What portfolio managers do with your money

I was speaking with someone over the weekend who asked me: “what exactly, does a portfolio manager do?” I thought it was a fair question and my MoneySense editors thought there might be other people ought there who were wondering the same thing. As such, I thought it would be a good idea to go over the high-level principles that I employ. Obviously, everyone has their own way of doing things.

The things to consider involve consistent, repeatable processes that can be applied consistently for all clients, irrespective of their age, risk profile, income, assets and other such metrics. There are three basic steps involved in portfolio construction:

Strategy: Setting the asset allocation (writing a portfolio blueprint);
Tactics: Determining the asset classes that will be used; and
Products: Choosing the individual products and securities used in populating the portfolio.

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Most people focus primarily on the third step, whereas evidence shows that the first two are far more important. The first step involves writing an Investment Policy Statement (IPS), which is a formal, written document that memorializes a number of important factors to be factored in to portfolio construction. These include, but are not limited to: age, experience, time horizon, risk tolerance, tax considerations and extraordinary circumstances.

Next, the asset classes to be used are explicitly identified. I should note that this is something that my firm does not require, but is something that I consider to be vitally important. Accordingly, my IPSs carry an Addendum that offers an express itemization of the asset classes to be used, the expected return for each class (and the portfolio as a whole) and the percentage allotted to each class.

Finally, individual products are recommended. I have a Recommended Product List that I use in portfolio construction. The 12 products on the list are explained in consistent, simple terms regarding their asset class, cost and value proposition. Once again, the single document format is something that I give to clients so that they can see how each product corresponds to the asset classes in question (the second step) and the overall portfolio design (the first). Taken together, these three documents allow for a seamless explanation of the principles applied in portfolio construction.

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Some people ask further questions, such as: what work tools or applications do you use? The answer is that I generally do not use additional tools because to me, tools like PALTrack (to gather statistics for mutual funds (or StockPointer (to obtain share statistics) cannot be a part of my process. Since past performance is not a reliable indicator of future performance, I ignore tools that are predicated the notion that past performance is relevant.

Other people have sometimes asked about what best practices I follow. One of my main strengths is objectivity. I’m always upfront with my clients. I do this by sharing with them the fund statistics that I’ve gathered and I inform them about the nature of management fees and other details as set out in the three documents I referenced earlier. I find that added transparency is a great selling point for people who want to understand what is being done on their behalf.

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In addition, I encourage clients NOT to compare the performance of their funds with that of similar funds. Past performance cannot be relied upon before the fact in making investment decisions and does not persist after the fact. For instance, a fund with 2% of management fees and a return of 10% per year for 10 year (ranked 2nd out of 300) beats all the indexes. There are some advisors who would suggest that its value exceeds that of the index fund whose management fees are 0.5%, but whose return is 6.5%. That suggestion presumes a number of things that may not be relevant:

 That a 10-year time horizon is appropriate;
 That a 10-year time horizon is statistically significant (it isn’t);
 That past performance will persist (there is no assurance that it will); and
 That the cost difference is not material (it is likely the most material consideration of all).

All told, there are a number of things that go into proper portfolio construction and, to the surprise of many, a few other things that are not part of the process at all.

John De Goey is a Portfolio Manager with Industrial Alliance Securities Inc. and the author of The Professional Financial Advisor IV. Industrial Alliance Inc.is a member of the Canadian Investor Protection Fund (CIPF). The opinions expressed herein are those of Mr. De Goey alone and may not be aligned with the opinions and values of Industrial Alliance Securities Inc. or any of its affiliated companies.