Commentary by Joshua Woodruff, CFA, Senior Manager, Portfolio Consulting

What makes a great investment portfolio?

It should have a purpose. It should include the mix of assets most likely to meet a client’s goals, balanced against their willingness and ability to take on risk. Costs should be minimal, given that they can seriously destroy returns when compounded out over the longer term.

A good portfolio should deliver its returns efficiently. The least possible risk should be taken to deliver the best possible returns.

These principles are easily stated, but they are fiendishly difficult to implement. In a world of low returns and long investment horizons, it has never been more important to shine a light on the hidden flaws that can steer a portfolio off-course.

Unseen duplications, submerged concentrations, and other unintended consequences, can mean a portfolio is less diversified than it appears on the surface. This can mean that the portfolio does not behave as expected. It may be more volatile. It may be less resilient in a crisis. It may capture less return in an up market.

The result can be a client taking on more risk than necessary, or failing to reach the goals that they might otherwise have achieved. As investors increasingly depend on their personal investments to support them through long periods of retirement, these are outcomes that can materially reduce a client’s circumstances.

Top-down, client-centred and methodical

Successful portfolio construction is most likely to come from a structured process that is repeatable and defendable. It should always start with the client. What are their current assets and what is the level of capital needed to meet their goal? The difference can be described as the portfolio’s required rate of return. But in an imperfect world goals will always be hedged with constraints, time and the investor’s appetite for risk being the most obvious and the most common.

Meeting the client’s specific need, within the context of relevant constraints, is the purpose of the portfolio, but there should still be an objective measure of the portfolio’s efficiency. Might the same ends have been met with less risk or at lower cost?

The three commonest measures are a market index, a peer group such as Morningstar or the Investment Association, or cash-plus. They each have advantages and disadvantages and many investors choose to form a view from comparing their portfolios to all three. In our view, a capitalization-weighted market index is generally the right place to start.

Successive studies over the past 35 years have shown that the critical element determining the variability of portfolio returns is the broad mix of assets, essentially the balance of equities and bonds. Active decisions such as market timing and security selection have relatively little impact.

Sub-asset allocation

It is at this level that mistakes tend to be made. For some investors, a simple combination of global equities and global bonds will be sufficient. But others will require something more. Those with more appetite for risk may want to overweight higher-risk assets with potential for higher long-term growth, such as emerging markets or smaller companies. There are also arguments for a degree of home bias, which may suit some investors, due to comfort with the domestic market and the level of currency stability.

These decisions can lead to a variety of unintended consequences. A home bias may involve a weighting toward a particular style or specific sectors, which may then lead to concentrations or dilutions through overlaps with other sub-asset classes. Parallel allocations to a short-duration bond fund and a strategic bond fund that is tactically long duration will cancel each other out, leading to costs that in effect detract value. These alternative weightings aren’t necessarily bad, but they can be if they are unknown and unexpected. See the example below.

Active/passive and fund selection

In our view, in every asset class, the starting point in fund selection is a capitalisation-weighted index fund. This is the closest it is practicably possible to come to the market itself and provides a frame of reference from which to make the active decision.

When should an investor prefer active? There is no doubt that active funds can outperform the market. The issue is that not all of them will outperform. It is highly unlikely that any fund will outperform all the time, and in most asset classes the majority of active funds have tended to underperform.

Before adding an active strategy, investors need to ask themselves three questions:

  • Is the anticipated alpha likely to exceed the cost of the fund?
  • Is the active risk, measured by tracking error, worth the additional alpha?
  • Does the investor have the patience needed to tolerate the added risk over time?

If the answer to any one of these questions is ‘no’, a passive fund is likely to be preferable.

Good fund selection, we believe, centres on the fund’s key inputs, which are typically the firm, the people, philosophy and process. The firm needs to have a strong culture in which talented people can flourish. The philosophy needs to be clear and the process well-defined and risk-controlled. The portfolio needs to reflect the philosophy and the process and it is this that will deliver the desired performance.

Common errors

Buying funds based on past performance can result in significant biases reflecting the stocks, sectors and styles that have driven that performance. Deliberate regional allocations can result in unintended overlaps affecting countries, industries and styles. As several fund managers may favour the same few stocks, small stock overlaps can turn into significant concentrations as a proportion of the portfolio’s value. The changing positioning of a strategic bond fund can either concentrate or dilute other bond holdings in ways that might not show in a typical asset-class breakdown.

Over time, these biases will skew the portfolio’s risk and return characteristics. A higher allocation to emerging markets is likely to increase the fund’s volatility, though it may also increase the long-term returns. A higher allocation to the UK, where the market has a natural weighting toward financials, pharmaceuticals and energy, may decrease volatility and dampen potential for long-term returns.

Balance and review

Failing to maintain a portfolio’s balance will have the same effect as gaps and overlaps in the asset allocation, skewing the risk and return characteristics. This can lead to difficult conversations if the portfolio behaves differently to expectations, not least during periods of market crisis.


A well-constructed portfolio should be more than the sum of its parts. In a world of lower returns, every element of the portfolio needs to be effective, earning its place in the whole. Flaws in the construction are likely to add unnecessary costs and result in a portfolio that is unable to meet its objectives.

Investment risk information:

Past performance is not a reliable indicator of future results.

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.

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.

The fund(s) may invest in financial derivative instruments that could increase or reduce exposure to underlying assets and result in greater fluctuations of the fund's Net Asset Value. Some derivatives give rise to increased potential for loss where the fund's counterparty defaults in meeting its payment obligations.

Other important information:

This document is directed at professional investors and should not be distributed to, or relied upon by retail investors. This article 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 does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions.

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

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

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