Portfolio Construction

The actual construction of portfolios can provide a second level of diversification that both manages risk and has the potential to enhance returns above market, albeit in a significantly smaller capacity than strategic asset allocation. Although the implementation stage is a second order contributor to the risk/return outcomes there are some important decisions that have to be made that can have significant impacts on your overall portfolio performance.

The key impacts on your portfolio's performance at the implementation stage are:-

Manager selection. The ability to select and combine managers that have different styles (the way they select stocks/financial securities), can provide a diversification benefit within a particular asset class.

Stock selection. In a portfolio of direct stocks a diverse portfolio will generally produce a lower risk/return outcome than a portfolio that is highly concentrated.

Active versus Passive management. Active fund managers take different stock holding positions to the market which is represented by the various market indices. Active fund managers believe they have the skills to exploit market mispricing to deliver added value (after fees) to the investor. Contrarily, passive style managers seek to replicate market returns (before fees).

Foreign currency exposure policy. Most well balanced portfolios will have an exposure to assets domiciled outside of Australia. Active or passive management of the exchange rate risk can significantly contribute to your portfolio performance.

Fees and expenses. The financial press talk up costs and there is no doubt that management expense ratios (MERs) and the buy/sell spreads of managed funds can seriously diminish your funds performance. However, you need to know that you are getting "value". Always consider the buy/sell spread when contemplating changing managers. If you focus on cost, remember that with direct investments need to include any brokerage fees payable on the transactions - both in and out of the stock. In the "Alternative Asset" space because of the higher risk/return relationship it is typical to find additional performance fees above a threshold level as well as a lower (but not cheap) on-going MER - the manager shares in the benefit of their expertise.