Portfolio Construction

What Is Portfolio Construction?

Portfolio construction is the process of strategically combining a diversified mix of assets to achieve specific investment goals within an acceptable level of risk. It involves several aspects such as establishing the correlation between different assets such as equities, bonds, property and cash, selecting an appropriate benchmark that the portfolio’s performance (and in some cases risk) will be measured against, determining the weights of assets/sectors and individual securities and selecting those securities.

There are several financial principles such as the Modern Portfolio Theory, that investors would use to assist their portfolio construction and it to their own objectives, risk appetite and investment horizon. In addition, other elements of the process such as asset allocation and portfolio rebalancing are also considered.

The Portfolio Construction Process

The portfolio construction process usually involves several key stages. These include:

1. Goal Setting – This is the starting point of the process where the investor’s investment objectives, time horizon and risk tolerance levels are determined. There are also additional factors such as liquidity or income requirements, ethical/ESG or in some cases even religious (for example, Islamic Finance) norms that should be considered.
2. Benchmarking – Here, investors need to select a yardstick that would help them measure the success of the portfolio. This is typically a market index or a composite. It is very important that the benchmark is in-line with the investment strategy. For example, a global large cap equity portfolio that invests in developed markets may only be looked against the MSCI World Index. On the other hand, portfolios that include some emerging markets might be best compared against the MSCI ACWI (All Country World Index).
3. Asset Allocation – This stage is key in striking the right balance between different asset classes such as equity, fixed income and alternative assets, based on the investor’s goals established one step earlier. Asset allocation typically relies on concepts such as the Modern Portfolio Theory and the Black-Litterman Model.
4. Security Selection – This stage requires picking up specific investments within each asset class/sector, considering factors such as return potential, valuation, risk and correlation with other holdings. For example, the selection process of the portfolio’s equity portion could be run by evaluating different ratios such as Dividend Yield, as well as analysing the quality of the management, competitive advantages and the market position on the business. .
5. Risk Management – This step is also quite important as it sets up the strategy that will control the risk in the portfolio. For example, the level of diversification both in terms of number of holdings (also known as portfolio concentration), their sources of revenue and the correlation between them, and hedging (often using derivatives).
6. Rebalancing – Although portfolio rebalancing itself is rather a step in the ongoing monitoring process, the frequency, method of rebalancing and transaction costs are also taken into account during the portfolio construction process.

The above process describes the traditional portfolio construction approach in active management, where the discretion of a portfolio manager is required. The below chart shows where portfolio construction fits within the overall investment process.

Source: EQ International

Portfolio Construction Tools

Portfolio construction tools are designed to help investors build stronger portfolios by identifying what is driving their risk and return and optimize their investment selection. There are various tools on the market, the majority of which are used by financial institutions and require subscription. For example, some of the popular providers are Bloomberg and their Terminal, Thomson Reuters (Refinitiv Eikon), BlackRock’s Aladdin and Morningstar Direct.

Below are some examples:

Stock screening via the Bloomberg Terminal

During the screening process, investors are exploring a particular area of the market and try to pick up the best companies that fit their criteria. Often the filters applied include (but are not limited to) company size expressed as market capitalisation, historic share price performance, valuation multiples and company earnings. Observation periods may differ, depending on the investment strategy, for example a “buy and hold” investor might look at longer-term data to determine the best price to buy a stock, while on the other hand shorter-term traders may seek to get in and out of a company on a number of occasions and therefore look mostly at recent data.

Source: Bloomberg

Asset allocation

During the asset allocation process, investors are observing various geographies and market segments in an attempt to determine those with the highest returns potential with a pre-set risk boundaries. The explored areas include overall health of the economy of a particular country or region, interest rates and currencies, the valuations of a specific market or sector as well as the current correlation between various asset classes. Below is an example of a correlation matrix, which investors may use to determine their optimal portfolio mix.

(Click to zoom)

Portfolio Construction Example

As part of their due diligence process, investors would usually use an official document called “Request for Proposal” (or RFP) to familiarise themselves with the team and the investment strategy of a fund. Along with the investment philosophy and buy and sell discipline, the RFP also outlines the strategy’s portfolio construction approach.

For example, the RFP for the Artisan Global Growth Opportunities Fund. Their portfolio construction process is described as below:

Portfolio Construction

All of our portfolios are constructed from the bottom-up and portfolio construction is driven by our approach to capital allocation. However, we employ a number of guidelines and constraints in order to manage the risks inherent in any investment portfolio constructed through fundamental stock selection.

Artisan Global Opportunities Fund

• Typical 30-50 holdings
• Maximum position size up to 10%
• Maximum of 35% in any country other than the US
• Typically less than 15% cash

On the back of this information, a few assumptions could be made:

1. Portfolio construction is driven by the bottom-up security selection (as opposed to the top-down approach in which macroeconomic factors and the market environment play more important role).
2. The portfolio is relatively concentrated since it typically invests in between 30 and 50 stocks. However, the concentration level in the top 10 or 20 holdings would also be important when assessing the potential risk and return profile of the fund.
3. With a maximum individual position size of 10% (which is typically the limit allowed by most regulators), the strategy could be able to take significant single stock bets, increasing the potential risk.
4. The fund must invest at least 35% of its assets outside the US, which is roughly in-line with its benchmark (the fund’s primary prospectus benchmark is the MSCI ACWI Index in which the US weights about 64% as of March 2024). Having a high allocation to a single market, in this case the US, would require further diversification at a sector and industry level.
5. The fund typically holds less than 15% in cash – high cash positions are typically maintained for liquidity purposes. If the portfolio is invested in more liquid, usually large and well-established companies, it can potentially handle large redemption requests even without having large cash position.

Conclusion

Portfolio construction is a key in the broader investment management process that requires careful consideration of investment objectives, risk tolerance, and market conditions. While in their core the more traditional methods for building portfolios would rely upon financial theories such as the MPT, the wider process involves expertise in asset allocation, investment selection and risk management. Professional investors are often aided by financial software, which helps them analyse portfolios and compare them against other peers or market indices. The whole process is aimed at delivering an optimal outcome within the pre-determined risk framework.

Additional Resources

Portfolio Performance