Active vs passive: Portfolio construction in today’s environment - Independent Thought Roundtable

By Jayson Forrest

Diversification of assets, style and strategies are essential when constructing portfolios in today’s challenging environment, explains Veronica Klaus (Lonsec).

Constructing portfolios in an inflationary and volatile environment is particularly challenging, with no single correct way of doing this, says Veronica Klaus — Head of Investment Consulting at Lonsec.

According to Veronica, the last couple of years have been an uncomfortable ride for equity markets and bonds, and although valuations have improved in equity markets, investors are still waiting to see elevated inflation recede. However, the sharp rise in interest rates will most likely result in an earnings downgrade cycle over the next 12 months, which means equity markets will remain cyclically sensitive.

But against this backdrop, bonds are back, as real return forecasts for most sovereign bonds return into positive territory, enabling bonds to once again play their traditional role of offering a source of income in a portfolio, as well as diversification. However, Veronica concedes investors aren’t out of the woods yet, with market volatility likely to continue moving forward.

So, what does this mean for portfolio construction?

Speaking at an IMAP Independent Thought Roundtable (in association with S&P DJI), Veronica believes the current volatile environment makes it even more necessary for advisers and portfolio managers to build portfolios based on a strong investment framework, irrespective of a client’s tilts or their philosophy to investing.

Referencing both the Australian and global equities market over the last 12 months, she acknowledges that the dispersion of stocks has been significant. However, she also believes this dispersion creates many opportunities for active fund managers.

“You might think that by going passive in this type of environment will provide a ‘no risk’ portfolio, but what you’re actually introducing into your portfolio is an explicit macro-overlay,” Veronica says. “So, when constructing portfolios in this type of environment, whether you’re looking at growth or value, it’s very important to look beneath the surface to see whether active managers have over or underperformed the benchmark.”

When it comes to portfolio construction, Lonsec’s investment process combines a dynamic approach to asset allocation with active investment selection, and a multifaceted decision-making process that isn’t just focused on investment returns. This approach to investing is underpinned by Lonsec’s robust investment philosophy, which includes research driven analysis, rigorous governance, and a strong focus on diversification.

However, this focus on diversification is not just aimed at asset classes. Instead, it also extends to diversification of style (value, growth, active, and passive) and strategy (such as long only, long-short, and concentrated).

“Diversification is key,” Veronica says. “It’s not just about going out and picking investments for a portfolio that are going to perform well, you have to take risk into account. You have to look at the client and the type of portfolio you’re building for them. You have to understand what risk means to them. That’s because for most clients, risk isn’t about tracking error or beating a benchmark. Instead, it’s about losing money.”

Therefore, Veronica says when it comes to portfolio construction, it’s at both the asset allocation and investment selection stages that diversification becomes particularly important for client outcomes.

By taking a diversified approach across investment strategies, Lonsec ensures it maintains a strong focus on risk, as part of its portfolio construction process. Veronica says defining risk is one of the many complexities of portfolio construction that can’t be ignored.

She says the key to ensuring these complexities are not ignored is by building and implementing a strong investment framework. Lonsec has done this by implementing a ‘building block’ approach to its investment process, which forms the basis of every portfolio it constructs.

“By using building blocks, we can clearly allocate a role for every single fund or product that we put into a portfolio. This helps us to not only better define what the fund or product is, but also to understand the performance profile that we would expect from it,” she says. “Risk control is very important for us, so this approach enables us to smooth the journey for our investors, because that’s what they care about.”

According to Veronica, the reason why Lonsec has taken this approach to portfolio construction is due to the market changing and becoming more complex, with the likes of absolute-return strategies, small caps, and long-shorts all now part of the mix.

“These different types of strategies are all now components of an Australian equities portfolio. So, you really have to understand what you’re trying to achieve when you’re using these different types of strategies,” she says. 

However, Veronica emphasises the importance of access to strong, quality research to underpin any robust investment framework. Lonsec assiduously uses fundamental analysis, combined with quantitative models tested through a range of market conditions, when evaluating different strategies and products as part of its investment process.

“When you’re looking at a market that has such large dispersions as we’re currently seeing, we do believe we can find active managers that are able to take advantage of the opportunities available in the market,” she says. “However, if we were to enter a period similar to five or seven years ago, when markets were running strongly and dispersions were small, then it would be worthwhile to go for a low-cost approach and invest passively.”

Lonsec is looking for strategies that are going to provide a different type of beta and market exposure, such as small caps, emerging markets, and long-short alpha extension type strategies. 

“For us, when searching for differentiated alpha sources, we’re paying for manager skill. So, we would typically use active managers in that space because we believe there are enough active managers in the market that are actually able to add alpha over a benchmark.

“And in terms of risk control, we’re looking at strategies that are going to smooth the journey for us and our clients. We’re looking at strategies with low volatility management,” Veronica says.

“It’s this combination of building blocks that helps us to construct portfolios. These are the levers we use, depending on the condition of the environment we’re in. I believe there are certain times in the market when there are definitely opportunities in which we would look to active management, but only when good quality research can support our decision.”

Veronica Klaus is Head of Investment Consulting at Lonsec.

Veronica spoke on Lonsec’s approach to portfolio construction at an IMAP Independent Thought Roundtable (in association with S&P DJI).