I’ve looked at thousands of portfolios over my career, most of them made up of mutual funds and/or ETFs but sometimes with individual stocks and bonds thrown in or even making up the entire portfolio. One thing that has repeatedly struck me is how sometimes adding “more,” more positions, more asset types, more specialized pieces, can lead to a portfolio doing less. It’s the principle of diversification gone wrong. If you don’t have a solid starting point as you try to differentiate, you may end up with a busy portfolio that in the end acts like what a simple, more benchmark-like neutral portfolio would give you.
Smart differentiation, the differentiation that provides genuine opportunities to add value, is the secret sauce of portfolio management. At Carson Investment Research we take a layered approach to portfolio management. Start simply and bring in added depth as we think it will be rewarded. There is quite a lot of room to create a more robust allocation, but beginning with a simple, solid foundation can also do a lot of work. We call this foundation our “neutral” portfolio. Finding a good foundation is not rocket science (which is part of the point), but it’s also not trivial.
So that’s the core advice. Start with a good idea of what your neutral portfolio is. Be thoughtful but keep it simple. It will both do a lot of work for a portfolio on its own, and as important, create an effective staging ground for potentially creating additional value.
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Here are four essential characteristics of a good neutral portfolio:
- Provides general participation in the typical rewards for investing – As investors, we foster entrepreneurship by providing funding for businesses to grow and are rewarded for the growth it helps create. A neutral portfolio does this more broadly, and therefore provides exposure to the rewards of economic growth in general. It’s the baseline potential reward for the risks of entrepreneurship. There may still be opportunities to add to returns or further mitigate risk, but having that baseline is important.
- Provides broad diversification – Depending on risk tolerance, a neutral portfolio will often include both stocks and bonds, which tend to complement each other due to low historical correlations. On top of that, stocks and bonds within a neutral portfolio are typically captured by broad indexes that have hundreds of underlying stocks or bonds. A neutral portfolio is often diversified and/or neutral across equity size, style, sector, and region as well as bond type within the investment grade universe. Some neutral portfolios pull in additional exposures, but it’s not strictly necessary.
- Creates an appropriate risk target – Choosing an appropriate level of risk is one of the most important decisions an investor can make, and one around which financial advice can be especially valuable. Risk can actually be very difficult to conceptualize and plan for. Neutral portfolios provide a concrete baseline for risk exposure as well as a history that provides feedback on what can happen during periods of market stress.
- Acts as an effective general starting point for an investment portfolio – This is where a neutral portfolio can come closest to behaving something like a benchmark. It’s not necessarily the optimum portfolio, but it covers the most general principles of sound portfolio construction in a simple format. The goal over the long run is to capture what the neutral portfolio represents, and then see where there might be opportunities to add differentiated value.
I have had many long conversations with top portfolio managers about what they use as a neutral portfolio and why. It’s not a trivial decision and there’s not a single right answer. But once decided, it will both take you a long way and provide a vantage point to scout out additional opportunities. At that point the trade-off is giving up some simplicity in exchange for more advanced opportunities to build a better portfolio that go beyond a thoughtful but merely neutral approach.
Even that part we handle in stages of slowly increasing complexity. Layered on top of the foundation of a neutral portfolio are our relatively static strategic perspectives. As Sonu discussed in a recent blog, these are based on viable research on structural risks that are likely to be rewarded over the long term. The strategic views form an anchor for our tactical portfolios as well, which are dynamic and account for our latest macro-economic and market views.
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