Even if we are happy with how our portfolio has performed as a whole, we should still take the time to look at the component parts to see if we are happy with their contribution to the whole.
As you can imagine, there are as many differently made-up portfolios as there are people listening to this, so it’s hard to cover everything here, but most of us will be invested in funds of some kind. If you have listened to my show or read my blogs for any length of time, you know that I counsel against investing in individual shares and instead in passive, multi-asset portfolio funds.
I also talk about a core and satellite approach to investing. This simply means that the core of any portfolio should be simple, low-cost and widely diversified. Some investors like to have satellite holdings around the core which allow them to try things out or follow a tip they may have been given or to pursue an interest.
I am all for experimentation and having some fun, but I don't think we should bet our future on these kinds of holdings. Keep them as satellites, that is, less than 10 or 15% of your overall invested money.
What to do Instead
Thinking about your constituent funds, you should be comparing them with their peers. The investment sectors are useful for this – I usually start with the Investments Association. The universe of available funds is divided into groupings or sectors of funds which are invested similarly.
Some of these sectors are really obviously named, for example, the UK All Companies sector does exactly what it says on the tin, as does the Japan sector. The mixed investment sectors are a little bit looser in their groupings.
For example, the mixed investment 40 to 85% equity sector includes funds with anything between 40% and 85% of their underlying investments held in equities. That's a big range, so while it is easy to compare a Japan fund with its sector average, it is less meaningful to do so in the mixed investment sectors. That said, it's probably still the easiest way to make sure your funds are at least keeping pace with their peers.
Another problem when reviewing the performance of an individual fund is that simple performance figures cover a multitude of sins. For example, let's say two funds, Fund A and Fund B, both deliver a 10% return in one year.
Fund A achieved this return by taking some big bets, which happened to pay off, but it was a very rocky ride on the way to achieving the 10% return. Fund B, by contrast, achieved its 10% return in a much smoother fashion, with just a few minor ups and downs along the way. Which is the better fund?
The answer is Fund B, because it achieved its return by taking less risk. But how can you determine this, as a layperson with better things to do than drill down into the underlying holdings of each fund?
The Sharpe Ratio
The answer is a very useful little figure called the Sharpe Ratio. There is no real need for me to go into the detail of how this is calculated or even who Mr Sharpe was – Google it if you care. Simply put, it is a measure of relative performance given a standard measure of risk.
If you have ten different funds that you want to compare, the Sharpe Ratio flattens the risk, so that you can then see how well each fund has done. There’s no ‘good’ or ‘right’ Sharpe Ratio, so if you’ve got 10 different funds, the one with the highest Sharpe Ratio has achieved the best performance per unit of risk.
However, you do want it to be positive, as a negative Sharpe means you’d have been better off leaving your funds in cash. It’s a simple comparative figure, so when comparing the Sharpe ratios of a bunch of funds, higher Sharpe is better.
In assessing the performance of my portfolio’s constituent funds, then, I would be looking at the following measures:
- Performance: Second quartile or above, that is, in the top half of all funds in its peer group. You want to be consistently above average
- Volatility: Below average
- Sharpe Ratio: Above average
For active funds, you want the Alpha, which is the amount of value added by the manager, to be above average.
Look at these figures over at least three years. Anything shorter than that is irrelevant. You could even track these figures over 3, 5 and 10 years and look for long-term trends.
Generally speaking, if your performance is above average, your volatility is below average, your Sharpe and your Alpha are above average, and you will have a tidy portfolio which should do you pretty well over the long-term.
