It’s a team game

There are decades of academic theory devoted to the science of portfolio construction, Fama and French, Harry Markowitz, CAPM, efficient frontiers and more! You’ll be relieved to know that I will fall asleep writing about it before putting you to sleep reading it. And you know what; a wholly scientific approach just never works. The collapse of the hedge fund LTCM in 1998, adroitly captured by the title of the book ‘When Genius Failed’, showed that the biggest boffins in the world can’t get it right because economic and market forecasting is just too imprecise a science. You need some science, but some art as well, some luck of course and above all a bucketful of common sense.

Putting together a successful long term investment portfolio is all about seeing the wood not just the trees. Everybody likes to pick ‘winning funds’ and make ‘clever’ tactical bets but every fund in your portfolio needs to be there for a purpose. A portfolio should not be a collection of ‘rifle shots’, each fund having individual merit but as a collective woefully unbalanced. A portfolio will hopefully contain not only outstanding funds, but funds that complement each other and blend together; each one a building brick in a cohesive and robust wall which will meet its investment objective for many years.

As I tell the U15 football players I coach (the ones that are prepared to listen to me anyway), a football team isn’t just 11 players. It’s a mixture of defenders, midfielders and attackers and within these sub-sections there is a blend as well. A good midfield will have some attack minded players and a ‘Declan Rice’ to provide defensive ballast. Likewise, a good portfolio relies on both the asset allocation (primarily) and fund selection to not only drive returns, but to manage risks too.

Stretching my analogy to breaking point, Gareth Southgate has made England contenders by adjusting the formation. A 4-2-3-1 allows more at attacking midfield options than a 4-3-3 and we’re well past the date of tired 4-4-2 of years gone by. If Southgate can get the right players (fund selection) and then deploy them in the right formation (asset allocation), thereby improving both his downside protection (less goals conceded) and his upside capture (more goals scored). The rest, with a little bit of luck along the way, will be history.

For each risk/reward profile, we have what we consider a neutral asset allocation based on long term returns and volatility for each asset class, in a steady state environment of average valuations and average economic growth. A Cautious Portfolio would have a very large fixed income component, whilst an Aggressive Portfolio would be predominantly equities. A Balanced Portfolio would traditionally be a 60/40 equity/bond split and so on.

We then populate each asset allocation with funds from our Buy List panel appropriate to the risk/reward of the profile. The Cautious Model will have more defensively minded equity funds so a strong bias to equity income whereas for the Aggressive Model, we will look for managers prepared to take on much more risk with the funds likely to have a high ‘beta’ (volatility compared to the index).

Valuation matters, because there is a strong body of historical evidence which tells you how cheap or expensive the market is and what future returns are likely to be when markets trade at various levels of valuation. Buying when markets are cheap and selling when they are very expensive isn’t rocket science and has a pretty good track record.

But, valuation itself is a slippery concept. Jude Bellingham moving to Real Madrid for £88m looks an absolute steal, even with add-on’s. Meanwhile, any of the mega-buck’s players Chelsea have bought in the last few years, less so.

Sometimes valuation and macroeconomics can conspire to force you off the asset allocation fence you are trying to sit on. The secret to good portfolio construction is accepting that you will never be right all the time and position yourself accordingly. We operate on a 7/10 basis (or as we like to call it the Trent Alexander-Arnold* rule) and assume we will get 3 out of every 10 decisions wrong and the three bad boys aren’t recalcitrant enough to terminally damage the portfolio overall.

While we make occasional mistakes in selecting funds (sorry), concentrating on managers with long term track records and repeatable processes normally ensures an acceptable ‘hit rate’. The tricky bit is balancing the funds together as a portfolio. No fund is top quartile and index-beating year after year because market drivers and trends are constantly changing. The best managers typically have a particular style bias which reflects their skill set and beliefs (e.g., growth, value, market cap) and we look at funds that over the long-term can outperform the peer group and relevant index over the long-term. Alternatively, they add a certain characteristic that has its own intrinsic value alongside obvious measurements such as performance, a less-volatile set of investment returns, for instance. We pick each fund to do a particular job, and the skill in portfolio construction is to make the long term ‘journey’ as smooth as possible, combining decent returns with controlled volatility and downside mitigation.

Markets move in long-cycles, so recognising the qualities of your funds and judging them against a sensible comparable peer-group, rather than the index that has performed strongest, is not only fair, but helps veer you towards too many funds of the same type.

*Editors note:

This article was written just after the second Euro 2024 game, so if you are reading this and Trent has just scored a hat-trick and put England into the Quarter-Finals, then I knew he’d come good, I was only jesting.

If you’re reading this and Trent has just scored a hat-trick and put England into the Semi-Final’s, then it was obviously the easiest and best decision Gareth could have made and who-knows why Klopp held him back all those years.

If you’re reading this and Sir Trent Alexander-Arnold has just scored a hat-trick in the Final, then I always knew Bellingham was over-rated and I demand Man Utd buy Trent for a great value £200m straight away.

(P.S There’s an investment lesson here too. Not getting carried away with your own conviction, not extrapolating trends and not falling in love with the latest hot-investment out there will serve you well too).

Enjoy the football.

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