Selecting investments and building a portfolio

Welcome to Finance and Fury. Last week, we looked at historical returns and their usefulness when selecting investments – this week, we will be looking at alternative options of selecting investments and building a portfolio

1. In regards to last week’s episode, if you didn’t listen, essentially you should avoid chasing the best returning funds in the short term – i.e. investing in a fund that has the best 12 month return, purely because it has had the best returns
2. but looking at past performance can have some purpose – mainly to compare how an asset has performed in comparison to its peers and benchmark over the long term – this can be used as an indicator of the managers skills over the long term and if it worthwhile to invest in, or if an index fund may be better
   1. But even this method should be one of the latter methods used when making an investment decision

Instead, in this episode we will be looking at a better way to select an investment –

1. When I say selecting an investment, I’m not talking about individual shares in companies listed on the ASX or international markets – where you would need to go through the financials and do some fundamental analysis, or if you are a short-term trader, technical analysis for companies, but instead, we are looking at investing in structured funds, like an ETF, LIC or managed fund – how to compare each of these
2. As a quick disclaimer – The contents of this episode are general in nature only and haven’t considered your personal situations at all – and as we went through last episode – Past performance is no indicator of future performance –

What is a more measured method on how to select investments? Well, this can differ from person to person due to one simple fact – everyone has different needs out of an investment –  

1. If you are 20 and want to invest for the long term, your investment allocation may differ from someone who is 60 and is retired, requiring a higher level of income from their invested funds
   1. Alternatively, you may be concerned about volatility risks, where you want to minimise short term losses – so investing in small or mid cap shares may not suit you, compared to someone willing to take the chance to maximise their returns in the long term
2. This is where the very first step is to understand your needs – This can be done through looking at what you want to achieve out of making an investment – and what the purpose of the investment is –
   1. Everyone investments for the same fundamental reason – to generate a return, which is normally above what cash savings can provide – or if you have a mortgage, what your interest expenses are
   2. But a total return is made of up income plus capital growth – you can invest in assets that provide an income, with little to no capital growth, you can invest in assets that provide only capital growth, with no income – obviously, not all assets are built alike
   3. So before making any investing decisions – you need to fully understand your current financial situation – in other words, you need to be clear and understand what your money is being invested for
3. The next step which is part of this equation, is working out your time horizon –
   1. This is the next major step in helping you identify when you’ll need all or some money back – this the concept of an investment horizon, and really helps to determine the investments and environment in which you invest, be it personally, in a trust, company or superannuation
   2. Say if you need all of your funds back in 12 months for a home deposit, then investing any of your deposit funds can often be the wrong decision, unless luck is on your side – just like anyone can be lucky at the casino in the short term, where a few spins of roulette go your way, but if you are playing a game of chance, you have a higher probability of up losing –
      1. Investing in an index has a higher chance of providing a return that is positive in 1 years’ time than say betting everything on black – where it is roughly 49% compared to 70% – but there is on average a 25% to 30% chance that your rolling 1-year returns are below what cash savings have provided
   3. The purpose of knowing your investment time horizon is to determine a suitable asset allocation – where do you put your money for the timeframe as well as the purpose that you need the funds for
   4. Some investments are more suitable for longer time horizons as you can afford to ride out the market fluctuations when there is more time remaining, whereas other investments are more suitable for the short-term, because the stability is more important
      1. There is also an allocation to create baskets of investments – where you keep cash to cover at least 12 months to 2 years’ worth of your income needs, with the rest invested in higher growth a higher income paying assets – which can help top up your cash reserves and you don’t need to sell down any of your volatile investments
      2. Keeping 1 to 2 years’ worth of cash helps to ensure that you have enough reserves where you can ride out any investment declines, both in terms of capital values but also incomes declining, such as recently – where as an example, bank shares cut dividends to increase their capital reserves
   5. The next step is looking at your tolerance in taking on risk – in other words, what potential price movements are acceptable to you
      1. Every investment has some degree of risk – even cash, which technically isn’t an investment but a medium of exchange, has some risks in terms of real returns, where after inflation you can lose money –
         1. So deciding what your short term volatility exposure can be is important – you should invest in a way that minimises absolute losses – through investing in a managed fund, or ETF, LIC or index fund should do most of this heavy lifting for you – but there are some managed funds, ETFs, etc. that invest in illiquid investments – in which case your chances of absolute losses increase
      2. The general rule of thumb is that the reward for taking on an additional level of risk (in terms of volatility) should have a potential for a greater investment return.
      3. Many factors can go into identifying the level of risk tolerance, for instance:
         1. the length of time that you can wait for the potential losses to recoup, your income capacity to top up investments if they lose value, or other existing investments as diversification, such as property, shares or cash savings.

Taking all of these factors can help to determine the overall allocation that you may take – But how to narrow down the investments in the mix – Say you need long term capital growth – selecting share funds – what share funds?

1. Tracking difference – This is the measure of a fund’s relative return
   1. This is appropriate when looking at both an index fund and an actively managed fund – as their returns are still measured against their benchmark.
      1. Looking at this piece of information helps to evaluate if the fund managers are doing what they advertise – i.e. providing a return above the index after the fees that you are paying to fund managers – even for index funds this can be important, as generally the lowest cost manager should outperform their peers
   2. Each active fund should disclose the benchmark that they use to measure their outperformance – which is measured by what is known as an alpha – this should be available on any fund profile, also known as a fact sheet
   3. The whole point of looking at an alpha is to understand whether it’s worth paying a manager a fee to actively manage the investments – if they underperform the index in the long term – this should also be a red flag –
2. Tracking error – This is a fund’s relative risk compared to the benchmark – as it measures the volatility of the return difference between the fund and the benchmark
   1. By taking the volatility of Excess Returns – or the Tracking Error – this measures the relative risk, known as a tracking risk of a portfolio against a benchmark –
   2. For any fund manager that is active – a moderate amount of Tracking Error should be expected – if the tracking error is too low, the manager may be benchmark hugging and less likely to generate excess returns after their management fee –
      1. In many cases, a high tracking error is not a bad thing, as it indicates that the manager is trying to do their job – so if there is a high tracking error with a tracking difference (alpha) that is in favour of the manager, this is not a bad thing – for an index investment, almost no tracking error should be present
   3. To measure risk – you can also look at the Beta of a fund – this looks at a comparison between a funds volatility compared to the index – the index should be represented with a value of 1 – so if a fund has a beta of 0.8, it means they are 20% less volatile, but if it is 1.2, it is 20% more volatile than the index
      1. Depending on what you need out of the investment, if it is a share allocation that is less volatile than the index, lower beta can be appropriate, but if you are looking at higher growth, higher betas may be appropriate
   4. Upside/Downside capture – Returns consistency – when the market goes up – does it outperform, or and when it goes down, does it also perform
      1. It also found high conviction funds had a higher likelihood of improving performance (i.e. strong performance after a period of underperformance) and a lower probability of declining performance (i.e. bottom quartile performance after three years of top quartile performance).
      2. Downside capture can be more important –
   5. Sharpe ratios – This can be used once you have a shortlist of funds that you are looking at
      1. The Sharpe ratio compares the return of an investment with its risk – it is a measure of the risk weighted returns – helps to show if excess returns over a period of time are due to additional risk or skill
         1. You get the Sharpe ratio by dividing a portfolio’s excess returns by a measure of its volatility (measured by the standard deviation) to assess risk-adjusted performance
      2. Generally, the higher the Sharpe ratio, the more attractive the risk-adjusted return.
         1. If you are looking at two of the same sort of funds and one has a Sharpe ratio of 1 and another of 0.5, then the fund that got 1 either got a better return for the same risk as the other fund, or the same return with less risk
         2. You can see which way this occurred by looking at the average returns
      3. Doing this does have some weaknesses – it works off the assumption that the historical record of a risk-adjusted returns has at least some predictive value
         1. In addition – it may be overstated for some investment strategies – either high risk or low risk share managers can provide very different results compared to the benchmark – so it could only really be useful if you are comparing apples to apples

Summary –

1. When selecting investments – first step is to look at what your returns needs are and what funds can provide these
   1. As part of this you need to consider your time horizon – how long the funds are going to be invested for
2. Comparing Past performances of funds isn’t the be all and end all – it is useful to measure the tracking difference, or alpha of a fund to see if it is worth paying fees for
   1. I have seen that in small cap or specialised markets, like emerging markets, active can be a better option on average
3. Looking at the risk, through tracking errors or betas – helps to determine if a fund meets your needs when it comes to risks
4. Then once you have a short list of funds – looking at the Share ratios of comparable funds helps to determine if the managers are outperforming the index due to skill over time, or simply additional risk that was taken on
5. This is just one method to help select investments – everyone can go about this differently
6. Hope this helps