Common Portfolio Pitfalls

Investors have a unique mix of needs that drives how they construct their investment portfolio. However, we think there is a ‘perfect portfolio’ with attributes common to every investor. At 5i Research, we believe such a portfolio is effective, inexpensive, low maintenance and will accomplish your financial goals.

5i Research recently launched a portfolio review service for the do-it-yourself investor. Over the remainder of this article, we provide details on common observations or trends we see when performing reviews and comments on potential solutions to any issues being addressed.

A Total Portfolio Perspective

When submitting portfolio review information, we see some clients treating each account as its own unique portfolio, independent of other accounts, with a stated objective and full allocation across asset class, geography and sectors. In our opinion, this is a mistake and it is better to take a total portfolio perspective, monitoring the combined allocation of these accounts against overall investor objectives and risk tolerance.

Looking at your portfolio on an account-by-account basis can easily lead to gaps in analysis and it is far easier for an investor to materially over/underweight a sector when failing to evaluate total exposures. As well, rebalancing can become a nightmare and very costly if you manage each account to particular objectives or asset mix.

Viewing each account separately can also lead to performance chasing within the accounts. As an example, in a diversified portfolio, one account portfolio may be performing well while another underperforms. The investor may then try to mirror the successful account, doubling up exposures. When the outperforming portfolio sees a downturn, more of the total portfolio is now exposed to this set of risks.

Investors should understand their total portfolio allocation across various exposures, including but not limited to asset class, geography, sector and capitalization. In particular, we look to see that the total portfolio asset mix is consistent with risk tolerances, and that the equity sector exposures are diversified and properly tilted to achieve both equity portfolio needs while accounting for developing market trends.

Portfolio Concentrations

By far the biggest repeat offender we see in our portfolio reviews is concentration risk, whether it is in a handful of sectors or within a security itself. From a sector perspective, we like to see sectors represented at a maximum 15.0% equity portfolio weight, with 20.0% being an absolute maximum for the tactical investor who wishes to overweight a sector based on an outperformance thesis.

We have calculated that in 81.0% of our reviews, customers have held the financial sector beyond our 20.0% maximum threshold. Of these clients, the average weight to the sector was just shy of 27.0%. In our opinion, considering there are 10 equity sectors (11 if you break out REITs), having more than one quarter of the equity portfolio invested in one sector is not a risk worth taking.

This should not come as a surprise to the Canadian investor, who tends to hold a home country bias to an economy largely dependent on the financial, energy and materials sectors. However, there are tools at the investor’s disposal that can eliminate these types of risk.

To help overcome concentration risks, the number one tool we suggest is ETFs. ETFs are excellent risk management products, which can help ensure the portfolio remains diversified. We look for ETFs that provide an offset against the current concentration risk while being consistent with investor objectives.

The Closet Indexed Portfolio

This type of portfolio sees the investor holding a higher number of individual securities and/or funds. While the portfolio is well diversified, performance results will mirror broad market returns, as no one position is held at a meaningful enough weight that it can be an alpha contributor. Achieving average market returns is in and of itself not an issue; however, doing so via the use of a large number of securities leads to unnecessary complexities, making the portfolio cumbersome to track and manage.

The use of a large number of stocks simply creates index-like performance. If index performance were a desired goal, we would prefer to hold a simple portfolio of five to six index ETFs versus the complexities that can arise when holding a higher position count. For example, tax filing can be a nightmare.

The average number of equity holdings observed across our review clients is 59 positions. In our opinion, one really only needs to hold 25–35 equity positions to be fully diversified. This is increasingly true if the investor shows a propensity towards using ETFs or mutual funds.

It is often difficult for the investor to realize they are achieving the benefits of diversification holding a portfolio of 25–35 securities versus 60+. In the event indexing is being achieved predominantly via funds, investors should understand which funds are adding value and worth keeping versus those that simply duplicate exposure or do not justify the fees being charged. The investor should also look to see which stocks could be a good source of alpha or provide diversification benefits beyond what can be achieved using funds.

Do I Have Enough to Retire?

One of the most frequent questions we get asked in performing a review is “Will my portfolio generate enough cash flow to meet a retirement spending need of ‘$X’ per year?”

In estimating how much cash-flow the portfolio could produce, focus particular attention on passive cash flows i.e. bond interest and equity dividends. Ideally, a retired investor should fund as much as possible of a spending need from passive cash flows and pensions, minimizing the degree to which a resulting shortfall will need to be funded by equity gains or principal withdrawals. Towards this end, we discuss throughout our reviews the optimal asset mix and equity portfolio sector mix that optimizes passive cash flow potential while still meeting other investor objectives.

Michael Southern, CFA, is an Analyst with 5i Research in Kitchener, Ontario.