This article was originally written by by Malcolm Holmes, Head of Portfolio Management, STANLIB Multi-Manager.
It is a tricky question as there are several construction methodologies that could be used, each with their own pro’s and con’s, but all following the same principle – get your client invested in an optimal combination of different asset classes that have the greatest probability of achieving your objective over time.
The focus in this particular article is the portfolio construction process and the considerations that go into building a goal-based portfolio aiming to achieve CPI+5% p.a. over the long-term.
Firstly, clients need to understand that this does not imply CPI+5% p.a. every year. Some years will be better than others depending on the level of inflation and the returns from various capital markets. However a well-constructed portfolio should produce CPI+5% p.a. on average over the long-term. The reason returns do not progress neatly from day to day, month to month, and year to year, is that many factors will influence their price over the short to medium term (and even over the longer-term).
Unfortunately, there are no asset classes in South Africa or globally for that matter that will deliver guaranteed real returns of CPI+5% p.a. for extended periods. Even inflation-linked bonds have return uncertainty over shorter periods, and could have return uncertainty to maturity if they paid coupons.
With South African cash producing around CPI+1% p.a. over the long-term, achieving CPI+5% goal-based portfolio construction for the total portfolio requires exposure to growth assets, like equity and property that can produce much higher returns over the long-term.
It will be enlightening to know whether the portfolio should change over time to reflect past performance. If you have achieved CPI+10% p.a. over the past three years, do you de-risk the portfolio on the basis that you will achieve your objective over the ensuing three years? There are a number of complications with this which are worth exploring in greater detail.
The first is that the portfolio is aiming to achieve the objective continuously for many generations of investors and many generations of their investments. Someone first investing in the portfolio after the three years of CPI+10% p.a. would not have enjoyed this return and would now be invested in a lower risk portfolio expected to produce a lower return than the objective.
The second is more scathing. If the portfolio had only achieved CPI+0% p.a. over the previous three years, do you increase the risk in the portfolio to try to make up for the shortfall, exposing investors to much more risk than had been initially assumed? Clearly this would have dire consequences if the risks materialized in large losses. The above approach lends itself to considering both active and passive investing paradigms within portfolio construction, or a combination as required given other priorities (like costs).
Once the portfolio has been designed and constructed to deliver the investment objectives; and is being managed to do this, it is important to reflect on how it is performing against the initial specification.Obviously one always needs to be careful with instinctive reactions of failure when the portfolio doesn’t deliver CPI+5% p.a. in the first complete six year period.
Ultimately, there are several ways to build a goal-based portfolio and hopefully whichever you choose is effective in meeting the investor’s goal. It is worth investing time upfront ensuring you understand the uncertainty in capital markets and how these uncertainties remain within portfolios even when they are constructed around very specific investment objectives.