Constructing & Managing a Healthy Investment Portfolio

William Buck Wealth Advisory - June Quarter 2020 Market Review

Published 30 July 2020

In our March Quarterly update, we highlighted the significance of our Investment Ethos. In-particular, we detailed the importance of patient capital, invested for the long term and how history rewarded this type of investor. We demonstrated what we had done leading into March, and that we would be watching the market closely for new opportunities. In light of the changes that have been made over the last 18 months, this edition is focused on portfolio construction and management.

We employ professional portfolio managers across all sectors of the market; fixed interest, equities and alternative assets. In order to meet their, and subsequently our, long term objectives, they will regularly fine tune their portfolio. That is, add a new security, sell an existing security or change the weight of an existing security within the portfolio. This activity is called ‘portfolio management’ and the extent to which it is undertaken is called ‘portfolio turnover’.

The reason professional managers generate ‘turnover’ is because the bottom-line fundamentals of their portfolios are constantly changing:

·        company earnings are revised up and down;

·        exposure to each individual security in the portfolio constantly changes as each price fluctuates relative to others; and

·        as individual security weights and profit outlooks fluctuate so will the valuation metrics for the overall portfolio.

Every time a portfolio manager re-balances the portfolio, or makes a change to consider the above factors, it is attributed to turnover. The level of turnover varies across funds (i.e. investment styles will differ). For equity portfolios:  

·        High Turnover = 70%+ (i.e. 70% of the portfolio is changed in a typical year)

·        Moderate Turnover = 40%

·        Low Turnover = 20%

If a fund has long-term annual turnover of 50% it implies that, on average, each security will be held in the portfolio for 2 years. Below is a snapshot of the turnover for some of the funds in your portfolio. We have also included the William Buck Australian Equity portfolio for comparison.

High turnover is usually the domain of the growth or alternative portfolio manager. Lower turnover is more commonly found in the value managers. So, what is the difference in styles and why does that lead to different turnover rates?

Growth managers generally have high levels of turnover. They are heavily focused on company earnings and will often have relatively concentrated portfolios (i.e. 20-30 holdings). They focus solely on industry leading companies with high levels of profitability and profit growth. Such companies tend to be relatively expensive. As a result, ‘portfolio turnover’ is required to manage valuation risk in the portfolio. It is also a necessary response if a particular company’s growth prospects flounder.

Value managers tend to have larger portfolios of 50-80 stocks. They generally have lower turnover due to their investment philosophy. They find companies that are undervalued relative to the market, hold them until they appreciate to a target value and then sell for a profit. This intuitively means they hold companies for long periods, have lower turnover and fewer transactions. This doesn’t guarantee a positive investment outcome and usually requires a longer holding period.

Ultimately portfolio performance is generated by sustaining healthy ‘bottom line’ fundamentals in terms of earnings growth, quality and valuation. As portfolio manager performance is assessed relative to the overall performance of the market (i.e. the benchmark), if they can construct a portfolio of superior quality (i.e. one that consistently delivers superior earnings growth) without taking on excessive risk they will do better than the benchmark. As such, active portfolio managers are constantly looking for that edge to outperform; a goal that necessitates portfolio turnover.

Our objective is to employ fund managers, on your behalf, who deploy capital in an ethical and proactive manner. We generally look for active managers (not passive index or ETF providers) who have a proven record of outperforming the benchmark or achieving a return above the long-term average. In relation to your direct Australian equities portfolio that we manage, we look to provide long term value with growing earnings and dividends – a mix of both styles.

Over the last 18 months we have made a number of changes to the model portfolio. We have replaced under-performing stocks and fund managers. We will continue to look for ways to improve the portfolio. The last thing you want as an investor is to have an expensive, low quality portfolio with little earnings growth and a stagnant dividend. You end up with all the risk and no return. Accordingly, portfolio turnover is required to consistently maintain a healthy bottom-line; this is what you are paying us for.

Note – Companies, Shares and Stocks are all interchangeable terms.