Avoid Unintended Bets in Your Investment Portfolio

Investors understand the benefits of diversification across asset classes within their portfolios. There are many resources describing how to properly conduct an asset allocation exercise.

Yet once the allocations are put in place, how do you know you are getting the exposures you were looking for? And how do you avoid assuming unintended risks?

Robert P. Browne, CFA, CIO at Northern Trust, discussed how asset allocation decisions are made using quantitative methods, while the underlying (active) portfolios are often run by managers from the fundamental school of investing, at the 70th CFA Institute Annual Conference

Portfolio managers “think [investing] is about being deep and thorough about one name against the other,” Browne said. “I always have to remind them, once you own more than 30 securities, you are no longer an analyst. You are a portfolio manager.”

“With all the quant tools and pressure in the industry, you’d think it’s common knowledge, and yet I continuously see it violated,” Browne said. During his presentation, he elaborated on how he avoids unintended bets.

Portfolio Ramifications

Browne started off with a warning to portfolio managers who hide behind a common defense: “Be careful when you say that you are benchmark agnostic.”

“Be conscious what’s driving the risk in your portfolio,” he continued. “Don’t tell me you underweight Apple without realizing that you are underweighting the technology sector without buying other tech stocks, or that you are making a size bet, or a bet against trends in consumer electronics. Those are all the implied bets when you underweight the largest name in your universe.”

Geopolitical Dynamics

The election cycles in the United States and Europe and tensions around the world have prompted concerns about geopolitical risks among investors over the past year. How can investment professionals help clients focus on what’s relevant to their portfolios?

When it comes to predicting the effect that geopolitical shocks could have on the market, Browne said that “the starting point is important.” His analysis shows that in a bear market, geopolitical events do tend to make bad situations worse.

In a bullish market, however, a short-term sell-off is just that — short term. In such an environment, investors are focused on economic growth, earnings, and monetary policy, he said. The market sees through geopolitical risk quickly, and the bull market resumes.

Market Corrections

“It’s important to help clients get comfortable with the inherent volatility of the market,” Browne said.

“Five percent corrections happen all the time,” he explained. In fact, they happen every 50 trading days on average, he said. Similarly, it takes 167 trading days before a 10% correction and 635 days before a 20% correction.

Browne reminded the audience that at the time there hadn’t been a 5% correction for 192 days, a 10% correction for 286 days, or a 20% correction for 2,000 days. He stressed that he was not making a bearish call, however: “To be chronically bearish on the market is dangerous to your clients’ portfolio and your business.”

Ahead of the session, Browne went into more detail about the investment process that he and his team follows in a one-on-one interview conducted in the Virtual Link studio at the conference.

This article originally appeared on the 70th CFA Institute Annual Conference blog. Experience the conference online through the Virtual Link. It’s an insider’s perspective with archived videos of select sessions, exclusive speaker interviews, discussions of current topics, and updates on CFA Institute initiatives.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Photo courtesy of W. Scott Mitchell