The Art of Portfolio Construction - Weekly Blog # 615

Mike Lipper’s Monday Morning Musings

The Art of Portfolio Construction 

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

This week had attention getting headlines that might be important to prudent investors.

1. The Barron’s Confidence Index dropped by an unusually large 2 points as high quality bond yields rose less than intermediate credit yields.
2. The 30-year yield to 3-month yield spread narrowed. 
3. The Baltic Dry Cargo Index was down 30% from a year ago (negative for world trade). 
4. SoftBank failed to raise the capital anticipated.

Despite all the news that has made headlines this week, we professional managers and serious investors must continue to manage the portfolios entrusted to us. Many professional journals are full of articles about Artificial Intelligence (AI), suggesting the management of investment portfolios can be done entirely “by the numbers”. Contrary to that view, I believe that portfolio management is an artform, similar to life in general.

That is not to say that math and related science has no place in portfolio management. The great artists of the world, either consciously or not, use mathematical principles in producing their art. It is the same with portfolio managers. Just as a painter looking at a blank canvas needs to contemplate the organization of the space, selecting the right colors to convey his/her point of view, so too do portfolio managers, particularly the successful ones.

One of the first choices the portfolio manager must make is whether to utilize many choices or just a few. Some portfolio “artists” will fill the space with many details, while others only use a few, concentrating on a limited number of opportunities. As someone studying investment portfolios for most of my life, I have come to some working observations.

1. The need to quickly convert some of the portfolio assets into cash in order to meet responsibilities focuses attention on liquidity. In markets of limited liquidity and occasional sharp price moves, owning a large number of securities often suggests the portfolio has a good amount of liquidity. This is not always true, but many portfolios do not need a great deal of liquidity.
2. The next consideration for portfolio strategists is career risk, as portfolio managers are rarely employed under long-term contracts. This is particularly true in the mutual fund industry, my preferred research laboratory. Termination is often triggered in one of two performance directions, up or down, depending on which is the greater fear. By definition, there are a limited number of individual securities that will be up significantly in any given period. If that is your goal, the best portfolio structure is to own only the big winners. On the other hand, career risks could be triggered by falling more than peers or the market and/or exhibiting an unnerving level of volatility. In that case, portfolios might include a large number of individual issues in order to generate returns similar to peers or market indices.

As a manager of portfolios of mutual funds, we utilize both extremes in some combination to meet the expressed or perceived needs of the account. Where possible, we want to use concentrated portfolios to give us better than average performance, accepting some additional downside risk. We offset these concentrated funds with a selection of portfolios that have numerous securities. They often look similar to market indices or are actual index funds.

I have great empathy for the managers of concentrated portfolios, as I for many years have managed a private concentrated portfolio investing in global financial services stocks and funds. I am not soliciting new members, nor am I recommending the purchase of any of the financial securities I will mention shortly. I am using a brief discussion of my experience to highlight some of the attributes of one particular concentrated portfolio, which might apply to other concentrated portfolios. The following are elements that may be found in concentrated portfolios:

1. During a recent period of positive performance for the portfolio and negative results for the benchmark/peers, only 7 of the 19 positions rose. The portfolio outperformed in part due to the two largest positions being the two best performing stocks and totaling 25% of the portfolio. The use of weighting is an important tool.
2. More important than what we own, might be what we don’t own, life insurance and large commercial banks.
3. Financial services can be used effectively beyond brokerage commissions and deposits to address other needs or fears. For example:  
1. Using ADP and Berkshire Hathaway to participate in GDP growth
2. Using Franklin Resources and Invesco to hedge the value of the US dollar.
3. Using NASDAQ for a general level of speculation.
4. Using Allegheny Corp. and Berkshire to participate in rising casualty insurance premiums.
5. Using the London Stock Exchange through Thomson Reuters to participate in the evolution of global stock exchanges.
6. Some of these options could also be considered hedges in a financial services portfolio.

Conclusion: Concentrated portfolios can work both offensively or defensively when appropriately structured, but need to have better security selection than portfolios with a larger number of issues.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/02/significant-turnaround-two-fearful.html

https://mikelipper.blogspot.com/2020/01/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/01/is-it-always-brains-over-flexible.html



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