Sometimes I inadvertently slip into financial jargon that is meant to convey a very specific message but ends up being gobbledygook that is off-putting for a lot of people.
Recently, I used the term ‘portfolio construction’ in a meeting and the client, understandably said, ‘Dave, I know you mean how it’s built, but what exactly are you talking about?’
It’s true, the term portfolio construction sounds obvious but isn’t necessarily. The term can be used very broadly, but I came across an example today that I thought was interesting.
Let’s say that you want to invest in biotech stocks because they’ve been great performers in the past and represent the future of healthcare. Sounds good, but the trouble is that for every one that succeeds, a half-dozen fail because the only drug that the company is working on fails the final Phase III FDA trial.
Instead, you decided to buy an exchange-traded fund (ETF) that tracks biotech stocks so that you can diversify and hopefully get the big-time winner that will more than pay off all of the big-time losers.
Two of the larger ETF offerings look fairly similar: the both track US-based biotech indexes, have about 100 holdings apiece, and are relatively low-cost.
Which one should you buy?
If you’re like most people, you’ll probably look at past performance. Over the last five years, the longest period that both have been available, one is up ~30 percent per year and the other is up ~35 percent per year.
That’s a big difference – an investor that bought the latter fund, would have 27 percent more money at the end of five years than the person who bought the first fund. What is causing this large performance differential? You guessed it: portfolio construction.
The first fund, which I will call The Equal Fund, tracks an index that equally weights all of its holdings, so most holdings are about two percent of the fund. In a sense, that’s less risky because it’s more diversified; the top 10 holdings only represent 20 percent of the fund.
The second fund, The Size Fund, tracks a capitalization based index (gobbledygook alert!), which means that each holding is weighted by the value of the company. A company worth $2 billion gets twice as much exposure as a company with $1 billion.
This is riskier because it’s more concentrated – the top 10 holdings are almost 60 percent of the fund.
Surprisingly, though, over the past five years, The Equal Fund, despite being less concentrated, has been about 35 percent more volatile than The Size Fund.
And, again, portfolio construction is the culprit because The Equal Fund has much larger exposure to the tiny biotech companies than the Size Fund that allocates the most money to the largest, most well established firms.
The average company size in The Equal Fund is $2 billion compared to $18 billion in The Size Fund. In general, small cap stocks tend to be riskier than large cap stocks, but that’s even more true in the biotech area because of the lottery type structure of the industry that I described earlier.
In this example, portfolio construction referred only to the decision to equal-weight compared to cap-weight.
In reality, the term can refer to asset allocation (large versus small or US versus international), sector weights (corporate versus Treasury bonds), active versus passive, ‘top-down’ versus ‘bottom-up’ or even the metrics used to select value stocks (price-to-book versus price-to-earnings).
As you would expect, there are many factors that go into picking an ETF or mutual fund even though the financial media would have you believe that all index funds are the same.
In fact, not all index funds are created equally and it requires some knowledge and skill to make an informed decision.