Flaunt Your Assets: Core Investment Portfolio

First of all, what’s a financial portfolio? It’s a grouping of financial assets that you choose to invest in. It can have both publicly tradable securities like stocks, bonds, futures and options and non-publicly tradable securities like private investments, venture capital, real estate, cryptocurrencies and art.

There are three key criteria to adhere to when constructing a portfolio:

1. The Portfolio Should Fit Your Investment Needs

As I’ve highlighted in my first book, Wise Investing, the most fundamental step should be that your portfolio fits your needs and your lifestyle. Your saving and investing activity should be something you can sustain your whole life and sleep tight at night. If portfolio construction is a new activity for you, then it is better to start safe and re-evaluate your risk profile later if you wish. Investing is as much a game of patience as it is a game of wits.

2. Diversification and Counter-Cyclicality

“Location, Location, Location” is a well-known proverb from property investors. Likewise, for financial portfolio it’s “Diversify, Diversify, Diversify”. Yet, just buying a lot of securities that carry the same type of risk is not good diversification. Aim for a portfolio that has some counter-cyclicality in it, which means that when one type of risk is triggered and that part of your portfolio diminishes in value, the other part of the portfolio actually increases in value or at least remains relatively unscathed. That’s why a lot of portfolios combine stocks or stock ETFs with high quality bonds. When the stock market corrects (falls), a high-quality bond portfolio will remain relatively stable and generate predictable income. Another example of good diversification is geographical diversification, which allows an investor to limit the impact to his or her portfolio due to, for instance, localised political events.

3. Analyse Your Biases

Biases are and always will be a part of our nature, however, it is crucial to understand their effect on our decisions regarding our investments. Like with any biases, there are limiting financial biases and empowering financial biases. An example of the former is home bias – a tendency to stick to investments in your home country, because for some reason they feel safer. An example of the latter is investing in sustainable businesses as research shows such investments perform better over the long run. Only you know which of your biases and beliefs are helping you and which are limiting you. However, one thing is certain: they require constant analysis.

I am not a proponent of hard written rules in investing because I believe that every investment portfolio is very individual. However, it is always wise to keep some guiding rules in mind.

Core Portfolio Rules

1. Keep at least 80% of your portfolio in publicly tradable securities, that’s what we call a “core portfolio”. You can experiment with the rest. However, do so only if you have a specific reason to experiment. Otherwise, keep all 100% of your portfolio in publicly tradable securities.
2. Keep your core portfolio in solid currencies that are strengthening, for instance, when a certain Central Bank or Monetary Authority is increasing their interest rates. In the near future such a currency will only be the United States Dollar (USD). However, please note that the relative strength of currencies changes over time.
3. Keep a significant amount of your core portfolio in bonds unless you have a specific bias and a strong reason to do otherwise. You can use a classic 50-50 split (50% bonds, 50% equities), which works well for a lot of investors. Alternatively, you can use my business partner’s rule and use your age as a gauge for the proportion of the portfolio to keep in bonds. For instance, if you are 30 years old you could keep 30% in bonds.

Total Portfolio Rules

1. Do not invest more than 10% of your portfolio into a single security or a single company, unless that security is a diversified index ETF.
2. Do not invest more than 35% of your portfolio into a single sector unless you have a very strong reason to do so
3. Do not invest more than 35% of your portfolio into a single geographical region, unless that region is a major economic block like the US.

Now that we’ve covered the key pointers, we will examine 2 of the most important tools that will enable you to build a high-quality core portfolio: ETFs and Bonds.

You may have heard of this term, or you may have even dabbled with it without really understanding it. Either way, I’ll give you practical steps to make better investment decisions within the world of Exchange Traded Funds (ETFs).

ETFs are funds that have been turned into a listed asset and are traded on an exchange. Most ETFs are listed on widely recognized exchanges like the New York Stock Exchange (NYSE) and therefore can be accessed via almost any brokerage platform. ETFs are designed by professional fund managers and generally follow a certain investment theme (investment declaration). The fund managers are then responsible for building and maintaining a portfolio that will deliver on the declared investment theme. Often, when we speak about ETFs, we refer to stock ETFs (ETFs that primarily consist of listed stocks, like QQQ). However, there are many other types of ETFs like fixed income or bond ETFs, gold ETFs and many more. For instance, one of the most popular ETFs in the world is SPY - the ETF by State Street Global Advisors that tracks the S&P 500 Index and contains stocks of some of the biggest companies in the world by market capitalisation. Another popular ETF is VOO (which is an alternative of the former by Vanguard Group). QQQ tracks Nasdaq-100 and is issued by Invesco.

ETFs like SPY, VOO and QQQ that track an index are commonly referred to as index ETFs. Index ETFs are created by large companies with sufficient skill and economies of scale. As a result, they are able to closely follow a certain index even in times of high volatility. They’re also affordable. The accessibility of individual ETFs will significantly vary depending on what exchange they're listed on. If your capital is below USD2 million, avoid exotic exchanges and stick to the large and liquid ETFs listed on established exchanges.

Not all ETFs are created equal. There are four crucial factors you need to look at when choosing an ETF: the ability to deliver as per the investment declaration, liquidity, size (Assets Under Management or AUM), and cost of the fund. There are ETFs that are superior in all four aspects whereas others will offer advantages in some aspects more than others. For instance, some ETFs could have an adequate amount of liquidity, have a substantial size, but be relatively expensive because they have a very unique investment declaration and they are good at delivering on it. A good example of such an ETF is BOTZ (Robotics & Artificial Intelligence ETF by Global X).

I’ve laid out some details on each of these aspects so that you can make more informed decisions.

Deliver According to the Investment Declaration

Can the fund manager deliver as per the investment declaration? You need to perform a high-level analysis of the fund manager’s ability to follow the investment theme of an ETF. For instance, if it is an index ETF watch how closely it follows the actual index.

If you are looking to buy QQQ – an ETF that aims to track the NASDAQ-100 index or NDX (100 largest non-financial, therefore mostly technological, companies listed on the NASDAQ) – then you compare the performance of the ETF to that particular index and look at how closely it correlates. This can be done on almost any brokerage platform or via Yahoo Finance’s full screen charts.

If it is a non-index ETF, look at the constituents (securities that the fund holds) and analyse how well they fit the fund’s investment declaration. Most ETFs will show at least their top 10 positions (holdings) by size. This will give you a good feel of what’s inside the fund.

Look out for Liquidity

After you’ve analysed the ability of the fund manager to deliver, you need to look at the liquidity of each ETF which is determined by its trading volumes. A good way to determine the liquidity of any security is to look at its average trading volume over a period of time. For instance, its Average Daily Volume (ADV), which is the average volume over 1 month and 3 months. When starting off, try to stick to ETFs where all 3 of these indicators are above 500,000 shares unless you have a strong reason to go below that.

If an ETF is actively traded (large volumes of it are being bought and sold) then you can get in and get out any time during trading hours. That’s why the liquidity of an instrument is essential for your risk-management practices.

As a rule of thumb, pick ETFs that have large amounts of data so that you can access the data volumes. If for some reason, liquidity data is not available to you and you need to make a decision, as a rule of thumb, the more assets an ETF has the more liquid it will be. So, in general, all ETFs with over 1 billion of AUM will have reasonable liquidity. However, aim to pick ETFs that have large amounts of data publicly available, so you can make an informed choice.

Watch out for Fees

As mentioned, investing in equity markets (or stock markets) via ETFs provides significant cost advantages compared to investing via equity mutual funds. This is the main reason why mutual funds underperform as compared to equities or stock.

To analyse the cost base of a fund, look at its expense ratio. This is the percentage of a fund’s assets that the fund manager is using to cover various fund expenses including management, administrative, marketing, compliance and various other operating expenses. Yes, they are using your money for this, so look at this number very closely. To give you a rough estimation, actively managed equity funds often have an expense ratio of above 1% whereas a lot of index ETFs have an expense ratio of below 0.1%. That’s a 10 times difference.

However, not all ETFs are that cheap. Before buying anything, look closely at the expense ratios, which are often publicly available. Choose the cheapest ETFs for the investment themes you are looking to pursue. However, before looking at the cost, shortlist ETFs with high quality fund managers who can deliver as per the investment declaration and which have sufficient liquidity. If for some reason, expense ratio data is not available, go for the largest ETF (the one that has the most AUM). Usually, the larger the fund size, the smaller the percentage of assets the fund manager has to use to cover expenses.

Give Priority to Index ETFs in Your Equity Portfolio

As of now our asset management company does not have any equity funds. Research shows that when it comes to stocks, active management in its classic sense doesn't work. Research shows that over 90% of actively managed equity funds underperform the indexes. The remaining 10% that do outperform the index change every year, so there is little consistency. Often equity mutual funds cannot offer an added return with their stock picking. They end up giving the same rate of return as the index, whereas their fees are much higher which results in consistent underperformance. Unless you have a specific niche expertise, I would recommend heavy use of index ETFs in your equity portfolio. So, if you have decided to allocate a certain percentage of your core or total portfolio into equity, whether it’s 5% or 50%, be sure to pick a nice basket of ETFs. Over time, that basket will outperform a large number of equity funds.

If you have no idea where to start, then the most obvious investment you can make is the S&P 500 ETF. There are various options for this like State Street’s S&P 500 ETF (SPY) or Vanguard’s S&P 500 ETF (VOO). These are great ETFs that should be in virtually any portfolio. You can evaluate them based on what I’ve shared above. It's a great investment tool that will outperform a lot of mutual funds and has lower volatility.

However, if you want to spice things up, you can add other ETFs that you have a bias towards. For example, if you believe that the technological sector will continue to grow despite the current fears in the market, then you can buy the Powershares QQQ ETF (QQQ). This will give you exposure to the largest technology companies listed on the NASDAQ. On top of that, if like me, you believe that certain sub-sectors of biotechnology like advances in gene therapy have a great opportunity for growth in the next 5 to 15 years, you can add an ETF that gives you exposure to that into your investment portfolio (for example VHT).

How you balance these is up to you, but the more you add sector specific ETFs like QQQ into your portfolio, the more volatile it may become. Make sure you follow good diversification habits and your investments fit your risk profile. If in doubt, stick to S&P 500 ETFs. All major ETFs can be accessed via an online brokerage account the same way you would access an Apple stock.

First things first, let’s get our definitions straight. Fixed income is a broad asset class which includes any instruments that provide a fixed or predictable return over a period of time. There are various types of financial assets that fit the definition of a fixed income security and each of them have different risk profiles. Technically, even your bank deposit can be called a fixed income instrument. Mortgage-Backed Securities (MBS) which became world famous after the Global Financial Crisis of 2007-2008 are also a form of fixed income.

Bonds are another form of fixed income and are one of the best asset classes you can invest in. A bond can be described as a formal IOU (I owe you) note which governments and corporations worldwide use to attract debt capital. Bonds represent a loan made by the investor to the borrower (or issuer) under a certain set of terms and conditions.

In its purest form a bond has:

• A fixed repayment term after which you get your money (the “principal”) back
• A fixed interest rate that the borrower pays to the investor (the “coupon”). Usually annually or semi-annually. For example, if the bond’s coupon is 6% semi-annually, it means that you will get 3% every 6 months.
• Bonds usually offer varying degrees of protection available for investors. Government bonds are usually guaranteed by the governments, whereas corporate bonds are secured with the assets of the company issuing the bond. We will examine this later.

This form of a bond is also called a straight bond, a bullet bond or a plain vanilla bond. There are many other types of bonds, however in the beginning it’s best to stick to plain vanilla bonds. If you know how to analyse them, bonds will become a great income vehicle for you.

To understand a plain vanilla bond’s return, you need to look at its Yield to Maturity (YTM) expressed as an annualised percentage. For example, if a bond’s YTM is 5% it means that if you buy the bond at a given price and hold it until maturity (end of its term) you will get 5% every year. The reason why YTM can differ from the coupon rate is because bonds can be traded at a discount or at a premium to the initial price they were issued at. The YTM of a bond is usually displayed in your brokerage terminal.

Rating Agencies

The biggest risk associated with bond investments is the risk of default. A default is a situation where during the lifetime or at the end of the bond, the issuer (a government or a corporation, for example) runs into financial trouble and fails to make a coupon or principal repayment. The best way to analyse this risk is to look at the issuer’s credit rating. A credit rating indicates the issuer’s chance of default in the opinion of the credit rating agency.

Stick to bonds that are rated by either Standard & Poor, Fitch, Moody or preferably by all three. These are the top three major credit rating agencies. Standard & Poor’s credit rating scale ranges from AAA (extremely strong issuer, a very low chance of default) to D (worst, default imminent). Fitch has the same scale, and Moody has an equivalent scale with slightly different names.

There is a rating cut-off point that is generally accepted and safe for investment and that cut-off point is BBB- (Triple B minus) on Standard and Poor’s scale (BBB- for Fitch and Baa3 for Moody’s). Anything in that category or better is called Investment Grade (or IG). Simply put, the chance of default of a 3-year IG bond is 0.5%, whereas with a 3-year non-IG (aka High Yield or Speculative Grade) bond that chance is 10%.

If a 3-year Investment Grade bond gives you 4% (YTM) and a 3-year High Yield bond gives you 8% (YTM), which should you pick? While you are getting 2 times the return with the latter investment, you would also get 20 times the risk! In terms of risk-adjusted return, which is something that every investor must keep in mind, the former investment (IG bond) is better. So, unless you have a specific reason to go into the world of High Yield bonds (for instance, a strong understanding of the issuer’s fundamentals), stick to Investment Grade bonds. Remember, asymmetric risk and return.

Government or Corporate?

Generally, government bonds of developed regimes are considered very safe investments, therefore, they offer little return. Even if a government and a corporation have the same credit rating, the return provided by a government bond will be significantly lower. So normally, investors looking to invest into IG bonds would go for corporate issuers to enhance their returns. Non-IG government bonds can provide decent returns, however, as said before unless you have a specific reason to invest in them, don’t go there.

For corporate bonds, it is important to ensure that the company you’re investing in is fundamentally strong. So, after you have a look at an issuer’s credit rating, spend some time performing your own analysis of a company’s financial strength. Download a company’s financial statements and have a look at them. Moreover, each bond issue comes with a Prospectus (an offering document) which outlines the bond’s terms and conditions. It also provides data on things like key fundamentals, company’s management and strategic plans. You can look for equity research on a company as it usually contains an analyst’s opinion on a company’s financial strength. If you like what you see, you can buy their bonds.

Pecking Order of Pay-outs

Another important thing you should look at is the bond’s position in the pecking order or the bond’s rank. There is a specific order of “who gets what” in case a company files for bankruptcy. Be aware of where you stand so that you have a good overview of the risk associated.

For instance, after settling salaries and taxes, a company normally would first cover senior secured debt (usually bank loans and rare bonds with senior secured rank). Then, the senior unsecured lenders get paid (usually bonds with unsecured rank). Next in line are subordinated (or junior) debtholders, preference shareholders and only then ordinary shareholders.

Of course, the lower you are willing to go down in the pecking order, the higher your potential investment return would be. But be wary of the additional risk. In terms of risk-adjusted return the sweet spot lies with senior unsecured bonds. So, try to stick with them, unless you build expertise to analyse subordinated debt.

ETFs in Your Fixed Bond Portfolio

The case for active investing in bond markets is different to that of equities. There is a lot of evidence that actively managed bond funds outperform the market. A famous advocate for active management for bonds is the Pacific Investment Management Company (or PIMCO) – the world’s largest bond house. You can check their website for more information on this under “Active versus Passive” Debate. Our asset management company is also a strong proponent of active management in bond markets and unlike with equities we do have an in-house bond fund.

So, if you are willing to take the risk and have the capital required, you have a chance at generating alpha (return in excess of the benchmark). However, make sure that you follow good diversification practices. The absolute minimum is to have 10 different positions in your bond portfolio, but your goal is to eventually reach 40 or 50.

Alternatively, if you do want to spend time picking individual bonds or you don’t have sufficient capital for diversification, you can go for a bond fund or an ETF. There is a good selection of good quality actively managed bond funds (for e.g. PIMCO’s Global Investment Grade Credit Fund), and ETFs (for e.g. BOND by PIMCO, EMCB by WisdomTree, FCOR by Fidelity).

Assessing the Research

Information on ETFs is available on the respective brokers’ platforms or ETF databases like ETFDB.com. Brokerage platforms usually provide bundled research which can be very useful. ETF databases will have a premium subscription to access research, but you can use the basic subscription, which is free, to access a lot of the information you need to make a decision.

Interactive Brokers is the best brokerage platform I've ever encountered, but it is geared towards professional trades so you will have to spend some time getting used to it. If you want something intuitive then go for SAXO. SAXO is a great platform that’s easy to use. The dashboard looks like Microsoft Excel. However, it has fewer functions, less research and is more expensive than Interactive Brokers. So again, I would recommend that you try Interactive Brokers and see if you can get used to their platform before you try anything else.

Before beginning your investment pursuits, it’s important that you consider all that I’ve covered in this book. Familiarise yourself with the above and I believe you’ll construct a great core portfolio.

1. Design Your Core Portfolio

Outline the key parameters of your portfolio/core portfolio. How much will you invest into publicly tradable securities? What will the bond/equity split in your portfolio be? Will you use individual bonds or funds or ETFs? How about equity? Ask yourself:

• What are my core and total portfolio rules?

• Does my portfolio fit my lifestyle?

• Is it diversified properly?

• Am I mindful of my biases?

• How will my portfolio evolve over time?

2. Do Your Research

Apply what I’ve shown you in this book. Start researching on the various bonds and ETFs. For ETFs look at how the fund manager is doing with regards to the investment declaration, look at liquidity and AUM, analyse the costs. For bonds, research individual companies and review their ratings. Note this down in order to decide whether you want to invest in them. Or perhaps you would find that it is not prudent to hold a portfolio of individual bonds and go for a fund or ETF.

3. Set up Interactive Brokers

Go on to the Interactive Brokers website and set up an account. Navigate through the website to get a feel of how it works. If you find it too difficult, you can consider SAXO. You don’t need to start investing if you’re new but just learn more about this website and how it works so that you’re more comfortable when you decide to begin.