Portfolio Construction – Part 1

Now that we’ve reviewed all the different asset classes, it’s time to put all that learning together and construct your investment portfolio.

Now that we’ve reviewed all the different asset classes, it’s time to put all that learning together and construct your investment portfolio.  We’ve broken it down, step by step.

Step 1:    How much cash will you need?

The first step in constructing your portfolio is determining how much money you will need to hold in cash.  You should hold in cash:

  • Any money that you will need to access in the next 3 years
  • Sufficient cash to pay any costs associated with your investment portfolio

If you have retired, the amount you need in cash would be your next 3 years living expenses.  The reason for this is that you don’t want to be in a situation where you have to sell your assets in a down market to cover your  expenses.

Step 2:  What is your investment time frame?

Determining your investment time frame will help determine which assets to invest in.  The time frame is how long you expect the assets to be invested for, i.e. how long before you’ll need the money you’ve invested.

In terms of appropriate asset classes by time frame, broadly speaking:

Time Frame Asset Class
0-3 years Cash
3-5 years Bonds
5+ years Property / Shares

Step 3:  How much risk are you prepared to take?

As we mentioned in earlier posts, your goal in constructing a portfolio is to maximise your return and minimise risk.  It is not possible to earn a high return with low risk, so when you consider your target return, you will also need to consider how much risk you are prepared to take.  Below we have set-out historic returns by asset class, and an indication of risk:

Asset Class Asset Type Risk Average Return p.a. over 20 years*
Cash Defensive Low 3.40%
Australian Bonds Defensive Low-Medium 6.80%
Residential Property Growth Medium-High 10.50%
Australian Shares Growth High 8.70%
International Shares (hedged) Growth Highest 7.60%

* 20 years to Dec 2015.  Source: 2016 Long-Term Investing Report, Russell Investments

Theoretically, the higher risk products should have the highest return, however this won’t hold true over every time period.

ASIC also has some useful information on their website about the expected risk of different portfolio types, which we have summarised here:

Portfolio Purpose Defensive Assets Growth Assets Risk Expect a loss Expected Return Value of $10,000 after 5 years
Growth 15% 85% High 4-5 years in 20 6.20% $13,500
Balanced 30% 70% Medium 4 years in 20 5.70% $13,200
Income / Conservative 70% 30% Low 0 years in 20 4.20% $12,300

 

Everyone wants to maximise their return, so it is easiest first to focus on risk.  How much money are you prepared to lose? As set out in the table above, would you be prepared to invest in a growth portfolio and take on the risk of losing money every 4-5 years out of 20? Or would you rather take a lower 4.20% return and preserve your capital?

Generally speaking, the younger you are the higher your ability to take on risk.  If you 25 and investing for retirement, then a high growth portfolio may be appropriate because losing money every 4/5 years isn’t an issue, given that you won’t be accessing the money for 40 years.  However, if you are 25 and saving for a home deposit, then you may not be comfortable at the thought of losing your hard earned savings, meaning that you would instead consider a conservative portfolio.

These are decisions that only you can make, and it will depend on your stage of life and what you are using your investment savings for.

Once you’ve completed the steps above, you are ready to choose your investments.  We’ll cover that next week.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

Investing In Alternatives – Part 2

Most people think that a company has made it when it is listed on the Australian stock exchange, but how can you invest before a company reaches this milestone?

Most people think that a company has made it when it is listed on the Australian stock exchange, but how can you invest before a company reaches this milestone?

The answer is private equity, which is another asset class usually grouped in the bucket called “alternatives”.

Private Equity

When you purchase shares on the Australian stock exchange, you are purchasing shares in publicly listed companies.  That is, they are listed for purchase by the public, on the public stock exchange.  When a company is listed publicly there are certain rules and regulations that must be met,  designed to ensure that the company regularly reports to the public and is transparent about their company management.

However public companies are only one part of the company landscape, there are also a number of other companies that are not listed on the Australian Stock Exchange.  These companies are known as private companies.

What:  Private equity are shares in privately held companies, i.e. those companies not listed on the stock exchange.

Why:  Privately held companies tend to be on a higher growth trajectory than more established, listed companies.  Some investors look to find private companies that have not yet met their full potential, with the view of getting in early, adding value to the company and eventually taking the company public and realising a profit.

How:  Investing in privately held companies is a very specialised area.  It requires:

  • Finding deals:  to invest in privately held companies, you have to be able to find ones that are suitable.  This can be tricky, as these companies are not listed in the same way that companies on the ASX are listed.

  • Analysing deals:  Companies listed on the ASX have to meet certain disclosure requirements in terms of the information they provide to investors.  Additionally,  the performance of the largest companies are covered by analysts who will provide a view on whether the company is a good investment.  The public infrastructure to analyse a company’s performance does not exist for private companies.  Instead it is up to you to ask the right questions, review the right information and analyse the data yourself.

  • Monitoring Performance:  Once you purchase shares in a private company, you will need to  monitor the performance.  The disclosure of performance data is not regulated the same way public company data is.  It is up to you to request the right information on a timely basis.

  • Large sums of money:  Many investments in private companies are restricted to wealthy investors and require a minimum investment sizes of upwards of $500,000.

For the reasons listed above, it is easiest to invest in private equity via either:

  • Exchange Traded Fund:  There are now a number of exchange traded funds that provide access to private equity investment.

  • Managed Fund:  You could also invest in a professionally managed private equity fund.  One thing to note about these funds, the fees are likely to be higher than your standard share fund.  This is because of the specialised nature of private equity investment.  A standard fee structure is known as 2/20, which means that the manager receives a 2% management fee and a 20% share of any profits that the manager makes above a set benchmark.

When investing privately it is very important to invest with someone that has specialised knowledge of the industry, and some kind of advantage in finding the best companies first. This is because private equity investing is very risky, and very competitive.   Next week we’ll take a closer look at some of the risks of investing in private equity.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

International Shares

Last week we covered Australian equities. This week we cover International shares, a worthwhile addition to a portfolio if you are looking to improve geographic diversity and access a wider range of industries.

Last week we covered Australian equities.  This week we cover International shares, a worthwhile addition to a portfolio if you are looking to improve geographic diversity and access a wider range of industries.

Why invest in international shares?

One of the main reasons to invest in international shares is diversification:

Sector Diversification: In Australia, approximately 60% (by market capitalisation) of the top 100 companies operate in a very narrow set of industries, namely financials, mining & materials, and energy.  If you invest only in the Australian market, your portfolio may lack sector diversification. 

By investing internationally, you get access to other sectors. For example, the top sector in the US is Information Technology, which accounts for over 20% of the 500 largest companies in the US.  In Australia, information technology accounts for only 0.85% of the 100 largest companies.

Geographic Diversification:   If you invest only in the Australian market, the performance of your portfolio will be tied to the performance of the Australian economy.  This can be problematic because your financial well being (i.e. your ability to find work, buy a house, meet interest repayments) is also tied to the performance of the Australian economy. 

Investing internationally helps to diversify your investment risk, by providing access to markets outside of Australia.

How can I invest in international shares?

There are a number of ways to invest in international shares:

Directly:  You could pick a handful of stocks and try to invest directly.  This is a little tricky, because foreign stocks are listed on foreign stock exchanges, which are not easily accessible.  Some brokers in Australia do allow you to purchase stocks listed on certain foreign exchanges. 

 However, before you do this it is important to consider the impact of foreign exchange on your investment.  If your international share portfolio rises by 10%, but the Australian dollar appreciates by 10%, then your net return will be 0.  It is hard to manage this foreign exchange rate risk when you purchase shares directly.

Exchange Traded Funds:  It is possible to invest in international equities via an exchange traded fund (“ETF”).  This means that you can purchase the international equity ETF on the Australian stock exchange (the same way you would a share) and get access to a number of international stock markets.  The upside is that you get access to a diversified international portfolio, through a purchase in Australia, and you can choose a hedged portfolio (more on that below) to minimise your foreign exchange rate risk.  The downside is that you will pay a fee for this management, usually around 0.3% to 0.5%p.a.

Managed Fund: Another option is to invest via a fund manager, this allows you to invest in a professionally managed portfolio of international stocks.  This is a simpler option that investing directly in a number of different stock exchanges, and you get access to professional investment expertise, including expertise in managing foreign exchange rate risk. 

 The downside is that this will cost you between 1-2% p.a.   According to the SPIVA report just over 10% of international managed funds in Australia outperformed the index over the last 10 years.

Too many international shares?

International shares are an important part of a portfolio, particularly for those who are able to take on a higher level of risk, however they should not form 100% of your portfolio.  This is because international shares have all the same risks as Australian shares, plus the additional risk of foreign exchange fluctuations. 

When you invest internationally, you are selling Australian dollars and buying the currency of the investment.  This means that the value of your investment will fall in Australian dollar terms when the Australian dollar rises, so you are exposed to the risk of the Australian dollar appreciating.

If you invest via a managed fund, or an ETF, you are likely to have the option to hedge your foreign exchange rate risk.  If you go with a hedged option, the fund manager will pay a fee to lock in a set foreign exchange rate.   This means that you are protected if the Australian dollar appreciates, but you will miss any upside if the dollar depreciates.

Hedging does not eliminate foreign exchange rate risk, instead you are paying a fee (via the cost of the hedge) to manage it.

The decision of whether or not to hedge is a very personal one and will depend on your ability and willingness to take on risk.  Foreign exchange can be very volatile, if you do not like volatility you should consider hedging any foreign exchange rate risk in your portfolio.  The chart below shows the Australian Dollar / US Dollar exchange rate over the last 10 years, as you can see the rate has been very volatile.

 

A further point to consider with international shares is diversification.  If you invest in a handful of international stocks in the US technology industry, then you have added only a small additional layer of diversification to your portfolio.  To get the largest diversification benefit from international stocks, try to avoid concentrating your stocks in a particular industry or country.

Next week we are going to cover another popular asset class in Australia, Property.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

How to add international exposure to your portfolio

Last week we considered the pros and cons of adding international stocks to your portfolio, this week we look at how.

Last week we considered the pros and cons of adding international stocks to your portfolio, this week we look at how.

How can I invest in international shares?

There are a number of ways to invest in international shares:

Directly

You could pick a handful of stocks and try to invest directly.  This is a little tricky, because foreign stocks are listed on foreign stock exchanges, which are not easily accessible.  Some brokers in Australia do allow you to purchase stocks listed on certain foreign exchanges. 

However, before you do this it is important to consider the impact of foreign exchange on your investment.  If your international share portfolio rises by 10%, but the Australian dollar appreciates by 10%, then your net return will be 0.  It is hard to manage this foreign exchange rate risk when you purchase shares directly.

Exchange Traded Funds

It is possible to invest in international equities via an exchange traded fund (“ETF”).  This means that you can purchase the international equity ETF on the Australian stock exchange (the same way you would a share) and get access to a number of international stock markets.  The upside is that you get access to a diversified international portfolio, through a purchase in Australia, and you can choose a hedged portfolio (more on that below) to minimise your foreign exchange rate risk.  The downside is that you will pay a fee for this management, usually around 0.3% to 0.5%p.a.

Managed Fund

Another option is to invest via a fund manager, this allows you to invest in a professionally managed portfolio of international stocks.  This is a simpler option that investing directly in a number of different stock exchanges, and you get access to professional investment expertise, including expertise in managing foreign exchange rate risk. 

The downside is that this will cost you between 1-2% p.a. According to the SPIVA report just over 10% of international managed funds in Australia outperformed the index over the last 10 years.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

The pros and cons of going international

Last week we covered Australian equities.  This week we cover International shares and the pros and cons of adding them to your portfolio.

Why invest in international shares?

One of the main reasons to invest in international shares is diversification.

Sector Diversification 

In Australia, approximately 60% (by market capitalisation) of the top 100 companies operate in a very narrow set of industries, namely financials, mining & materials, and energy.  If you invest only in the Australian market, your portfolio may lack sector diversification. 

By investing internationally, you get access to other sectors. For example, the top sector in the US is Information Technology, which accounts for over 20% of the 500 largest companies in the US.  In Australia, information technology accounts for only 0.85% of the 100 largest companies.

Geographic Diversification

If you invest only in the Australian market, the performance of your portfolio will be tied to the performance of the Australian economy.  This can be problematic because your financial well being (i.e. your ability to find work, buy a house, meet interest repayments) is also tied to the performance of the Australian economy. 

Investing internationally helps to diversify your investment risk, by providing access to markets outside of Australia.

What are the risks of investing internationally?

Lack of familiarity

If you’re investing in Australia, there is a good chance that you have used the services of the company you are investing in, or at least be familiar with them.  This is a good starting point for the due diligence an investor should complete prior to investing.

If you are investing offshore, the due diligence is a little harder as you don’t have “local knowledge”, like what’s the difference between Walmart and Home Depot?  or who shops at Whole Foods? You become entirely reliant on research reports to form a view on a company, instead of first hand knowledge.

Foreign Exchange

Another risk with investing internationally is foreign exchange. 

When you invest internationally, you are selling Australian dollars and buying the currency of the investment.  This means that the value of your investment will fall in Australian dollar terms when the Australian dollar rises, so you are exposed to the risk of the Australian dollar appreciating (going up).

If you invest via a managed fund, or an ETF, you are likely to have the option to hedge your foreign exchange rate risk.  If you go with a hedged option, the fund manager will pay a fee to lock in a set foreign exchange rate.   This means that you are protected if the Australian dollar appreciates, but you will miss any upside if the dollar depreciates.

Hedging does not eliminate foreign exchange rate risk, instead you are paying a fee (via the cost of the hedge) to manage it.

The decision of whether or not to hedge is a very personal one and will depend on your ability and willingness to take on risk.  Foreign exchange can be very volatile, if you do not like volatility you should consider hedging any foreign exchange rate risk in your portfolio.  The chart below shows the Australian Dollar / US Dollar exchange rate over the last 10 years, as you can see the rate has been very volatile.

SMLXL

Source: Yahoo Finance

The USD is one of the most frequently traded currencies.  If you are investing offshore, try to stick to the liquid currencies (USD, Euros, Sterling) and avoid the smaller, less frequently traded currencies.

Perceived Diversification

Investing internationally should result in a more diversified portfolio, if you make the right investments.  If you invest in a handful of international stocks in the US technology industry, then you have added only a small additional layer of diversification to your portfolio.  To get the largest diversification benefit from international stocks, try to avoid concentrating your stocks in a particular industry or country.

Next week we are going to look at how to add international exposure to your portfolio.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

 

Asset Classes & Investment Styles

Once you’ve decided to start an investment portfolio, the next step is to decide what to invest in.

Once you’ve decided to start an investment portfolio, the next step is to decide what to invest in.  The average person will pick a handful of stocks and hope for the best, here we explain some more sophisticated techniques for constructing your investment portfolio.

Asset Class Selection

Your first decision is which asset classes to invest in.  Your broad choices are set-out below, each week we are going to delve into one of the asset classes and explain exactly how you can invest in it, and why you may want it to form part of your portfolio:

Asset Class Prupose Risk Time Frame Products
Cash Keep some money available for short term cash needs Low Short term High interest savings accounts, term deposit, cash exchange traded funds
Bonds Earn some interest while keeping risk low Low – High Short to medium term Government bonds (low risk) to junk bonds (high risk). Bond exchange traded funds, actively traded bond funds
Property Earn income via rent and increast the value of your investment over time through property price increases Medium – High Medium to long term Directly through purchasing a property. Indirectly through a property exchange traded fund, a property managed fund, or through shares in property companies
Australian Shares Earn income via dividends and increase the value of your investment over time through share price increases High Medium to long term Direct shares, equity exchange traded funds, equity actively managed funds
International Shares Increase the value of your investment over time and spread your risk globally, rather than being concentrated in the Australian market only High Medium to long term Direct shares, equity exchange traded funds, equity actively managed funds

Investment Style: Passive or Active

Your next decision is which investment style you prefer:

  • Active Management: Active managers believe that they can outperform the market by picking the best investments.  Active managers are likely to charge a higher fee for this skill. 

  • Passive Management:  Passive managers believe that it is not possible to beat the market.  Instead of picking individual stocks, they believe it is better to be invested in the whole market.  Passive management fees are lower than that of active managers.

Your decision about investment style will determine how you invest.   If you believe in active management then you can either:

  • Do the research and make the investments yourself – we only recommend this if you feel confident that you have the time and technical skills required to do the necessary due diligence on each investment, and that you have some kind of advantage (e.g. in depth knowledge of an industry) over professional fund managers.

  • Pay a fund manager – You can outsource the investment decision by paying a fund manager to manage your money.  The cost is typically 1 – 2% of the amount that you invest.

If you decide to follow a passive investment strategy then your main investment tool will be exchange-traded funds (“ETF”).   An ETF gives you access to an entire market (e.g. the top 200 shares in the Australian market, known as the ASX200) through one single purchase on the stock exchange.  Fees for an ETF are lower than for an actively managed fund, they are more likely to be between 0.10% – 0.50%.

In deciding whether to follow an active or a passive strategy, it is worth considering this semi-annual report by S&P which shows that in most asset classes, the majority of active managers do not beat the market.  This report suggests that a passive management style can potentially be better for your portfolio.  The key exception is in Small Cap stocks (i.e. smaller companies listed on the stock exchange) where it has been shown that 60% of Small Cap fund managers have outperformed the market over the last 5 years.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs and before acting on the advice.