Constructing an Australian equities portfolio is an exercise that investors are approaching with an increasing array of options at their disposal. As the range of products and strategies grows, the notion of sticking to an exclusively active or index approach is becoming less and less feasible, portfolio construction experts agree.
The complexity of blending the right strategies places a premium on the role of financial advisers in the ecosystem. Choice has become critical for advisers, according to BlackRock director and head of portfolio analysis and solutions, James Kingston.
“The repertoire of securities and investment vehicles available to advisers is quite broad,” he explains. “More choice means a better understanding of how to combine these strategies is needed.”
Kingston says his team works with financial adviser clients, to blend active and index strategies to obtain a cost/risk mix that meets investor objectives, while simultaneously pursuing higher returns.
Ultimately, Kingston says, a blended strategy is in the best interests of investors. “Active in X and index in Y is too simplistic,” he adds.
Clients are increasingly looking to their advisers for a measure of control, and for their ability to create order out of chaos, Kingston says. The challenge for advisers is to combine them to deliver income and withstand different market cycles that align with the client’s goals. With financial market uncertainty set to continue, risk management and the selection and blending of strategies is arguably more important than ever.
“You’ve got strategies like smart beta and megatrend investing whilst ESG considerations are also becoming more important to many investors… all this can be factored into the portfolio construction process,” Kingston says. “Then we’ve also got to be aware of the different objectives; depending on client preferences you’ll adjust risk/return, cost with overlays of ESG or different flavours of investing.”
Miriam Herold, who is head of research at Centrepoint Alliance, says her team also employs a blended strategy in their model portfolios, “particularly in sectors such as large cap Aussie equities, where a lot of providers haven’t demonstrated an ability to generate alpha.”
Understanding the market
To make sense of the choices available to investors, Kingston breaks down strategies by the three drivers of return: ‘index’, for traditional market capitalisation exposure such as the ASX200; ‘factor’, through smart beta ETFs that are weighted to take advantage of risk factors that outperform over time; and ‘alpha’ by way of actively managed funds.
Clearly, ETFs are an important and growing part of the investment landscape. Low cost and liquid, they offer an easy entry into the market and a level of surety highly valued after the Hayne royal commission.
As head of iShares Australia, Christian Obrist, notes: “Values like transparency, liquidity and the client’s best interests have all come to the forefront, and ETFs really fit the bill.”
While ETFs are commonly referred to as passive products, they can be used as part of an active strategy. Model portfolios, for example, are typically built with ETFs but form part of an active portfolio.
“You’re essentially still buying an active product, but the building blocks used are ETFs,” Obrist adds. Kingston agrees, adding that any decision made within a portfolio – even if it’s choosing an index fund – is an active decision.
“You can get top quartile performance by using a dynamic asset allocation strategy with ETFs,” he says. “This is the most important point, especially in today’s uncertain environment, as asset allocation drives over 90 per cent of portfolio risk”. If you have the time, resources and fee budget, you can potentially blend some good alpha fund managers with your core index exposures to enhance the risk-return of the portfolio.
Centrepoint’s Herold notes that by using index funds to get beta at low cost Centrepoint can free up fee budget to allocate towards potential alpha. The smart beta part of the portfolio construction equation exposes investors to investment techniques that have long been used by institutional investors, but now easily accessible to advisers. The focus is on delivering outperformance through quality, size, momentum and value, or managing risk through reducing volatility but maintaining diversification, Kingston explains.
“Typically used in addition to traditional index exposures, they can also provide a better benchmark to compare active funds against,” he says. “Investors shouldn’t be overpaying for performance which can’t beat index or factor benchmarks”.
In terms of alpha, there is an array of providers and product options. One way to access outperformance in Aussie equities is through a high-conviction strategy that holds a limited number of stocks. BlackRock’s Concentrated Industrial Share Fund, for instance, holds just 20 to 40 stocks and eschews the ASX’s largest players such as the big four banks and BHP.
“We’re not looking to buy those very large cap stocks,” explains BlackRock head of fundamental active equities, Australia, Charlie Lanchester. “We’re looking to scour the rest of the market, which is something retail investors generally don’t have time to do.”
A high conviction holding carries more risk, yet Lanchester contends that it plays an important role in a well-balanced portfolio. “It’s definitely at the higher-risk end of the portfolio,” he says, “but with the goal that it brings a higher return.”
Less is more, more or less
Diversification of alpha only works up to a certain point, and overdoing it with a bunch of overly correlated managers can negate returns and actually invite risk.
According to Kingston, the overdiversification of alpha is a well-known consideration.
Selecting “five, six or seven” managers in an asset class is overrated and ultimately self-defeating, he says. Instead, Kingston suggests picking two or three managers in an asset class and pairing them with index managers.
“Make more of a concentrated bet on a few managers, analysing them to make sure they’re uncorrelated and providing diversified return sources,” he advises. “The last thing you want to do is add a lot of managers that are correlated to one another.”
Herold agrees, adding that building an “allweather” portfolio with a variety of styles requires a fine balance. “The danger in overdiversifying is that you’ll just end up with benchmark returns,” she says.