. Matt, if I could just come over to you now, where investors are choosing an active strategy, then the selection of the fund manager becomes important, doesn't it? Ankul mentioned patience, but you've got a lot of experience in identifying and selecting and monitoring active fund managers and I just wondered - what are your key thoughts on that process?

Matt Piro: Right Leo, so when you look at the slide in front of you here, it really hits on the three keys as we see it. This applies to active management, you could also argue this applies to passive management, but I'll focus mostly on the active side since that's where we get the most questions as it relates to this.

Now I'll start with cost. Ankul's already touched on that, but at the end of the day you need to be able to acquire the talent of the active manager at a reasonable cost, and that comes down to lowering that performance hurdle for the active manager to deliver value to the end client, net of performance. So we absolutely think cost is critical, so you're looking for good value for your money effectively here with talented managers.

Ankul also touched on patience, and patience is required in everything as it relates to investment, so even again going back to passive just for a minute, when you're tracking the market, we all know there will be ups and downs in the performance of the capital market, and that in itself requires patience. There's an added element of patience required when you work with active managers and you select active managers because there's typically an outcome they're looking to achieve related to outperformance that naturally introduces the possibility of underperformance.

And I would argue it's more than a possibility, it's going to happen at some point in time. The idea though is to be able to work with managers who over the long term can deliver that outperformance.

Leo Schulz: No-one can deliver miracles, can they?

Matt Piro: You just can't expect it year in, year out from an active manager. I mean some of the most successful managers out there that are well known and renowned, have had many years of underperformance, and in many cases, consecutive years of underperformance. So any time you pick an active manager, and we'll touch on some of the points around the talent and what makes a talented manager, at any time you pick an active manager, you just need to have that realistic expectation that in order to achieve that long-term outperformance outcome, you will have to work through periods of underperformance, you just have to know that going in.

But touching on the last key, which comes down to talent, this is really where we spend a significant amount of time, we have a team here at Vanguard that focuses just on active manager research, you know, their intention is to identify the best managers out there and we try to use a clear framework in order to do that. And our framework really focuses on the drivers, when we talk to clients and when we get queries from clients, a lot of times the questions are about the outcomes. And the outcomes are the portfolio, you know, ultimately what you see held in the fund, which stocks, which sectors, countries, so on and so forth, and then performance.

From our perspective, having a long history in active that we do, we understand that it's the drivers that lead to those outcomes that ultimately investors are interested in, so that's where we spend our time. So when we talk about talent, when we talk about these four drivers, we evaluate every manager and every fund through this lens. So you can see here we talk about the firm. When we talk about the firm, that means just getting to know the firm, understanding who they are, what they stand for, what their culture is, what are their incentives, what is their ownership structure?

There's no perfect or right answer here, it's just about having an understanding of that so that you have a good view of the firm before you enter into a partnership with them. We spend a lot of time thinking about the people. I mean this is a people business, right, whether you're a traditional, fundamental bottom-up manager making decisions based on fundamental research, or a quantitative manager who's using a model that's being built by people, it comes back to the people.

So we spend a disproportionate amount of time on the people side of things here. There we'll focus on the depth and the quality of the team, the stability of the team, and we're really getting to know how that team works as a unit. We try to avoid working with the firms and teams that are dependent on any single person, so that's something that we value very much - a team-orientated culture when we work with firms.

And the last two I'll kind of talk about together, around philosophy and process. When we talk about a philosophy, this is all about what the fund manager believes. Why do they think they can add value? There's something fundamental in the way they view the markets that leads them to believe they can outperform. So when you talk about philosophy, some of them are related to value strategy, there's something about a value strategy that’s embedded within a value manager's philosophy, growth managers the same, so we really dig into that, understand what they believe.

We also want to hear a shared belief in that philosophy across the team, so many of these points and these drivers are connected, and for us that philosophy when we talk to the analyst, the portfolio managers, or leadership, we want to hear a shared vision about that philosophy.

And then it gets into how you implement it, and that's the process. So that's how the team comes together to ultimately build the portfolio, and to deliver the performance. And we need to have reason to believe that that process is repeatable, that that process is enduring, and there's something to that process that gives us the confidence, that our clients' money can go into this fund with that expectation of that future performance.

Leo Schulz: I think what really interests me, Matt, about the way that you go about selecting fund managers is the emphasis on what I would think of as the soft information. Although you're looking at the hard information: the portfolio, the tracking error, the performance and so on, those are, as you actually call them, outcomes, and really it's the drivers which are the people, the process, the philosophy, that are that soft information that you're really focusing on. And my understanding is you might go three years, two years, three years, quite a long period of time working with a fund manager, before bringing them into the fold so to speak. What are some of the practical steps that you take in order to get to know those people?

Matt Piro: Yes, it's a very good point, Leo, because we don't rush into anything. Because our intention when we hire a manager to run a part or all of one of our subdivised funds, we start a partnership with them that we believe can be long term. So something we come back to a lot at Vanguard is long-term discipline, patience, and that is embedded in our structure and embedded in our process because we deeply believe in that.

So because of that long term view on what we want that partnership to be, we think it's only right and appropriate to do that work up front, and that requires sometimes to your point, years of getting to know a firm, getting to know the people. And what are we doing for years as we evaluate an active manager? Well we're meeting with some of the same people year in and year out, we're meeting with new people to the firm, new people to the team.

We're getting a sense of how they're being onboarded into the investment process and that gets back to how do we have that belief about that shared philosophy, the enduring nature of that process? A lot of this is done through interaction, it doesn't always have to be in person, sometimes it's on a call, sometimes interaction can be an email.

One of the things we look for is an openness and a transparency in terms of how they communicate with us. I have several years of manager research experience and some of the best partnerships and some of the highest conflict managers I've worked with, have been willing to share with me some of the questions they have about an analyst on the team, some of the things they're working on to get better. And that goes a long way to establishing that trust and getting that belief in a manager over the long term.

So there's a lot of things we try to do and it's hard to say there's a formula, because there's not, at the end of the day it comes down to a balancing of quantitative and qualitative judgement, and you're blending that together to hopefully make a really informed decision to improve those odds for success of our clients over the long term.

Leo Schulz: Matt, a question that every adviser has to deal with, has to work with, is what I think of as the milestones. We’re talking about patience, we're talking about talent, we're talking about getting to know the people, Ankul was talking about goals, some of which can be very long term. But the adviser needs to meet the client every six months, every twelve months, look at the portfolio. What are some of the milestones - let's start with you, Matt, at the fund manager level - what are some of the milestones that you would suggest an adviser should be looking for?

Matt Piro: We definitely are continually monitoring, and we're always looking at the portfolio and the performance and keeping up with what's happening with the firm; that's not a milestone per se, but it is just part of the process. And I lead with that because there really are no milestones necessarily. What we do and the way we think about it, is it always comes back to the overarching process I talked about earlier; that everything we're doing and thinking about comes back to those drivers.

So when we believe there have been changes to those drivers, whether it's across the firm, something within the team, some evidence that the process may have shifted, that's what leads us to question funds and therefore managers at times, and in our experience, that's when we make changes. It's never solely about performance, performance sometimes is a clue that something else could be going on, but we owe it to our clients to dig into the why, dig into what's really happening there to lead to that.

It's when we lose confidence in one of those drivers, that's when we move on. So I can think about over the years I've been doing this type of work, the few firms that we've had to part ways with, you know I can remember a situation with elevated team turnover that's led us to question some happenings within the firm and a cultural question, we parted ways.

Performance was actually really good, but we still parted ways because it's not about what has happened in the past from a performance perspective, we always need to be thinking about what's going to happen in the future, which is why we come back to those drivers. So I wish there was a silver bullet as an answer to say this is the milestone, this is the clue, but there's just not really that simple an answer.

That's why when you work with a firm, it's really important to understand what they do to make sure they are on top of those drivers, whether it's a firm who manages all that money in-house, or a firm like Vanguard that has a hybrid approach and we manage money in-house but we also subadvise, we just want to make sure the firms keep across those drivers.

Leo Schulz: Ankul, at a portfolio level, the same question for you, in those regular, relatively short-term meetings, six months, twelve months, what should the adviser be discussing with the client to indicate that the portfolio is doing what it's meant to do?

Ankul Daga: So I would say every six to twelve months, the clients would have a review meeting with their financial adviser, looking at what are the goals that they set and whether there have been any life changes on the part of the client. So for instance if the client was saving for retirement and earlier they were thinking of retiring at the age of sixty-five, but now they've decided to retire a little earlier, let's say at age sixty, now that's something which is very critical for the financial adviser to know and to bear in mind, and then review the asset allocation.

So I think whilst Matt was talking about funds, I think we need to take the conversation back one step when we're looking at the goals of the investor, and at that point asset allocation is critical. Now similarly if the client has had any other changes around let's say their kids' education, right, straight away their time horizon changes. And there again you go back and you say hang on - the strategy I set up on day one needs to change to accommodate that.

I think the third thing is to actually review the goals themselves and then the next thing is to actually revisit the cost of achieving those goals. Has there been any change in the marketplace, are there lower cost vehicles available, which are again offering a high quality exposure to the end investor? So I think every six to twelve months our clients should have a review and make sure they revisit the goals, focus on the costs, and then rebalance the portfolio back to the strategic asset allocation. Even though it pains me to remind about it here, the strategic asset allocation is the most important decision.

Leo Schulz: But very often Ankul, in a rebalancing, it will be about selling assets which are doing well and buying assets which are not doing well, how do you discuss that with your clients?

Ankul Daga: I think quite often it's in a reframed as kind of watering your weeds and cutting your flowers, you know however you take it, right, but the reality is, what rebalancing does is it sets a discipline to ensure that you're constantly selling the assets which have done better than expected and buying assets which have done less well, so you're in effect, implicitly you are selling high and buying low, quantitively.

Now while on the spot when you rebalance, it might appear like there is a trend, the reality is over the long-term, this strategy tends to add value to an investor, and it saves the investor from unforeseen accidents. So sometimes an investor might start with a balanced portfolio and let's say the risky part of the portfolio, equities, have done really well and if they didn't rebalance, they might come really close to an equity crisis and then have a surprise waiting for them.

Now I think again with investing, it's very important to focus on what is the purpose? At the end of the day money is a means to an end and the purpose is the accomplishment of financial goals that the client has set. And to that end goal, we've got to make sure we manage the risks around those goals very carefully, and rebalancing helps us do exactly that.

Leo Schulz: Now I can understand that in normal times, and I'd be interested in an answer from both of you on this, but in a crisis such as the global financial crisis, which we all remember all too painfully - a big event like that - surely that's a catalyst for changing your portfolio? Matt, perhaps you'd like to start on that one?

Matt Piro: Yeah, I don't know if that's necessarily the case. I mean it's certainly, and I think Ankul will touch on this, it does give you reason to maybe review where you stand, check in on your goals and your objectives, but when I think about it from a manager of a fund level, I would definitely say that's not actually the case, because what you want to do is actually look for the managers that remain committed to what they believe in.

The crisis was actually a very good example, Leo, because you had a lot of managers with certain investment styles that were punished particularly hard during that time, and there were managers out there that I would argue did lose their mettle a little bit and they did compromise on their approach just a little bit, because of the down risk they were feeling, because their particular style, the types of stocks they tended to own, did get punished more so than others.

Now what happened when that occurred, is you missed something on the way back and some of those managers did in fact miss that snap back on some of those stocks, so not only did they feel that pain on the way down, they did not experience the benefit on the way up. That in itself is not bad; what's bad is the fact that they didn't stay true to their approach.

So during those times of crisis, and I remember vividly going through this with the teams, when that was happening and the amount of engagement we had with all of the firms and the teams to test them and understand exactly how they are standing committed. And we encouraged them to do that, so we hired you to run money in this way, keep it up, we're behind you, we understand that this is a tough time, but you'll get through it because what you do is enduring and it's something you believe in.

And how you're working with your teams too, just how are you working with your team? Because the way we saw certain firms respond to the people and the decisions some of those firms took during those times, set many up to be stronger coming out of the crisis, where others struggled continually after the crisis. So that's a very significant crisis, we all felt but I think it's a real example of exactly how we think about crisis management when it comes down to managers' stock selection.

Leo Schulz: Ankul, what's your view?

Ankul Daga: I think the global financial crisis definitely tested a lot of investors and there was a big debate within the industry around the effectiveness of asset allocation, whether it still worked, and in our view it actually works really well, particularly during the time of crisis. So if you look at what happened in 2007, 2008, while equities had a really kind of sharp correction, bonds, and particularly high quality bonds, were providing a lot of support and cushion to the portfolio.

Now I say this just to illustrate the point, that when you have well diversified portfolios, which have a good blend of equities and bonds, and that blend is a reflection of the risk appetite of the investor, it actually does its job. Now what does help on top of this is to make sure the equity component and the bond component is globally diversified, and that investors get the opportunity to improve their portfolio outcome from global growth, not just domestic growth.

The other key element which comes to light in those times is the role of the adviser; how much the adviser is able to coach their client and save them from sometimes very expensive mistakes they can end up doing. And this is something we have done a lot of research on and published a paper around: adviser’s alpha, just explaining that there are a number of things an adviser can do in these times of crisis, which can help the clients stay on course, not react to specific events, and make sure they benefit from the market upswing as much as they suffered from the downswing.

At the end of the day, what we can control is cost, what we can control is have a discipline when we are tested. The market outcomes are something which are very, very difficult to get a grip on, let alone control, and I think this is where staying long term serves us really well.

Leo Schulz: And Ankul, in one sentence or less, what makes a successful investment portfolio?

Ankul Daga: I think it's going back to the four principles, which is make sure your portfolio is focused on the end purpose and goals, keep it diversified, keep the costs low, as long as you do that you will maximise your chance of success.

Leo Schulz: Matt, one sentence or less

Matt Piro: One sentence or less, I think when it comes to funds and managers, it's about coming back to your process and remind yourself about why you purchased the fund or the manager that you partnered in the first place and if you remain convicted in those views, stay the course.

Leo Schulz: A lot there to think about and some great ideas on implementation and particularly on client communication, which is always both a valuable and a challenging topic. Matt and Ankul are both speaking at our symposiums, Matt will be presenting on manager selection, so an opportunity to learn more there from Matt's very long experience in that area, and Ankul will be talking more on blending active and passive strategies, which is again an important topic.

We will be in Leeds for the symposium on 3 October and the London symposium is on 4 October, if you haven't already secured a place, please do so as soon as you can, we already have record numbers and spaces are becoming limited. Our next webinar will be at 2pm on Tuesday 17 October; the subject will be Diversification: the magic ingredient, and our guests will be Alexis Gray, an economist in our investment strategy group, and Neil Cowell, head of UK intermediary distribution. Until then, Matt and Ankul, thank you both very much and to our listeners, thank you all for dialling in.

Important information:

This material is directed at professional investors and should not be distributed to, or relied upon by, retail investors. This information is designed for use by, and is directed only at persons resident in the UK.

The opinions expressed in this material are those of the individual speakers and may not be representative of Vanguard Asset Management, Limited.

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

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

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

© 2017 Vanguard Asset Management, Limited. All rights reserved.

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