Portfolio Construction Philosophy

Seeking Alpha contributor David Van Knapp asked the following question on my post the other day about efficient portfolio construction in relation to account size;

Roger, do you have a template for general asset allocation, one that perhaps serves as a starting point (with variations for individual circumstances)? I find myself wondering about narrower and narrower slices of asset classes (or within asset classes), and when does it reach a point of diminishing returns or ridiculousness?

Trying to answer this requires mentioning my starting point which is constructing portfolios for other people and then navigating through cycles with these portfolios. We get paid based on assets under management so aside from being in the clients’ interests to minimize fees where possible it is in our best interests as well. I believe this line of thinking also pertains to drawdowns during declines but that is a little more philosophical.

The starting point is the equity/fixed income targets which in most instances will be determined by one of my colleagues as the primary point of contact for the client. Focusing on the equity portion of the portfolio we have three types of accounts based on size.

The type of account I write about most frequently is the large account where I have no concerns about the commission drag from buying 30-40 stocks/ETFs. This is subjective as some might be ok doing this with a $100,000 and some would be uncomfortable with that many positions in a $1 million portfolio. This is in the eye of the beholder, there is no single right answer.

As to David’s question about when narrow gets ridiculous, this too is in the eye of the beholder. As a matter of philosophy I view part of the task of navigating cycles as tweaking the portfolio as needed to alter things like cap size, foreign exposure and yield among other things to manage the volatility of the portfolio and try to catch any cyclical tailwind. To the extent this is successful or not is measured by stats that are easily available in the software we use (I would think this would be available to any RIA). I believe this is important in terms of smoothing out the ride and I believe this is much easier to do with narrow exposure which means individual stocks or narrow ETFs. I mention this as I realize the typical do-it-yourselfer may not spend too much time on doing this. I just realized I’ve not used the term risk adjusted return in this paragraph which is of course what I’m talking about.

To the extent David’s question is about position sizing, long time readers know I target most stock positions at 2-3% of the portfolio. The reason for that sort of number is that I believe this is large enough that should a stock with that target weight go up 50-100% in a year it is enough to have a noticeable impact on the overall portfolio; obviously a stock targeted at 3% that doubles would add 300 basis points to the overall portfolio which can be a lot even in a year like 2010 where the SPX was up 15%. If a stock targeted at that weight blows up it would be a drag of course but not require a re-write of the financial plan. As one quick note in a portfolio of 30-40 stocks the odds of at least a couple of names going up a lot is quite good even if it is not the names that might be expected to go up a lot.

This too can be a little fuzzy as I know some people think that a stock needs to be weighted at 10% of the portfolio in order to make a difference.

We have what I would call a midrange portfolio where the size makes 30-40 equity holding not so great for the commission drag. In these portfolios there might be 14-20 holdings most of which are ETFs. In thinking about ten large S&P 500 sectors each sector would have 1-3 holdings; for example one ETF for utilities, telecom and maybe energy and the other sectors have two or three holdings where the financial sector might have three holdings including one individual stock.

From the top down the mid range captures much of the effect but will yield a little less and miss out on a couple of stocks we own. For example our position in Vale (VALE) is easily captured in just about any materials ETF but our position in Novo Nordisk (NVO) is not. The proliferation of narrower ETFs makes picking exposures a little easier but 18 holdings is not 34 holdings.

The third type of portfolio is mostly about broad asset class . It is these portfolios where the two Schwab ETFs mentioned the other day come into play along with an emerging market ETF, a developed foreign ETF (one that avoids Europe and Japan) and a gold ETF. Depending on the dollars in the account there might also be one or two thematic ETFs.

Embedded in all three strategies is the focus of an entire stock market cycle, if not longer. I’ve written about the defensive action we take hundreds of times so I won’t repeat that today other than to say we are trying to add value over a period of years not months so the above is tailored toward that goal. In the really big picture the job of an RIA is to give clients the best chance possible of having enough when they need it, prevent the occasional freak out and try to effectively communicate the strategy being employed and why.

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