Carrigan: The ABCs of building a good portfolio

A few weeks ago we built a benchmark for an investor who was 50 years old, in good health and whose circumstances allowed the choice of an aggressive investment strategy. Now we need to build the portfolio.

Just to review: The benchmark is the level of investment performance against which to measure your portfolio’s performance over time. The theory here is that if you consistently underperform your chosen benchmark, you may as well buy that benchmark. The benchmark must be appropriate for your personal circumstances, and there must be a way to buy it.

The benchmark we built was 80 per cent equities and 20 per cent bonds of short duration. For the equity portion, we went with 75 per cent Canadian stocks and 25 per cent split between U.S. and emerging markets. There were five positions in total, all exchange-traded funds, or ETFs.

Let us assume we are either going to be our own portfolio manager or we will partner with an investment adviser who is licensed to trade in equities and ETFs. That means we won’t buy mutual funds and we won’t deal with front-line bank staff and financial planners who are not licensed to deal in equities.

Before we begin, let us do some “top down” work on the investment landscape. The initial step would be to slice the global pie into three pieces — commodities, developed and emerging investments.

The commodity portion would be our own S&P/TSX Composite Index and/or the Australian All-Ordinaries Index. The developed slice would be any of the mature economies such as the United States, Britain, Germany, France or Japan. The emerging or growth slice would be the economies of Latin America, Eastern Europe, Southeast Asia, Russia, India, and China.

We can use ETFs to buy that global pie with only five investment products.

For commodity exposure we buy our own iShares S&P/TSX 60 Index Fund, which trades under the symbol XIU on the Toronto Stock Exchange. The XIU gives us direct ownership of 60 Canadian large-capitalization companies, more than half of them being commodity sensitive.

For mature economy exposure we buy the SPDR S&P 500 ETF Fund, which trades as SPY on the New York Stock Exchange. The SPY gives us direct ownership of 500 U.S. large-cap companies. We could also buy the iShares S&P Europe 350 Index Fund (symbol IEV on the NYSE) for direct ownership of 350 large-cap European companies. We can’t ignore the world’s third largest economy, so we buy the iShares MSCI Japan Index Fund (EWJ on NYSE), which gives us direct ownership of Japan’s largest companies.

For the emerging markets we buy the iShares MSCI Emerging Markets (EEM on NYSE), which gives us direct exposure to the emerging economies of China, Brazil, South Korea, Taiwan, Russia, South Africa, India, Mexico, Malaysia and Indonesia.

We are now broadly diversified through ownership of only five investment products. We own all the largest North American, European and Japanese companies and we own a piece of all the smaller emerging economies.

Keep in mind that as our own portfolio manager it is our job to outperform our personal benchmark. This is now unlikely because we are overdiversified and have become the market, so to speak. As Warren Buffett once said, “Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.”

To boost the performance of our overdiversified portfolio, we need to gain direct exposure to the sectors that are currently the prime drivers of the global equity landscape. Use some restraint, because when you introduce sectors into the portfolio to boost performance, you must accept the higher volatility that accompanies sector investing.

A good way to introduce sector investing into the portfolio is to start at home with our own S&P/TSX 60 Index, the XIU. A visit to the iShares.ca website allows us to break out the XIU into sectors, with the top three by market cap being financial (31 per cent of the index), energy (27 per cent) and materials (21 per cent). Note that the two commodity-sensitive sectors (energy and materials) make up almost half of the total index by market cap.

Our chart this week shows the iShares S&P/TSX Materials Index Fund (symbol XMA on the TSX) plotted above the iShares S&P/TSX Financials Index Fund (XFN). Note their respective price peaks early last year and the recent price activity. Clearly the materials sector is leading the financial sector, but the lagging financials are just beginning a move. An active portfolio manager may decide to boost the portfolio returns by cutting the materials exposure and placing the proceeds into the financial sector.

Bill Carrigan, CIM is an independent stock-market analyst. He can be reached at: info@gettingtechnical.com.