It’s time to do an annual portfolio health check. Here’s how

There are three steps in checking the health of an investment portfolio. Pendal multi-asset portfolio manager ALAN POLLEY explains

• Annual asset allocation review critical to successful investing
• Three steps: strategic asset allocation, active asset allocation and diversification
• Find out about Pendal’s multi asset funds

A REGULAR portfolio health check is a critical part of successful investing — doubly so after a volatile 2023.

But what’s the right way to conduct a check up on your portfolio?

There are three parts to a successful annual portfolio review says Alan Polley, a portfolio manager in Pendal’s multi-asset team.

Here’s a quick snapshot.

1. Review strategic asset allocation

The first and most important step is reviewing your strategic asset allocation — in other words checking he long-term investment strategy is still consistent with your return objectives and risk tolerance, says Polley.

“It’s been a tough year. Equities and bonds are both down around 15 per cent this year. 

“Some people may feel like their portfolio construction process is broken. But that’s where you come back to your long-term strategic plan.

It’s important to keep in mind the long-term returns from staying invested.

“Markets go up and down and you get paid through the cycle for those ups and downs.

“Since 1900, the average equity real return is around 5.4 per cent a year for developed markets, and a good per cent higher for Australia and the US.

“There were all sorts of global events and wars in there. But you got that return by keeping your long-term strategy consistent with your risk tolerance and your annual return objectives.”

Sound economic rationale

There is a sound economic rationale why this is true. Financial markets should pay a risk premium to people who choose to put their money at risk by investing,  instead of keeping their savings safe in cash.

The strategic asset allocation part of a portfolio review is about adjusting your portfolio to ensure it still matches your long terms goals, risk tolerance and investment return objectives.

“Your risk tolerance changes naturally over time as you age, and potentially other exogenous life events,” says Polley.

“As you get older, you simply have less time left to recover from drawdowns, so you need a more capital stable portfolio. At some point, you will also need more income.”

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But your risk tolerance and long-term goals are not changed by a negative year on the markets, says Polley.

“When markets are volatile, your portfolio can stray away from your risk tolerance, either to a more defensive or aggressive position and potentially at the wrong time.

“The point of the strategic asset allocation process is to provide a sound central portfolio that enables you to rebalance, buying cheaper assets and selling more expensive ones.

“Buying cheaper asset classes at lower prices — the ones that have sold off and are giving you the pain — should add to your returns over time. As should selling the more expensive assets.”

2. Consider active asset allocation

Overlaid on the strategic asset allocation process is a review of your active asset allocation.

“This is where you can make short-and-medium-term asset allocations around your strategic asset allocation to enhance returns.

“This is what we refer to as going overweight or underweight relative to the strategic asset allocation.”

Active asset allocation changes the risk profile of a portfolio slightly — but the incremental additional gains can compound over a lifetime into a significant difference at retirement.

Polley says there are two keys to successful active asset allocation.

The first is having the discipline to ensure the active positions in a portfolio average out over the course of a cycle to match the overall risk objectives.

“If you go overweight, you should at some point also go underweight such that sum of those overweight and underweight positions is zero — which means the average allocation along the cycle is equal to your strategic asset allocation.”

The second is ensuring that your active position sizes are modest compared to your strategic asset allocation.

“The sizing of an active allocation should be roughly up to 10 per cent the sizing of the strategic asset allocation because it’s the strategic asset allocation that is calibrated to meet the investor’s return and risk objectives over time.

“Active allocations need to be incremental because we don’t want them to put us off the path of the optimal long-term portfolio and the portfolio’s targeted risk tolerance.”

The complexity and discipline required to successfully manage active tilts in a portfolio is why many investors choose to use professional fund managers for this portion of their investments, says Polley.

3. Ensure sufficient diversification

The final step in a portfolio health check is ensuring you have sufficient diversification.

“It’s often said — but tends to be forgotten — that diversification is the only free source of return in investing. So when you think about your strategic asset allocation, really try to maximise the level of diversification in your portfolio.

“That means having non-traditional assets alongside your traditional assets.

“Non-traditional assets should at least hold their value like they have this year when traditional assets fall and that gives you the dry powder to sell and rebalance.

“The benefits of rebalancing doesn’t work if all your asset classes fall at the same time.

“You need something that holds value or better yet performs at different times to traditional assets — cash holds its value and non-traditional assets almost by definition perform at different times.”

About Alan Polley and Pendal’s Multi-Asset capabilities

Alan is a portfolio manager with Pendal’s multi-asset team.

He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.

Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.

Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.

Find out more about Pendal’s multi asset funds:

• Pendal Multi-Asset Target Return Fund
• Pendal Sustainable Balanced Fund
• Pendal Sustainable Conservative Fund

Contact a Pendal key account manager here