Sanlam : How to Construct a Well-Diversified Portfolio

1) Determining one's risk profile and objectives

Defining one's risk profile comprises three components:

• Psychological willingness to take risk, sometimes called 'risk attitude'
• Financial ability to take risk or 'risk capacity'
• Need to take risk, including the need to accept risk to meet an objective and avoid falling short of a goal or having wealth eroded by inflation.

'Your personal risk profile shows how ready you are to potentially lose money in return for the prospect of rewards. Your profile depends on your attitude to risk and your reason for investing. It also depends on your financial situation and how long you have to invest' (Vanguard, 2014, p.4). Matching the risk profile to the risk characteristics of a portfolio is one of the most important steps in constructing an investment portfolio. Glacier divides the client risk spectrum into five bands, namely Conservative, Cautious, Moderate, Moderately Aggressive, and Aggressive.

2) Understanding the Association for Savings and Investment SA (ASISA) fund categories

The recent changes to the ASISA classification system benefit retail investors by making it easier to understand and compare funds. The latest classification system divides funds according to domicile and types of underlying assets, allowing for the selection of appropriate funds specific to investment needs and to compare funds across and within categories. For example, multi-asset categories (previously asset allocation) invest in a broad range of underlying assets (i.e. shares, bonds, money markets, foreign and property) with mostly an equity exposure bias in sector names ( multi-asset high-equity funds),with the intention of reflecting different levels of risk. The classification system alone helps to eliminate the essential tactical asset allocation decisions. Therefore if you understand your risk-profile, you can select from one of the multi-asset categories which cater to investment appetites from conservative through to aggressive.

3) Researching and selecting fund managers

It's well known that if a manager has performed well in the past, it's not necessarily an indication that he or she will perform better than others in the future. According to ABSA Wealth, success generally leads to greater assets under management which means that a portfolio has reduced liquidity and flexibility because it owns a greater proportion of an underlying security's float (Lee.T.Romhilt.D.2013). Therefore the size of the manager's funds is not an aspect to ignore. The next step is to take a comprehensive view by following Robert Ludwig's 3P's. 'Ludwig's Three P's' states that manager performance is an output and that initial manager evaluation should not focus on performance but on three critical input factors that result in performance output, namely:

• Philosophy - This addresses investment philosophy or style as well as attributes when making investment decisions.
• Process - This is the process followed by asset managers: is the process repeatable and does it lead to effective implementation of investment decisions?
• People - This is the investment team or people involved: are they qualified, and do they have experience? How are they incentivised? This is important as it will determine if your assets are managed in your best interest. These factors are about the quality of the company with which you invest.

4) Portfolio construction and blending of complementary funds

There are a number of approaches or methods to constructing a portfolio. These include the traditional building-block approach, the multi-asset split funding approach and a hybrid strategy.

The approach that I will discuss is called the multi-asset and split-funding approach. By following this approach you will invest into multi-asset class funds based on your risk profile and long-term strategic asset allocation - evenly allocating among the selected funds (managers). The key benefit of this approach is that tactical asset allocation is done by the underlying fund managers, while the portfolio remains within the strategic asset allocation limits. Thus if you selected more than one multi-asset fund in your portfolio, you will receive the benefit of multiple tactical house views and not a single manager's tactical view.

Blending funds managed by different investment house/managers, who subscribe to different investment philosophies and processes, significantly increases the level of diversification within the portfolio and ultimately improves risk management. (Jakoet.I.2013.p1).

The key is to identify complementary funds and one good way of doing this is by comparing the past performance of the funds. This, however, does not guarantee that the funds will perform in a similar manner in the future. Another way of identifying complementary funds is to use a useful measure called the correlation coefficient. The correlation coefficient is a statistical measure which measures how two things behave (or move) relative to each other. A correlation coefficient of +1 indicates that two funds move together perfectly and -1 indicates an opposite movement relative to one another.

Managers that prescribe to different investment styles tend to have lower correlation numbers or even negative correlation numbers. Lowly correlated funds will be better suited for blending purposes within a portfolio.

If the correct funds and managers have been selected for inclusion in a portfolio, then - over time - a well-blended portfolio should display lower levels of volatility than a single fund and would typically protect capital better over time, resulting in a smoother performance profile.

5) Understanding cost and the effect on returns

The fund fees are found on the individual fund fact sheets as total investment charge (TIC). The fund fees typically accrue in the price of the fund and therefore are reflected in the market value of the portfolio. As a result, fees can have an effect on portfolio returns and investment objectives. Thus ensure the cost is worth the return.

6) Monitoring and rebalancing the fund

Regular monitoring of changes made by the selected fund managers is required to ensure that the changes made don't affect investment objectives and fees charged.

It is important to ensure that as your life changes, your risk profile and investment objectives are still in line with your investment strategy.