What are some common portfolio construction mistakes?
GR: I think they essentially revolve around underestimating the scope of knowledge and skill, competence issues, and failing to undertake appropriate due diligence into third parties that are supplying you with information. If you’ve subcontracted to the provider of model portfolios and other research materials, and haven’t undertaken intense and pervasive due diligence, in my view under FSR you are at risk. You can’t assume that just because you’ve outsourced it, that you’re safe. What that leads to is a naïve and old-fashioned style of portfolio construction including assuming that historical returns are appropriate in determining your asset allocations going forward, rather than determining how you are designing forecasting for your asset allocation models.
DM: I think that advisers are going with yesterday’s trends. They back what has worked well, rather than taking a more critical approach. Often the things that will work in the future are those that may not have done that well in the last few years. They’re not being contrarian enough with their approach to investments both in terms of asset allocation and sector selection and also the management. Advisers often just buy the ‘flavour of the month’ managers, not understanding that there’s a particular type of manager who because of their style may have underperformed, but the environment in the future may be better for them.
RM: On the asset allocation side, I have seen too much of a reliance on more recent history. I think that there’s too much focus on yield — that has been an issue and on an after-tax basis it doesn’t really make sense. With manager selection, they’re also relying on fund managers to give them information and obviously fund managers have a vested interest in saying some things. For example, if you go and ask a property syndicate manager, of course they’ll say, “Direct property’s the way to go and look what a low correlation it’s got in terms of Australian equities, put more money in direct property”. I think the value of an external manager is they have access to the full market if they choose to.
CB: Apart from not utilising the services of professional specialists, one of the most common mistakes that advisers tend to make is to seek high returning products without understanding the risk profiles of such products. Some advisers are trying to give their clients high returns without understanding or explaining the high risks that generally attach to potentially higher returning investment opportunities. Advisers are not doing their clients any favours unless they make them fully aware of the risks involved in all their investments.
SI: Most model portfolios don’t come with the correlations between managers, so advisers can’t see how different managers work in shifting markets. It is also difficult to read the economy at the big picture level and while advisers use economic view points, five economists will give eight views and it is hard to be disciplined enough to synthesise those views.
