Why you should consider the expensive loser

Most investors consider only two criteria when selecting investments portfolios: historical returns and investment management fees. That makes sense. But what if you were told that it could also make sense to consider the slightly more expensive portfolio that has underperformed? Would you believe that?

Although it is a good start to look at the historical returns and investment management fees when selecting portfolios, it is somewhat concerning that little attention is given to the make-up of the portfolios and that the intellectual property embedded in the portfolio construction is overlooked.

Well-constructed portfolios can easily underperform sub-optimally constructed portfolios. This often happens like in recent times when local and global equities were the top performers while “other” asset classes, which provide valuable diversification benefits, underperformed.

When returns are presented, the Financial Advisory and Intermediary Services Act requires a specific disclosure stating that past investment returns are not an indication of what could be expected in future. Although this is almost a given, little attention is paid to the portfolio's construction and how it is likely to behave in different market cycles.

Without advocating a short-term focus, it is important to consider how much of the capital invested in a particular portfolio is at risk, how this portfolio is likely to behave in a declining market environment and what the possible drawdowns are.

Should we not spend a bit more time talking about the targeted outcome, given the time frame and the “risk budget”? The risk budget is different for risk profiled portfolios that are not alike. It is an indication of the risk appetite and how capital can most effectively be deployed to achieve the required outcome.

Consider the following aspects as part of the portfolio review process:

• The probability of not achieving the real return objective over the specified period;
• The expected drawdown measured against the objective over the period (i.e. the extent to which the portfolio could underperform), and
• The probability of a capital loss over any given period and the extent thereof.

Unlike fees and relative returns, portfolio construction is not usually top of the discussion list. Asset class exposures, why certain asset classes have been included or excluded and why the asset allocation has been set at certain levels, just don't draw much interest. It is important to understand the portfolio's objective over specific periods and how old generation asset classes (such as equities, bonds, cash, etc.) and new generation asset classes (such as private equity, hedge funds, etc.) are used in an attempt to achieve the set objectives.

Portfolios investing in such a wide range of asset classes could end up being more expensive than portfolios only investing in traditional asset classes. Although there is no guarantee that more diversified portfolios, which are often more expensive, will outperform in all market cycles, they are more likely to achieve their set objectives in different market cycles.

Another ignored topic is style exposure. Although style exposures (i.e. value, growth, etc.) within the different asset classes are not as important as the asset allocation itself, it supports consistent returns over time and using a combination of styles and strategies could be slightly more expensive.

Manager selection, for multi-manager portfolios, is another way of diversification. Selecting larger, well known investment managers with superb long term track records is often more expensive than the new “up and coming” investment managers. Negotiating competitive fees with well-known managers is often a difficult task.

The emphasis on costs is one of the main reasons why many service providers offer passive solutions. Although there is a place for all types of solutions, investors should be comfortable with the portfolio construction methodology and how the portfolios are likely to behave in different market conditions. Many investors consider themselves to have the stomach for market volatility and negative returns, but have been proven wrong. Investors tend to disinvest from the market instead of sticking to their long-term investment strategy during uncertain times.

So yes, it can make sense to consider the more expensive portfolio that has underperformed the cheaper solution in a specific market cycle, as long as it is for the right reasons. Although some members have to target relatively high real returns to achieve their retirement objectives, only calculated investment risks should be taken through well diversified portfolios.