It can take higher volatility on investment markets – triggered by such events as the sell-off on the Chinese share market and the Greek debt crisis – to drive home the rewards of having an "all-terrain" portfolio.
A robust, all-terrain portfolio could be defined as one that is designed to ride over short-term upheavals on investment markets to keep powering forward to achieving an investor’s long-term investment goals.
To continue and perhaps stretch this motoring analogy, such a portfolio is intended to travel over some rough roads and tracks from time to time on the journey to reaching its destination.
As is often discussed in Smart Investing, two of the biggest influences on a portfolio’s performance over the long haul are its long-term or target or strategic asset allocation and its level of costs. The combination of an appropriate strategic asset allocation and low costs are a critical combination for a robust portfolio.
For instance, a landmark research paper – Determinants of portfolio performance by Brinson, Hood and Beebower – confirmed in 1986 that a diversified portfolio’s strategic asset allocation is responsible for the vast majority of its return over time. (This research has subsequently been revisited and updated, including from an Australian investor’s perspective).
Adherence to an appropriate asset allocation spreads an investor’s risks and opportunities while maintaining a disciplined approach to investment, which is critical during bouts of higher volatility and uncertainty.
And it makes much sense for investors – whether investing in passively or actively-managed funds – not to handicap their returns with excessive costs. The advantage of taking a low-cost approach is truly highlighted when markets become highly volatile and/or returns are low.
The 2015 edition of a mainstay Vanguard research paper, The case for index-fund investing, makes the point that "cost is one of the largest factors driving tracking error or deviations" from a fund’s benchmark index. In other words, costs really matter.
Higher investment costs tend to particularly standout when investors are trying to make their way forward in a low-interest environment.
More investors are turning to Exchange Traded Funds (ETFs) and what is known as a core-satellite approach to create their all-terrain portfolios.
Under a typical core-satellite strategy, investors hold the core of their portfolios in ETFs or traditional index funds tracking broad market indices with much smaller "satellites" of directly-held securities and actively-managed funds.
This is potentially a suitable all-terrain portfolio for a range of reasons including:
- The use of ETFs tracking broad market indices provides a way for investors to readily create portfolios that reflect their long-term strategic asset allocation for their portfolios.
- Investors can easily rebalance their core ETF portfolios following movements in the markets to ensure their portfolios don’t drift away from their long-term strategic asset allocations.
- Costs are kept to a minimum. By holding the core or bulk of their portfolios in low-cost ETFs or traditional index funds, investors are lowering the average cost of their portfolios even if they decide to hold a minority of their investment assets in higher-cost actively-managed funds.
When aiming to create an all-terrain portfolio, keep in mind that it is not a matter of active management versus passive management – the long-running active vs passive debate. There is room for both types of investment management in a portfolio.
While the costs of active management make it difficult for the majority of active managers to outperform their benchmarks, many investors understandably have sound reasons to include some favoured actively-managed funds in their portfolios. A core-satellite strategy provides a way to accommodate both.
Is your investment portfolio robust enough to readily cope with the next inevitable bump in the road to meeting your long-term goals?
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Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia. As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment. |
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