Foundations of Financial Economics

Building sound investment portfolios

What is a sound investment portfolio …

In our view, a sound investment portfolio should exhibit the following characteristics:

it should be consistent with your chosen risk exposure (see Asset Allocation Decision);
it should be diversified as broadly as cost effectively possible both within and across asset classes (see Diversification is Key);
it should be low cost and, therefore, is likely to be passively managed (see Markets work );
it should be tax aware, with a focus on after-tax returns rather than pre-tax returns; and
it should be invested in asset classes where risk has been reliably rewarded in the past, and can be expected to be rewarded in the future. Ideally, it should provide access to the small and value share sub asset classes (see Risk and Return are related).

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Index funds provide a base to build a sound portfolio …

In Structure explains performance, we introduced the following five, progressively more growth oriented and, hence, risky portfolios:

Asset Class / Portfolios	“90/10” %	“70/30” %	“50/50” %	“30/70” %	“10/90” %
Cash and fixed Interest*	90	70	50	30	10
Australian Shares**	6	18	27.5	35	45
International Shares***	4	12	17.5	25	30
Property****	0	0	5	10	15
	100	100	100	100	100

*As measured by UBS Warburg 90 Day Bank Bill Index

**As measured by S&P / ASX300 Accumulation Index

***As measured by MSCI World ex Australia (net dividends)

****As measured by S%P / ASX300 Property Trust Accumulation Index

These portfolios can be constructed using readily available passively managed index funds. They track accepted asset class benchmarks at relatively low cost compared with the parallel asset class offerings from active fund managers. Portfolios built from index funds deliver on most of the desirable portfolio characteristics summarised above:

it is relatively easy to build and monitor a portfolio consistent with your desired risk exposure;
within each asset class, index funds are broadly diversified e.g. an Australian share index fund that aims to track the S&P ASX300 Accumulation index will hold approximately the largest 300 Australian shares, by market weight;
index funds are low cost because they mechanically track their asset class benchmarks. There is no need to employ expensive analysts to attempt to select winning shares or to incur high transaction costs associated with increased levels of buying and selling implicit in active funds management;
index funds are low turnover, buying and selling only when underlying investments either enter or leave the benchmark being tracked. As a result, compared with many active managers, capital gains’ realisations are reduced, meaning tax is deferred and, in the many cases, may be avoided completely; and
index funds provide efficient access to the cash/fixed interest, share and property asset classes, that have in the past provided and are expected in the future to provide reliable risk/return characteristics. Currently, in Australia, index funds do not provide targeted access to the small and value sub asset classes. We will consider the historical implications of this below.

The table below provides some of the key performance characteristics of the portfolios, based on relevant asset class benchmarks, both before and after inflation, for the period December 1981-June 2008.

Portfolio Performance
December 1981 – June 2008

Portfolio	Annualised Return (%)		Growth of $1		Annualised Volatility (%)
	Before Inflation	After Inflation	Before Inflation	After Inflation	Before Inflation	After Inflation
“90/10”	9.81	5.37	$11.95	$4.00	2.70	2.20
“70/30”	10.67	6.20	$14.67	$4.92	4.98	4.68
“50/50”	11.39	6.90	$17.45	$5.86	7.43	7.22
“30/70”	12.01	7.49	$20.20	$6.79	9.96	9.79
“10/90”	12.57	8.04	$23.08	$7.75	12.60	12.47

While we believe all these portfolios are sound, their appropriateness depends on a person’s desired risk exposure – they vary considerably in terms of their risk/return outcomes and expectations.

For example, the above data indicates that the most defensive portfolio – the “90/10” - returned an average of 5.37% p.a. after inflation over the period, with annualised volatility of 2.2% p.a. This implies that about 95% of the annual returns varied between 1.0% and 10.8%.

In contrast, the highest growth portfolio – the “10/90” - returned an average 8.04% p.a. over the period with annualised volatility of 12.6%, implying about 95% of the annual returns varied between about -16.9% and 33.0%. To achieve the higher long term returns, you would have needed to be able to handle extreme volatility.

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However, this volatility was considerably lower than that which would have been experienced by an investor who placed 100% of their investment funds into one of the individual growth asset classes (i.e. Australian shares, international shares or property) over this period. The table below compares the after-inflation returns, growth of $1, volatility and range of 95% of returns for the “10/90” diversified growth portfolio compared with the individual growth asset classes:

Performance Comparison
High growth Portfolio v Growth Asset Classes
December 1981 – June 2008

Asset Class / Portfolios	Annualised Return (%) After inflation	Growth of $1	Annualised Volatility (%)	Range of 95% of Annual Returns (%)
“10/90”	8.04	7.75	12.47	-16.9 – 33.0
Australian Shares	8.45	8.58	17.27	-26.1 – 43.0
International Shares	7.02	6.04	16.82	-26.6 – 40.7
Property	7.21	6.32	13.08	-19.0 - 33.4

The “10/90” portfolio reveals the benefits of diversification across the asset classes, achieving returns comparable with the individual growth asset classes but with a significant reduction in volatility. Any individual asset class may significantly outperform the diversified growth portfolio over short term periods (e.g. up to 3-5 years). However, over the long term (i.e. 10 plus years) it will achieve returns roughly equivalent to the weighted average of the individual asset classes, but with portfolio volatility almost certainly significantly below the weighted average volatility of the individual asset classes – the “free lunch” provided by diversification.

Adding “small” and “value” shares …

Can adding the “small” and “value” share sub asset classes offer additional, soundly constructed portfolios with desirable risk/return characteristics? We think they can.

Rather than just replicating the performance of Australian and international large share benchmarks for the share components of our portfolios, in the table below we assume that both the Australian and international shares’ allocations are held as 50% large, 30% value and 20% small shares. The table compares the after inflation performance characteristics of the indexed or benchmarked portfolios with the “structured” portfolios i.e. those that include weightings to small and value shares.

Performance Comparison (After-inflation)
Indexed versus Structured
December 1981 – June 2008

Portfolio	Annualised Return (%)		Growth of $1		Annualised Volatility (%)
	Indexed	Structured	Indexed	Structured	Indexed	Structured
“90/10”	5.37	5.50	$4.00	$4.13	2.20	2.14
“70/30”	6.20	6.67	$4.92	$5.54	4.68	4.55
“50/50”	6.90	7.76	$5.86	$7.05	7.22	7.07
“30/70”	7.49	8.54	$6.79	$8.77	9.79	9.60
“10/90”	8.04	9.38	$7.75	$10.77	12.47	12.25

For all portfolios over the period examined, the structured alternative outperformed the indexed alternative, with a similar annualised volatility. If you interpret volatility as risk, it appears that by adding small and value share components to the portfolios you would have achieved a higher return without additional risk.

We do not believe in such financial alchemy. If the structured portfolios outperformed the indexed portfolios in the past and are expected to do so in the future, they must be riskier. Volatility is only a measure of risk and not the measure of risk. There are other elements of risk (e.g. short term illiquidity, particularly for small shares) driving the higher returns.

So, we do not think the structured portfolios are necessarily better than the indexed portfolios. However, the funds to implement the portfolios are available in Australia and provide the opportunity to build sound portfolios with additional risk/return characteristics to those provided by indexed funds.

Go to the asset allocation decision

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