The arrival of spring means one can spend extra time exercising outdoors (at least when the weather cooperates). While one doesn’t need to run a marathon to get back in shape, we think active portfolio management is more like a long jog than a short sprint – the key is keeping the right pace. Being active requires discipline and effort. In finance, like in sports, it’s not easy. Take Peter Lynch, who grew the then-obscure Magellan Fund, which only had $18 million in assets in 1977, to $14 billion with more than 1,000 individual stock positions when he left in 1990: “If you’re terrific in this business, you’re right six times out of ten”. Yet, activity, in the correct dose, can pay off and help capture opportunity and mitigate risk.
A key pillar of our investment philosophy is active portfolio management. There’s no single definition and it’s all about keeping a healthy balance. If you become hyperactive, you risk shifting back and forth for nothing, just piling up transaction costs in the process. However, if you become too passive or even static, you fail to adjust portfolios to changing market conditions.
Below, I explore the three layers of our active investment process:
I wrote about this in my previous blog: the cornerstone of our investment approach is ensuring that portfolios are well-diversified by exposing them to a diverse range of assets that perform differently in different scenarios. This can contribute to reduce portfolio volatility and potentially help them perform better than strategies narrowly focused on just a handful of asset classes and geographies.
Our strategic asset allocation reflects these concepts. We’re long-term investors across the major regions and asset classes. The important thing is the mix. We aim to blend funds, stocks, bonds and other instruments in an optimal way, based on the expected risks and returns of those asset classes.
Strategic asset allocations tend to be static in the financial industry. This means that they reflect a constant proportion of, say, stocks and bonds. Imagine that, given an investor’s long-term financial objectives and a set of assumptions on risk and return, the mix that looks right is fifty-fifty. This 50% allocation to stocks and 50% to bonds will remain the same regardless of market conditions.
The idea behind keeping things static is that long-term strategic asset allocations offer nothing more than a benchmark to beat by increasing or decreasing the investment in different asset classes over the short term and selecting the right instrument. However, we disagree with this approach. We see significant value in the strategic asset allocation itself, as it represents the bulk of expected future returns.
The value is in how we mix the asset classes and how this mix shifts over time. This is why our strategic asset allocation is dynamic. When we believe risks are low and return opportunities are high, we increase the share of risky assets such as equities. And, vice versa, when we think risks are high and return opportunities are low, we invest more in safer assets such as quality bonds. However, in both cases, we never invest so much either way that it alters an investor’s long-term risk and return objectives.
In our view, the long-term strategic asset allocation is the primary tool for helping investors achieve their financial goals over an extended period. But that’s not the whole story. We also run a tactical investment strategy that adjusts a portfolio’s asset mix based on considerations over the next 6-12 months.
We use a tactical asset allocation to take advantage of market trends or economic conditions by actively shifting a portfolio’s allocations across or within asset classes. We can also use it to exploit temporary valuation imbalances or other inefficiencies in specific markets.
However, tactical shifts made with the expectation of exploiting short-term market moves are easier said than done. You need to ensure that your shifts are significant enough to influence the portfolio, but not so large that you’re overly dependent on them for positive portfolio performance. In other words, put enough eggs in the basket, but not all of them.
Of course, activity doesn’t mean buying and selling continuously. Sometimes, the best active decision is staying the course. So, while we believe activity is important to deliver the best risk-adjusted returns, it’s not about activity for activity’s sake and the key is to maintain a healthy balance between doing too little and too much.
Portfolio construction is about populating an asset allocation with the right investment instruments. So, in the context of portfolio construction, active investing means changing the investment in these instruments when we think it will help investors better achieve their financial goals.
Take our flagship portfolios, for example. Typically, around half of the portfolio will have active exposures in funds, stocks and bonds. They aim to beat the market. We mainly use active instruments in markets that are less efficient or where we believe particular active managers have an advantage. These instruments tend to populate our long-term, strategic asset allocation.
Within funds, the bulk of our active exposure is made of Quintet’s multi-manager funds, which we designed with Blackrock (known as our QMM funds). These actively managed, single-asset class funds are available exclusively to our clients. Each fund blends a selection of third-party managers that we believe will support portfolio performance and enhance diversification.
Our global portfolio of single stocks, together with our sovereign bond portfolio, makes up the rest of our active holdings in flagship portfolios. Within stocks, we typically invest in quality US and European companies with strong balance sheets, pricing power and competitive positions, of course keeping an eye on valuations. By selecting these types of companies, our aim, as with the QMM funds, is to beat the broader market and deliver consistent returns to our clients.
We invest the other half of our flagship portfolios’ allocation in passive instruments, like exchange-traded funds (ETFs) or index funds. These are passive in the sense that they simply aim to track the markets they represent, but we make active decisions on which funds to select, their weight in the portfolio and how long we hold them for. Generally, but not exclusively, we use passive instruments to implement shorter-term investment decisions (our tactical asset allocation).
The reason we use passive instruments is that they provide us with a much cheaper and efficient way of accessing the market. Passive instruments also tend to have lower tracking-errors. In other words, they track the market’s actual performance more closely than active funds, which are trying to beat the market.
This makes them good tools to use when we believe a particular asset class or region will outperform in the short term, to get an accurate exposure to that asset class or region. For example, if assume we believe global small-cap equities will outperform the broader equity market. In that case, we’ll make an active decision to invest in a passive tracking fund of global small-cap equities, like an ETF.
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