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From Planipedia
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 | Best Practice Principle: While the research shows that security selection itself is relatively less important than the broader asset allocation decisions in influencing investment outcome, it is an important area and the one by which many clients will measure the effectiveness of investment recommendations. Consequently, it is a best practice to ensure that the specific securities selected align with the Investment Policy Statement in all aspects, in particular with respect to meeting client objectives and having suitable return and risk characteristics.
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Selecting Securities
This section assumes that the Advisor and client have a mutually agreed upon investment strategy, preferably expressed in a written Investment Policy Statement (IPS) which was created with the assistance of portfolio optimization software or through other discussions with the client. Note: see the topic entitled Investment Policy Statements in this manual. It is also assumed that by this point in the process, the relative merits of cash, debt and equity assets have been considered and agreement reached regarding the percentage weightings to be given to each of those asset classes in recognition of the client’s objectives and risk tolerance.
The final step in the portfolio design process, then, is to actually choose the specific investments (stocks, bonds, segregated or mutual funds, etc.) to be included among the client’s portfolio holdings. The progression from asset class level decisions to selecting which securities to actually own is one of narrowing from those more general conclusions to very specific ones.
A word of caution to advisors is warranted. Human nature being what it is, this is the part of the investment process on which many clients expect their advisors to spend the most time because it is where they think the advisor can have the most impact on the ultimate investment results. This happens because newspapers and TV reports are filled every day with specific details about the success or failure of one company or another, the rise and fall of the stock market, changing bond prices or mortgage rates followed by page after page of fund performance data. However, as Gary Brinson proved with his famous study of the determinants of portfolio performance, security selection actually explains only a small portion of the final results achieved. Be that as it may, it does have strong psychological importance to clients, so let’s look at a couple of approaches for handling this part of the investment process.
General comments on the power of diversification
To be an effective investment advisor does not mean we need all the expertise of a professional money manager – just a fundamental understanding of the way investment markets work and an appreciation of the trade-off between risk and reward. To gain that insight, it is worthwhile to discuss how investments and the markets function, that is, what causes the value of stocks, bonds, mutual or segregated funds, and returns to fluctuate.
We’ll begin by looking at the concept of total investment risk, which is, in fact, a combination of business risk and market risk. For clarity, we’ll initially consider a single publicly traded stock to illustrate the concepts and then expand our discussion to pooled assets such as mutual or segregated funds or other “managed money” products.
Business risk
Simply put, business risk (also called unique or non-systematic risk by some academics) is the hazard of investing in a particular business. If we were considering, for example, adding shares of Ford Motor Company to a portfolio, we would first want to gain some confidence by knowing the answers to such questions as:
- Has the company been profitable over the past few years?
- Are those profits rising, falling, or the same as in the past?
- What is their history of paying dividends to shareholders?
- Is the stock fairly priced relative to the company’s profits?
- Have they kept up with product development?
- Do consumers like their products?
- Are their labour relations good?
- Is management stable and competent?
- How do they rank with their competitors?
In real life, of course, we would not likely do this evaluation ourselves – that’s what professional investment analysts and portfolio managers do. However, a best practice would be to appreciate the types of questions an analyst would ask to determine the suitability of any particular stock. If, for example, Ford scores well on these criteria, an investor may decide to buy some of their stock because they believe Ford is well positioned to grow along with the automotive industry. In other words, owning a piece of Ford would mean owning a piece of a good business.
Managing business risk
Buying shares in a good company, however, does not automatically guarantee investment success. We all know that even the best run companies, from time to time, suffer setbacks. That’s why our parents taught us not to “put all your eggs in one basket.” So prudent investors diversify by buying shares in more than one company. Thus, wise investors might add some bank stocks, oil companies, retailers, manufacturers, and service firms to their portfolio to “spread the risk” around.
And it works – to a point. It should be expected that each time a new stock is added to a portfolio, the “risk” is reduced through increased diversification. That is true. However, the impact of each additional stock is normally less than the one before. Let’s take a simplified example. Assuming that a portfolio is divided more or less equally among a number of chosen securities, it’s easy to see that increasing the number of stocks in the portfolio from two to three has a greater impact on risk reduction than increasing the number from 49 to 50. In the first instance, the new stock’s performance will represent one-third (331/3%) of the portfolio’s total performance, whereas in the second case the additional stock’s contribution represents only onefiftieth (2%) of the overall result. This is an obvious oversimplification but it makes the point.
It is interesting to note that it has been statistically shown that a portfolio comprised of approximately 40 to 50 different stocks has probably gone about as far as it can to reduce business risk. Adding more companies beyond that may increase return if the additional stocks perform well – but they don’t contribute much to further reduce risk. It should be no surprise, then, to learn that almost all pooled equity funds own shares in at least 40 to 50 different companies – to wring the business risk out of the portfolio. Similarly, fixed income portfolios should contain a number of bonds or other debt securities to reduce the risk of one or more defaulting.
Few investors that employ only individual securities in their portfolios have as many as the 40-50 stocks required to reduce business risk to a minimum. That explains the popularity of pooled mutual or segregated funds – they offer instant diversification. That having been said, the notion of diversification to reduce risk can be applied to portfolios of any size. Market risk Should an investor, having built a portfolio of quality stocks, be able then to rest comfortably in the knowledge that their investments will increase in value? Of course not! While diversification will reduce business risk, there isn't much consolation in owning a broadly diversified portfolio of stocks if the entire stock market is on its way down. When the stock market falls, as it inevitably does from time to time, chances are that even the best-chosen stocks will go along for the ride.
Market risk (or systematic risk) will always exist because there are so many broad-based influences on our economic world, such as interest rate fluctuations, global conditions, currency valuations, inflation, recessions, political stability and, of course, investor confidence. While investments such as segregated or mutual funds may be ideal for substantially mitigating the risk of holding individual stocks and bonds, market risk still remains.
Managing market risk
Can a portfolio also be diversified to deal with market risk? Good news – the answer is “Yes.”
Just as it makes sense to diversify within an asset class such as stocks by owning a number of them, it is also equally appropriate to diversify among various asset classes. We know that individual stocks do not all fluctuate in value in perfect tandem; neither do stock, bond, and cash asset classes. In fact, the research indicates that a portfolio of five or six different asset classes is probably optimal for reducing market risk to its minimum. Is it difficult to build a portfolio balanced among five or six asset classes? No – simply start with the three most basic ones; cash, debt, and equity and further diversify within them according to meaningful variations within each asset class. The example below is not meant to imply that all portfolios should look like this, but here is an example of just how possible it is to diversify across asset classes.
Implementing The Client’s Investment Policy Statement
As we all know by now, the creation of an Investment Policy Statement is an important first step in investment management, but the effective implementation of that strategy is equally, if not more, critical when it comes to the attainment of a client’s overall goals and objectives. In implementing the investment strategy, there are a number of methods, approaches and styles from which to choose.
Implementation Methods
Individual Investments – Select individual stocks, bonds, GICs and other direct investments to implement the portfolio recommendations. Mutual or Segregated Funds Portfolio – Select a portfolio of different funds from a variety of different asset classes and manually re-balance the portfolio at periodic intervals to maintain its intended risk/reward profile.
Asset Management Service – Identify an asset management service appropriate for the client’s situation. The selection will take into account personal preferences, portfolio size, reporting requirements and range of investment options, measured against fees charged to ensure good value is received. The asset management service provider invests in asset class pools/ funds according to the client’s Investment Policy Statement. Their portfolio is automatically re-balanced whenever it becomes necessary, to maintain its intended risk/reward profile.
Private Money Management – Identify a private money management service that is appropriate to the client’s situation. The selection will take into account personal preferences, portfolio size, reporting requirements and range of investment options, measured against fees charged to ensure good value is received. The private money management firm may allocate money to pooled funds that invest in specific asset classes or, possibly, individual securities, depending on the client’s investment management strategy. The private money management service will re-balance the portfolio in accordance with a pre-determined strategy, which is also outlined in the IPS. Due to the higher level of customization with respect to portfolio design and monitoring, many private money managers limit their services to individuals with portfolios of a certain minimum size, for example, one million dollars or more.
Asset Allocation Approach
There are several schools of thought when it comes to the approach to be used with it comes to implementing a target Asset Allocation. The two primary approaches are “Strategic” or “Tactical”. A choice needs to be made as to which of these approaches should be used in a particular client’s situation.
Investment Style
Investment Managers tend to favour certain types of securities in the portfolios they manage. They are thus often referred to as either “growth” or “value” oriented. It’s also possible to be a combination of the two. As the client’s portfolio is structured, these investment styles will be taken into consideration.
Management Style
The Management Style used will determine how the client’s money is managed. The two possibilities are either “passive” or “active” management styles. The choice of investment’s within any portfolio will also dependent on the management style most appropriate for the client.
The following chart graphically illustrates a sample method of implementation that would vary, depending on the client’s profile and objectives:
Portfolio Design – Getting Started
For simplicity, we will follow an example that assumes the client’s primary investment objective is growth but he or she isn’t prepared to own a 100% equity portfolio, due to their risk tolerance. Consequently, the following mix was agreed to:
The Simplest Approach – A Packaged Solution
Balanced Funds
We can choose our securities to get to a portfolio with this asset mix in a number of ways. The simplest approach would be to use a balanced segregated or mutual fund. There are numerous segregated or mutual funds available that are structured to include all three major asset classes. Almost all funds maintain some cash to handle redemptions ¾ frequently in the 5–10% range. Once the cash component is allocated, most so-called balanced funds then allocate what’s left over in some proportion of debt and equity securities. That could be 50% of the remainder of the fund to each of the debt and equity asset classes; 60/40, 70/30 and so on, depending on the fund’s investment philosophy. These percentages (or specific ranges within which they must be kept) might even be described in the segregated or mutual fund’s prospectus. Using an electronic fund database to search should make it relatively easy to find a fund that comes very close to the desired asset allocation. Note, however, that unless the fund’s manager is constrained to certain percentages in each asset class, the proportions may vary significantly from time to time.
Of course, using a pooled fund means that the fund manager is left to do the actual security selection on behalf of all investors in the fund. He or she would select the stocks, bonds or whatever they felt would perform consistently with the fund’s mandate. They would periodically trade some of those securities for performance reasons or to maintain the balance among the asset classes according to the fund’s investment philosophy described in the prospectus.
Asset Allocation Funds
For smaller portfolios and particularly for more “passive” investors, balanced funds may be quite appealing. However, if the client desires something more actively managed than a ‘fixed percentage balanced fund’, they might be interested in the asset allocation funds available in the market.
The strategy employed by the managers of asset allocation funds could generally be considered a refinement of the balanced fund approach in that the manager does try to maintain a balance between cash, debt and equities; however, the mix is not as rigidly enforced. The manager is normally free to adjust the percentages in each asset class depending on his or her view of the market. When they were optimistic about the stock market, for example, they may increase the equity portion; when they are less enthusiastic, they may increase their bond or cash holdings. Some managers are given more leeway than others to adjust the asset allocation.
The more aggressive asset allocation funds are often described as “tactical” while less aggressive ones are frequently called “strategic” asset allocation funds. In the latter case, the manager is frequently constrained to maintaining a minimum percentage in each asset class regardless of how they feel about the markets so that the funds can legitimately be labelled as ‘balanced’ or ‘asset allocation’ funds rather than ‘market timing’ funds. They would seldom, for example, be allowed to have 100% of the portfolio in any single asset class or to completely exclude one.
Fund of Funds
In recent years, a number of mutual fund management companies have launched a “fund of funds” product, which, as the name implies, is a group of funds packaged under one umbrella-type entity, which itself, acts like a mutual fund. In other words, the securities held in the fund of funds, are pooled funds themselves.
These investments have become popular because it is not uncommon for mutual fund investors, over time, to move money among asset classes within the same fund family. However, assuming the investor’s holdings had increased in value over time, such transfers would normally result in taxes to be paid. This may reduce the benefit of the transfer even when good asset allocation practices might dictate a change. To resolve this, “fund of fund” products are most often structured as mutual fund corporations (rather than mutual fund trusts) with multiple classes of shares where each class represents a different investment category or asset class itself. All these special shares are redeemable and convertible to shares of any other class. On conversion from one class to another, there is an automatic tax deferral until the shares are ultimately redeemed. Thus, investors can shift from one asset class to another by simply converting one class of shares for another, without income tax consequences at the time the change is made.
Advisors who are considering recommending a “fund of funds” for its tax advantages should familiarize themselves with the underlying fund mandates to ensure the client’s investment objectives can be met. Tax considerations should not overrule good investment strategy.
Managed Money Products and Services
This section addresses the use of managed money products and services as distinct from the mutual and segregated funds described previously. While they share the benefits of instant diversification, pooling of assets and professional management, when most invest advisors talk about managed money, they are referring to accessing investment services such as those that follow.
Wrap Accounts
The term “wrap” originally referred to how the fees for this type of investment were charged to investors. Rather than assessing individual transaction fees (commissions) each time a security was bought or sold, the advisor “wrapped” everything into one annual charge, usually a percentage of the total value of the assets under management. In practice, there is often only a fine line between a “fund of funds” and a “mutual fund wrap account” in terms of having a variety of asset classes under one umbrella.
As this arrangement refers more to the fee structure than the security selection process, we will not explore it in detail except to note that many wrap accounts are based on at least a general assessment of client risk and objectives which result in specific asset allocations and recommended portfolios. Regardless, however, of the degree of sophistication offered by the wrap account provider, it is still incumbent on the advisor to ensure that the underlying investments are suitable and appropriate for their client’s individual situation.
Private Wealth Management Services
The purest form of managed money is found among firms that dedicate themselves to meeting the needs of high net worth clients. Commonly insisting on a minimum portfolio of at least $1 million, these managers often have more personal contact with their clients and offer a higher level of personalized service, including the development of a sophisticated Investment Policy Statement. Holdings in the portfolio can include individual stocks and bonds, pooled funds normally not available to the general investing public and other specialized securities.
Developing Your Recommended or “Pick List”
As a best practice, many seasoned advisors have taken time to examine the universe of investments available to them for recommendation to clients and developed a “short list” that they will normally look to first to determine their suitability for any particular client. This streamlines security selection and, assuming the process of identifying the individual selections that will “qualify for the list” is well founded, the client is normally better served by having only well researched options that meet their needs presented to them.
For example, a mutual fund data provider such as Morningstar can be used to identify and rank funds that meet certain criteria. As a consequence, an advisor might select one, two or three funds that fit his or her “Value Equity” parameters. In client situations where value equity funds are appropriate, having already done the research, the advisor can feel confident in recommending one or more of the chosen funds. Obviously, the identification process has to be sound and a regular review is required to ensure that the chosen securities continue to meet the selection criteria. Following are several parameters that might be useful in the evaluation process.
Evaluating Managed Money Products and Services
For all managed money and pooled assets in general, including mutual and segregated funds, avoid the natural tendency to focus solely on rate of return as a measure of the attractiveness of any particular fund or manager. In fact, potential money managers should be scrutinized from four perspectives: results, risk, rank and resources. Discuss each individual manager or pooled fund with the client according to all four criteria.
Results
The availability of a long-term track record is one of the advantages that managed money products have over other investments. However, a caveat must be added to remind us to use cumulative past performance as a preliminary screen to selection only. It is also essential to look at year-by-year results as an indication of volatility; and consistency to give you some notion of the degree of risk associated with that volatility. Only by considering all three characteristics to get a sense of the risk-adjusted returns can you accurately assess a portfolio manager’s prowess and his or her suitability for your client in view of their personal risk tolerance. Let’s illustrate with a simple example using a couple of mutual funds using actual performance data to show how this works in real life. The numbers are rounded for clarity.
Suppose the client was given the choice of investing $10,000 in either of two funds with the following results:
On a cumulative basis, both funds would be worth exactly the same after five years and consequently, their five-year performance would be listed in the various financial information sources as being identical. However, look at the different tracks taken to get to the same result. Fund A did four times as well as Fund B in the first year, twice as well in the third and two-and-a-half times better in the fifth. That would have been exciting for the client! On the other hand, Fund A also lost 20 percent of its value in the second year. That, too, would probably have gotten the client’s heartbeat up a bit! This is an obvious lesson in the danger of looking at short-term performance, good or bad, because as illustrated, there would be no dollar difference if you were in either fund for the full five years.
But what if the client sat on the sidelines through the first year until the media hype surrounding Fund A’s first year performance convinced him or her that Fund A was the place to put their money? They might have jumped in at the beginning of the second year, just in time to watch their investment shrink by 20 percent! Or, suppose they had to redeem their fund at the end of the second year. Fund A would have generated a net return of about six percent annually while Fund B yielded more than 11 percent average per year. And finally, they would have to ask themselves, “Was the excitement of the good years worth the psychological roller coaster ride that came along with it?” Quite possibly not so the client’s preference may well be to avoid funds with inconsistent performance.
Risk
The investment industry has developed a number of ways to measure and report on risk-adjusted returns, including the Sharpe Ratio, which was developed by Nobel Prize winner, Bill Sharpe. This statistic illustrates the amount of additional return an investor should expect to receive for every additional unit of risk assumed, making it, in effect, a “reward-to-volatility” ratio. The actual calculation yields a decimal number, like 0.55 for example, which would mean that the investor has historically been rewarded with a 0.55% increase in return for every 1.00% increase in volatility. Obviously, then, the higher the Sharpe Ratio, the better the trade-off is between risk and reward. A ratio of 0.80, for example, suggests more incremental return for each additional unit of risk than a ratio of 0.55.
It is not essential for advisors to overwhelm their clients with such statistics. However, information such as the Sharpe Ratio is becoming more widely published in newspapers in the mutual fund performance columns, etc. and clients may want to discuss it. It is also a useful guide to advisors in assessing individual securities and funds.
Rank
The statement has often been made that “all money managers are not created equal” and, particularly when it comes to generating returns, all portfolio managers are clearly not blessed with the same talent. Therefore, advisors must look beyond absolute performance to improve the chances of picking the best managers for their clients’ needs. They must consider the ranking of investment managers relative to their peer group.
It’s wise, of course, to recommend a manager with a track record that gives both the advisor and client confidence in the manager’s ability to generate the rate of return needed to meet the clients’ long-term objectives. But if that performance is substantially lower than what other managers with similar funds are achieving, the client may be taking on more risk than is necessary. If, for example, the target rate of return is 10 percent and the recommended manager achieved that level, the client might be satisfied, until they discover that most other managers of similar funds earned 14 percent during the same period. That would mean that investors in that fund were exposing themselves to the same risk for a 10 percent return, as their neighbours would be for a 14 percent return.
Here’s the rule: “All other things being equal, if the risk is the same, choose the investment with the greatest expected return” or stated the other way around: “All other things being equal, if the returns are the same, choose the investment with the least amount of risk.”
Resources
The final criterion addresses the ability of the manager to provide the client with the level of expertise and service they require. The first of these, expertise, merits special attention.
Expertise
If performance is going to be used as any sort of guide to picking a professional investment management firm, advisors must ensure that the portfolio manager in charge of the fund at the time of the recommendation is the same one who was responsible for the returns that made the fund attractive in the first place. It does happen that good managers retire, die or are attracted away by competitors. This is less of an issue if a committee rather than an individual “star” manages the particular fund in which you are interested. Under either condition, however, the advisor must determine who is responsible for the fund’s track record and whether or not he or she is still in charge. For most portfolio managers, it is possible to obtain at least five years’ performance history, even if some of that time was spent managing money elsewhere. However, if you are looking at the track record of a manager while he or she was managing another fund, compare the type and mandate of the previous fund with the new one being considered. If they are substantially different, you may not want to rely on the manager’s past success being carried forward to the new environment.
Service
The second consideration is service. Assuming the money manager (or managers) is carefully selected, they will hopefully be part of the client’s investment strategy for many years so it is only good business sense to deal with an organization that can provide both the client and the advisor with the level of service required. Some firms provide every imaginable service while others scrape by just meeting regulatory requirements for reporting and so on. An advisor’s experience in dealing with various managers on behalf of their clients will often be the best guide to what any individual client can expect.
The Security Selection Process
To further our discussion, however, let’s assume that the client wants to have a more active involvement in the selection of the securities that will make up their individual portfolio. The following process may assist you in deciding which ones to choose.
Step #1
Let’s return to our sample portfolio of 70% equities, 20% debt assets and 10% cash. In determining which specific securities to include, it is probably prudent to concentrate on the equity portion first because it is the largest and, therefore, likely the most important component. And, in keeping with a best practices approach, it would be appropriate to confirm the client’s perspective on risk before proceeding further with the selection of specific securities.
By way of illustration, to do this, we might begin by dividing the equity part of the portfolio into the risk categories of ‘value (conservative)’, ‘ growth (aggressive)’ and ‘specialty (speculative)’. Then we would assign weighting to each of these categories to parallel the client’s risk tolerance. For simplicity, let’s assume the assets available for investment total $100,000 and the client’s risk profile is described as “moderately aggressive”. Given that, we may choose to organize the equity portion something like this:
This arrangement allocates half of the equity component in conservative securities and half in aggressive-to-speculative choices. As a result, when we look at the client’s overall portfolio, we see that slightly more than one-third of the total portfolio would be invested in conservative equity securities and the same amount in aggressive-to-speculative choices. This would be consistent with their “moderately aggressive” risk profile.
Step #2
The next step would be to ask, “If the client wants 70% of their portfolio in equities, with what type of equities would they be familiar and comfortable?” From that question, we might end up with a list that looked something like:
- Growth segregated or mutual funds
- Individual common stocks
- Real estate
- Business interests
- Collectibles
- Options
- Etc.
The list for any particular client might be longer or shorter depending on their investing experience and preferences. Bear in mind that whatever securities are chosen, as the advisor, you should have confidence that they will meet the client’s needs and be within their tolerance for risk and not be biased by your personal preferences. A client, for example, may like the potential return of investing in real estate because they have had success in doing so before. But if they had been ‘burned’ in one of the numerous real estate boom-bust cycles experienced across Canada, they may be considerably less willing to include that type of security in their portfolio again, even if your asset allocation software has shown that it has great risk/return characteristics. For many clients, the psychological discomfort may outweigh any promise of reward. For our purposes here now, however, let’s assume the above is the client’s list of ‘eligible’ securities.
Step #3
The next step would be to further evaluate the list of potential investments in terms of their risk/reward characteristics. For example, we included ‘growth segregated or mutual funds’ as one type of equity security in which the client would be interested. But ‘growth’ comes in many disguises in the world of investing. Segregated or mutual funds invested in well-known, multinational companies with large stock market capitalization are, in long-term market history, generally considered to be conservative equity investments. On the other hand, funds that invest exclusively in one sector or major industry, such as biotechnology, telecommunications, precious metals or single country funds that focus on developing countries, are broadly deemed more aggressive. Yet all of these funds could be labelled as ‘growth’ funds. Consequently, this may require you, as the advisor, to sub-divide the broader groups into something more definitive, particularly if the client’s portfolio is large enough to permit diversification across some of the sub-asset classes as well as the three major ones. We would then be able to weight these more specific types of securities into the equity component. The result may look like this:
So in the ‘Value (conservative) equity’ category, we have diversified by choosing a Canadian and a US Large Cap fund and two ‘blue chip’ stocks.
For the ‘Growth (aggressive) equity’ portion, we have chosen a more narrowly focused Canadian fund that invests in smaller, specialized industry companies along with a foreign fund concentrated in one geographic area of the world know for its superior return potential that is often accompanied by higher volatility. We have completed the category by including a relatively young, fast-growing, yet enormously successful global firm.
Finally, on the very aggressive or ‘speculative’ front, we are going with one of the major players in that volatile dot.com field. And finally, speaking of ‘players’, we have decided that the memorabilia of the world’s greatest hockey star is going to multiply in value now that he is retired from the game, so we are going to try to speculate on that. (Note, of course, that the securities shown in this example are for illustration purposes only and should not be construed in any way as specific recommendations.)
That completes the high-level equity security selection. Let’s move to the next largest component ¾ debt. The process is the same as that used for the equity position. It is only the way in which the asset class is sub-divided, if applicable to the client’s portfolio size, that differs. In this example, we have segmented the debt portion of the portfolio by maturity date of the potential holdings. It may look something like this:
To this point, the broad-based security selection is complete. Obviously, we have not yet evaluated the merits of the various securities themselves. This was intentionally done to emphasize the process rather than the products. Determining which large cap Canadian equity fund, for example, is the right one for your client or whether they should own Microsoft stock rather than Intel stock is a matter of the client’s personal preference. Recommendations may also be limited to those that can be given under the level of security licensing held by the advisor.
Following is a summary worksheet that may be modified in any way that makes it more personally meaningful and useful. For simplicity, consistency has been maintained with the examples used so far. Regardless, however, of the number and descriptions of whatever categories and divisions personally used, the procedure is essentially the same:
- Start by filling in the dollar amount of the total (100%) portfolio in the left hand column
- Divide that amount into percentages and dollar amounts for each asset class according to the allocation decisions already made (second column)
- Sub-divide as appropriate for the client’s personal situation (percentages and dollar values)
- Select the preferred securities and assign dollar values
Working with Larger Portfolios
The above worksheet allows for two specific securities in each of the cash and debt groupings and four in each of the equity categories. That is just for convenience and illustration. You may not use all the spaces on the worksheet or you may wish to add more, depending on the client’s personal situation. This does, however, lead to the question of how to deal with a substantial portfolio where it is possible to achieve a much broader diversification. As we know, best practices dictate broader diversification over the long term. Not surprisingly, the process with a larger portfolio is virtually identical ¾ the only real difference is the greater number of options from which to choose for the specific securities to be included. Let’s illustrate by comparing the original $100,000 portfolio example with a $1,000,000 portfolio. For simplicity, we’ll consider the ‘Value (conservative) equity’ component only, knowing that the same procedure could be applied to the ‘Growth (aggressive)’ and ‘Specialty (speculative)’ equity portions as well as to the cash and debt holdings.
| Value Equity (35%) | Total $ Value | Securities | $ Value |
|---|---|---|---|
| $100,000 Portfolio | $35,000 | Large Cap Canadian Equity Seg. Fund | $20,000 |
| Large Cap U.S. Equity Mutual Fund | $ 5,000 | ||
| IBM | $ 5,000 | ||
| TD Bank | $ 5,000 | ||
| $1,000,000 Portfolio | $350,000 | Large Cap Canadian Equity Seg. Fund #1 | $ 50,000 |
| Large Cap Canadian Equity Mutual Fund #2 | $ 50,000 | ||
| Large Cap Canadian Equity Mutual Fund #3 | $ 50,000 | ||
| Large Cap Canadian Equity Mutual Fund #4 | $ 50,000 | ||
| Total | $ 200,000 | ||
| Large Cap U.S. Equity Mutual Fund #1 | $ 25,000 | ||
| Large Cap U.S. Equity Mutual Fund #2 | $ 25,000 | ||
| Total | $ 50,000 | ||
| Growth Stock #1 | $ 20,000 | ||
| Growth Stock #2 | $ 20,000 | ||
| Growth Stock #3 | $ 20,000 | ||
| Growth Stock #4 | $ 20,000 | ||
| Growth Stock #5 | $ 20,000 | ||
| Total | $ 100,000 |
Clearly, this is a dramatic oversimplification and there would be issues surrounding making choices like those outlined above. These might include concentration and duplication. For example, many equity funds that invest in Canadian companies with large stock market capitalization will, by necessity, end up owning the same stocks. This is simply because the Canadian large cap market is highly concentrated among a fairly small number of companies and most portfolio managers with a mandate to invest in that market would want to include the best performing ones in their funds. There are ways to compensate for this overlap, such as seeking out managers who follow a ‘value’ approach to investing and pairing them in the portfolio with managers who follow a ‘growth’ approach. The important point to be made is that the process of security selection may become more extensive as the size of the portfolio increases but it doesn’t have to be any more complex.
Additional Considerations
1. Transaction Costs and Taxes
Almost every transaction involving a security results in a cost, in some form or another. This can be direct trading costs, sales commissions, deferred sales charges and, of course, income taxes. Before any recommendation is made regarding the purchase or disposition of a security, the associated costs should be calculated so they can be communicated to the client and form part of the decision making with respect to the ultimate portfolio construction.
2 Dealing with assets that cannot be changed
Many clients will have assets in their portfolio that cannot be altered for a variety of reasons. This may include such items as pension plan assets, locked-in deposits, and shares in private companies or simple sentimental favourites. The strategy for dealing with these securities is to “put them in the portfolio first and build around them”. For example, if a client already owns shares in, say, Microsoft, as a result of working there for a number of years and they are so sentimentally attached to them that they will not consider selling them, account for those shares as part of the “Growth equity” portion of the portfolio and make the balance of the recommendations assuming they are a fixed part of the overall holdings. This may result in a less-than-perfect security recommendation but it does recognize the realities of many previously owned assets. It may be possible to schedule a re-organization of those securities at a later date.
