Produced in partnership with Colonial First State.
Effective portfolio construction is essential for delivering superior investment outcomes for clients.
In today’s evolving economic environment, it requires careful navigation of market inefficiency, risk diversification, and strategic investment opportunities.
The macro landscape: Key considerations
Recent economic conditions underscore persistent volatility and unpredictability, making it difficult to construct an all-weather portfolio. Key macroeconomic challenges include geopolitical risks, tariff uncertainty, supply chain vulnerabilities, and stubbornly high inflation.
Australia is experiencing a “per capita” recession, with economic expansion struggling to gain momentum. Although inflation appears to be stabilising, concerns about its long-term trajectory persist. Additionally, ongoing policy shifts and political tensions continue to disrupt global markets. The aftermath of Covid-19 pandemic supply disruptions remains a significant challenge, and the fluctuating use of tariffs as a policy tool by the US administration presents risks to both inflation and global trade.
Portfolio implications for a higher for longer interest rate environment
Following the recent cash rate cuts, markets are speculating on the trajectory of further reductions. While further rate cuts appear likely, advisers should prepare for a ‘stable for longer’ scenario where rates remain elevated due to sticky inflation.
Investment experts should assess how portfolios are positioned relative to interest rate sensitivity. Key adjustments to consider include increasing allocations to CPI-linked bonds, listed infrastructure, and real assets for inflation protection. Fixed income repositioning should also be considered by shifting away from traditional five-to-six-year duration bonds in favour of shorter-maturity bonds, floating-rate credit, private credit, and leveraged loans.
In the CFS managed account portfolios, there is a preference for credit over government bonds within fixed income. Credit is offering highly attractive all-in yields and has demonstrated resilience in recent years.
Despite the rise in yields, enthusiasm for bonds is tempered by the view that ‘higher for longer’ can also be seen as a ‘return to normal’ in a longer-term context. Inflationary pressures still linger in the developed world. Within government bonds, the ‘stable for longer’ thesis is playing out more strongly in Australia than overseas. Against this backdrop, we view Australian bonds as a relative safe haven from a geopolitical perspective.
Index concentration and risks
Market-cap-weighted indices inherently reward momentum, leading to a growing concentration in a small number of top-performing stocks.
While such concentration may yield outsized gains in bullish markets, it also amplifies downside risks when sentiment shifts. This index concentration has profound implications for constructing portfolios, presenting diversification and alpha challenges for active managers investing in top 20 stocks.
A better approach to managing fee budgets within a portfolio is to index exposure to the top 20 to ensure market alignment while deploying active strategies beyond the top 20, where mispricing opportunities and inefficiencies are greater, to generate alpha.
CFS research found that between 2008 and 2023, the top 20 active positions for Australian equity managers underperformed by 0.27 per cent, per year; while positions outside the top 20 outperformed by 0.45 per cent, per year. Therefore, the recommended strategy is to adopt a passive approach for the top 20 and an active approach for the rest.
The core-satellite approach: A strategic framework
Another portfolio construction strategy that allocators may consider is a well-structured core-satellite approach to optimise risk allocations, cost efficiencies, and opportunities to produce excess returns over the benchmark.
The core-satellite approach combines broad-based, low-cost, low-turnover passive investments like index funds and ETFs (the core) with targeted, actively managed funds or specific assets aiming to outperform (the satellites). Key benefits of this strategy include cost efficiency, diversification, and flexibility.
In terms of portfolio implementation, core allocations may include domestic and global large-cap equities and large broad-based bond markets, real estate investment trusts, and listed infrastructure.
Examples of potential satellite high-alpha markets include small/mid/micro caps and below investment grade bonds and loans. A common guideline is to allocate 60 per cent to 70 per cent of the portfolio to the core component, with the remaining 30 per cent to 40 per cent dedicated to satellite allocations.
Alternatively, some managed account solutions now offer a professionally managed core-satellite option in a single off-the-shelf solution that utilises the ‘full toolkit’ of active, passive, or enhanced smart beta building blocks. This means portfolio construction becomes an exercise of prioritising the right mix of strategies at a mid-point fee budget.
This limits the need to hold multiple managed accounts to achieve the desired outcome, resulting in unintended duplication of holdings and the risk of conflicting house views on asset allocation.
Optimised portfolio implementation
Efficient portfolio implementation is another factor that must be considered to ensure optimal portfolio performance. The quality and cost of trade execution directly impact performance. Poor execution can erode returns, and different platforms display materially different levels of trade efficiency and execution quality, which, if not managed carefully, can cause performance slippage and leakage.
Conclusion
Investment Trends research revealed 56 per cent of advisers are already leveraging these solutions by directing two-thirds of new client funds into managed accounts.
According to the IMAP Millman Census report, the Australian managed accounts sector has surged past $233 billion in funds under management as of 31 December 2024 and is projected to exceed $470 billion by 2030.
This shift highlights the efficiency and appeal of managed accounts, which offer access to diversified professional portfolio management without the administrative and compliance burdens associated with individual investments.
Optimising portfolio construction in today’s dynamic investment climate demands a sophisticated approach. It involves balancing cost efficiency, risk management, and alpha potential to enhance client outcomes.
Frances Taylor is executive director, managed accounts for Colonial First State.
