This is the fourth in a series of articles on Unpacking the Investment Process, which provide clarity about various aspects of the investment process of a professional investor. We now commence our investigation of the Construction Phase of an Investment Process.

Our earlier article introduced our ACE approach to articulating an Investment Process. ACE has three phases, Assessment | Construction | Execution.

Construction Phase

We now look briefly at different aspects of the Construction Phase.

Question

The Construction Phase asks the question How Many?

• How many shares will I buy?

Purpose

As well as the answering the How Many? question, the purpose of the Construction Phase is to convert an Investment View into an Order List.

Unsurprisingly, the way to do this is known as Portfolio Construction, and we note that there are many, many different methodologies that can be used.

Before we look at these differences, let’s identify some things that are the same for all Investment Managers.

[definition] An Order List is derived from the difference between the Target Portfolio and the Legacy Portfolio.

[definition] The Target Portfolio is the portfolio of Assets you want to own.

[definition] The Legacy Portfolio is the portfolio of Assets you currently own.

Portfolio Construction Inputs

To arrive at the Order List, we need to determine the Target Portfolio, which is the output of Portfolio Construction.

We know each Investment Manager has a unique Portfolio Construction methodology. However, they all have inputs into their Portfolio Construction, including any or all of the following.

1) Investment Scope

The Investment Scope of a portfolio reflects it’s Investment Universe and related Benchmark and Benchmark Weightings.

The Investment Universe specifies the broad range of Assets that may be eligible for inclusion in the portfolio.

Each portfolio has a Benchmark, whether it be explicit or implicit. Ideally, the Benchmark is selected to best match the Investment Universe.

Benchmark Weightings are the weights of each Asset in the benchmark, for example:

• an Equities portfolio requires the weighting of each constituent in a Benchmark Index
• a Tactical Asset Allocation portfolio requires the strategic weightings of each Asset Class

2) Current Portfolio Holdings

A list of all Assets currently held, including Cash.

3) Funds Flow

The net of all cash inflows and outflows in and out of the portfolio since the last portfolio re-balance.

4) Return Expectations

As described in our previous article on the Assessment Phase, different Investment Managers express their Investment View in different ways. Popular ways of expressing Return Expectations for each Asset include:

• Investment Return, often a forecast over a specified horizon, such as +15% over 12 months, or -20% over 3 months
• Investment Rating, such as 1-to-5, or 5-to-1 or A, B, C or Strong Buy, Buy, Hold, Sell, Strong Sell, Avoid

5) Risk Expectations

Popular ways of expressing Risk Expectations for each Asset include:

• Variability Metrics, such as volatility, correlation, covariance and beta

6) Factor Exposures

Any portfolio that uses Style Factors will need a Factor Exposure for each security in its Investment Universe.

• The most common Style Factors are Size, Value and Momentum
• Other Style Factors include Quality, Growth, Volatility, Liquidity and Leverage

7) Investment Classification

Each security is classified according to the way an Investment Manager views their Investment Universe. In most cases a default third-party classification is deemed sufficient, with exceptions being overridden by the preferred in-house classification.

• Popular classifications include asset class, region, country, currency, sector, industry and size

8) Investment Objectives

Investment objectives vary by portfolio type, for example:

• a Balanced Portfolio, with objectives such as Inflation + 2% annual return over a rolling 3-year horizon
• an Active Portfolio, with objectives such as 3%pa active return, 4%pa tracking error and 0.75 information ratio
• a Market Neutral Portfolio, with objectives such as 6% total return with 6% volatility

9) Investment Restrictions

There are many different hard restrictions than can be placed on a portfolio, for example:

• Regulatory Restrictions, such as limits around ownership or disclosure requirements
• Concentration Restrictions, such as no Investment has more than a 10% weighting, the 10 largest holdings can be no more than a 40% weighting
• Shorting Restrictions, such as no shorting, or short positions to 30% of assets
• Ethical Restrictions, such as not investing in tobacco or weapons companies
• Instrument Restrictions, such as not using options or other derivatives

10) Investment Guidelines

Unlike Investment Restrictions, Investment Guidelines are not mandatory. Guidelines help the portfolio to be managed in a consistent way. They are often presented as ranges and are generally set in-house or in conjunction with a client. Some examples follow.

• Investment Ranges, such as International Equities weighting between 5% and 25% in a Balanced Portfolio, Active Weightings between +5% and -2.5%, and Sector Weightings between -10% and +10% in a Large-Cap Equities Portfolio
• Portfolio Turnover, such as annual Portfolio Turnover of 70-80%
• Security Count, such as holding 30-40 stocks in a concentrated equities portfolio
• Portfolio Factor Exposure, such as Momentum from +0.25 to +0.50, other factors -0.15 to +0.15

11) Liquidity Metrics

Based on forecasts or estimates for Daily Volume.

12) Transaction Costs

Transaction Costs are incurred when buying or selling Assets, and include:

• monetary costs, such as commission, taxes and custody fees
• pricing costs, such as bid-ask spread and market impact

Portfolio Construction

As you can see there are many possible inputs into Portfolio Construction.

Despite this, most ways of constructing a portfolio can be grouped by the level of focus on risk and return. In our next article we will look at different approaches to Portfolio Construction.

a) Focus on Risk, not Return

b) Focus on Return, not Risk

c) Focus on both Risk and Return

d) Focus on neither Risk nor Return

e) Combining different approaches

People

The Construction Phase in many Investment Management Firms often only involves a Portfolio Manager. Other firms also include a Quantitative Analyst, and some a Risk Manager.

Appendix: Definitions

We recently proposed that Definitions are the Tools of Clarity. The definition of any term that is Capitalised can be found in our Glossary.