The original version of this article first appeared in The Business Times.
CHILDREN (and adults) around the world have found delight in the art of Lego construction — using these iconic bricks to build anything from Star Wars Starships to whole intricate cities. Play is serious business for the Danish toymaker, which was started in 1932 with a mission to leg godt, that is, to "play well".
Each Lego piece is popped out from moulds made accurate to the margin of 0.005 millimetres — 10 times thinner than a strand of human hair. Each piece fits snugly, and a 2-by-2-inch brick can support the weight of 375,000 bricks atop it. That precision and attention to detail create a good foundation for whatever model is being built.
So literally, the building blocks matter. And if that matters for a toy company, the same question must surely be asked about how your investments are being built to fit, and last.
That’s one relatable way we can think about portfolio construction — the way digital platforms and robo-advisors fit the right pieces together to create a portfolio that endures through time, and is suitable for the investor.
How to build a diversified portfolio
Nobel prize-winning economist Harry Markowitz called diversification "the only free lunch in finance". By building an investment portfolio with assets that are not perfectly correlated, you lower portfolio risk without sacrificing expected returns.
If you have a higher risk tolerance and a longer investment horizon, a bigger share of your investment would be allocated into equity funds. Equities carry higher risk, greater short-term volatility, and higher long-term expected return than fixed income. If you have a lower risk tolerance, your portfolio would mostly skew towards global fixed income funds.
This is how portfolio diversification, as anchored by years of scientific research, should be executed. Morningstar recently published numbers showing that the classic 60/40 portfolio for moderate-risk investors still delivers on its risk-adjusted returns.
Many people talk about asset allocation, but then start putting additional layers, such as geography, sector, industry, or style. Here is exactly where this wild confetti of variety is wrongly conflated with trying to achieve portfolio diversification. There is only so much risk that can be diversified away to an optimal level — at some point, you are actually making active allocations that increase risk instead of reducing it.
A global stock index is weighted to represent the gains of the biggest and best global companies around the world, allowing investors to ride market gains over time. So instead of speculating on the next big stock, buying a portfolio that passively tracks the benchmark will mean that you are always exposed to the earnings potential of these champions.
A well-diversified portfolio will always have a few investments that are faltering, such as a tiny percentage of exposure in Russian companies, or Chinese stocks facing policy risk. But by using highly diversified funds, the size of these positions are relatively small in a portfolio comprising more than 10,000 stocks and bonds. There is not one name or one position that will blow up the portfolio.
A portfolio model built on a sturdy foundation stands firm. It doesn’t sway on whims. This gives investors greater peace of mind to stick to their long-term investment plans and increases the probability of success. At Endowus, we call this a core portfolio built on Strategic and Passive Asset Allocation (SPAA).
The China tech bust
The passive-portfolio approach is completely different from tactically allocating money to various countries and sectors. That is an active approach to investing.
Imagine having a fund that tracks the Chinese technology sector making up nearly a quarter of your portfolio, even though China as a country, or even all of Asia, does not make up a quarter of a global market index. That’s an example of an active tactical allocation to a very narrow segment of the global markets that you should not be exposed to in this outsized manner. Many who held on to that position didn’t do well last year, and this year too.
If a robo-advisor or financial advisor allocates a meaningful position like that in a portfolio comprising funds tracking various sub-sectors in a single market — instead of the whole global market — your returns will be more volatile. They are, in effect, running the portfolio like active traders. Such active investing normally does not bring good outcomes over time.
This also means you are at the mercy of a robo-advisor that can unilaterally make big bets on a sector. Investors bear the risk of such a robo-advisor making a wrong call, chasing certain markets or sectors on the way up, or selling at the lows and missing the rebound that follows.
Investors can certainly use a core-satellite strategy with satellite positions that give additional exposure to a specific market, theme, or sector, or buy single funds to express a tactical call. But it starts with a well-diversified core portfolio designed to track the broad market over the long term.
Time in the markets, not timing the market, is what matters. A person who invests at the peak of the market in every decade from 1970 to our present day would still have had an annualised return of almost 9%, just by passively following the market.
The basis of the performance for a robo-advisor is the process through which it designs its advised portfolio. It is what funds you buy and how you do asset allocation that drives the bulk of long-term returns.
Brickbats and ETFs
There is a misconception that all exchange-traded funds (ETFs) are passively tracking the markets. There are now more ETFs globally than the number of stocks — so it cannot be true.
Returning to the Lego analogy, think of ETFs as bricks in all random shapes and sizes. They are not uniformly built, or from the same precise mould; many of them are, in fact, tracking different sub-sectors of a single country’s market. Numerous ones are not even indexed and traded actively, such as the ARK ETFs.
A portfolio modelled on these ETFs in different shapes and sizes is effectively built on a narrow, uneven base. That’s very different from a portfolio built with funds that are passively tracking market indices on a broad, diversified basis — be it through the appropriate listed ETFs, or unlisted unit trusts.
A financial advisor who is diligently working for the best interest of the clients should anchor his or her investment philosophy on evidence-based, scientific research that shows that there is no need to try to beat the entire market. The core portfolio asset allocation should be passive in implementation, with no tactical or active changes to your allocations.
In 2021, the variation of returns by the 3 most popular robo-advisors in Singapore exceeded 20 per cent when their equities-only portfolios were compared. While all robo-advisors are easily bucketed together, there must be fundamentally different investment philosophies that separate them for such performance outcomes.
With the recent market volatility, investors need to look closer at the building blocks of their core portfolios, be it from digital wealth managers or traditional wealth advisors.
The bar should be set higher for all financial advisors. How client portfolios are built makes all the difference, especially during market downturns. Is your investment portfolio built well, like good Lego pieces fit snugly and precisely in place? Or it loosely put together with fake Lego pieces and false promises — if so, that just might buckle and fall apart under pressure.
Investment involves risk. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested. Past performance is not an indicator nor a guarantee of future performance. Rates of exchange may cause the value of investments to go up or down. Individual stock performance does not represent the return of a fund.
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