Understanding portfolio construction methodology

The methodology used by fund managers to construct their portfolios will very much depend on the type of fund that they are managing, as well as the style of management that they use. Although there are many general funds, such as segregated pension funds, that invest globally, there is a continuing trend towards specialization in particular funds, such as segregated pension funds, that invest globally, there is a continuing trend towards specialization in particular markets, and each market will have its own principal considerations.


Equity management involves an element of asset allocation, either to countries managed by the European, Far Eastern Latin America or Emerging Markets desks, or to industries within single countries, especially within the UK. Having said this internationalization of many companies in recent years has resulted in fund managers looking at industry grouping irrespective of the country in which the corporate is based.

Since firms derive an increasing proportion of their earnings from countries outside their domicile, it is becoming less and les relevant analyses them on the basis of economic prospects for that country (e.g. GDP growth etc), More relevant are the issues facing each industry. Glaxo welcome have traditionally derived the greatest proportion 9over 40%) of their earnings from overseas. Others, such as Vodafone, are rapidly increasing the percentages earned outside the UK.

The number of different influences on a portfolio is quite diverse. This Creates the need For a broad range of different analyses so that the fund manager can look at his portfolio broken down in different ways, particularly useful are analyses of portfolio giving the weights allocated to each category, especially where these weights are compared to the constituents of the index used as part or all of the fund’s bench mark.

Other Analyses: Equities are sensitive to a number of different factors affecting their market prices in the short, medium or long term. This means that the fund manager needs to look at his portfolio, and the securities held in them, from a number of different perspectives and involves assimilating the huge quantities of data available to fund managers, sourced from external brokers as well as their own firm’s analysts. The Key is the interpretation of the data: what does the news imply for a security or overall industry grouping? Portfolio level analysis includes the following.

Fund Break down By:

Company Size - In an economic upswing smaller companies may grow faster than larger firms, whilst in a recession investors may prefer larger, more resilient (through cash availability or diversification ) companies .

Economics theme – E.g. Sensitive to oil prices, interest rates, factors affecting other economics in to products are sold. Over all portfolio factors such as the fund’s beta can also provide useful risk information. As with most types of fund level analysis, the comparison of the funds against the bench mark is the most useful. Other security level analysis include the price to earning ratio growth which is a dynamic measure of a trend of changing value (if you are a value- style manager ) or changing growth (if you are growth manager ) .

If it is important to the fund manager that he receives dividends (eg if he is running an income fund), then he might look at the ‘dividend cover ‘ , which is the ration of earnings per share over dividends per share (ie, a measure of how easily a company can afford to pay the dividend ). Again, the trend of this over time will be useful information.

Industry Case Studies:

Each industries sector will be affected differently by macro economics news as well as by industry specific factors, such as well as by industry specific factors, such as technological innovation. The Following is a very high level review of three industrial sectors, included in attempts to bring out the fact that industries need to be individually analyzed by fund managers.

Telecom Industry :

The Telecommunications industry is a relatively new sector and is still experiencing a high rate of growth as its market continues to develop. Let us look at the share prices for two participants, Vodafone and British Telecom, for the period from January 1st 1980 to 1sr January 2001, displayed as relative to the FT All share.

While BT’s Relative growth over this period is impressive (590% to the FT all share’s 350%) it is some what eclipsed by the performance of Vodafone at 2,500% growth. How ever, the threats to the industry and consequent risks to market value are serve. In recent months several factors have had a detrimental effect on the sectors; these include the high level of market competition (assisted by deregulation, internationalization and general removal or barriers to entry).

In addition, on – going research and development costs and huge third generation data (3G) license fees have given rise to a huge requirement and consequent competition for funding (making borrowing in the bonds market both difficult to achieve and expensive ). From 1st January 2000 to 1st January 2001, the industry has struggled.

Thus this sub – theme can be very important factors: both firms performed well initially , on the back of the general Telecoms Boom, but BSkyB are now in the ascendancy further to their ‘ first mover’ advantage in brining their digital products to market . This analysis also emphasizes the importance of all aspects of a business (e.g. effective marketing as well as innovation and development capabilities).

Consumer Goods :

The consumer goods sectors are strongly affected by macroeconomic factors, as well as changes in tastes which will affect the sales revenue and profits of individual firms. One of the key assets for consumer goods firms is the strength of their brand. A good examples of this can be seen their company valuation wax and wane on the basis of inter alias, the strength of their brand.

Macroeconomics factors having a significant impact on consumer goods firms include the following . Rises in the Expected costs of production, particularly labor, which represents a very high proportion of the cost of goods, will have a detrimental effect on this sector. Demand factors, which might include the savings ration, will affect firms ‘pricing power ‘ie their ability to determine retail prices . Similarly the strengthening of the exchange rate between the firm’s currency of domicile and that of its major export market will reduce the competitiveness of goods and tend to reduce sales revenue, profits and consequently equity earnings.

Oil :

The oil industry is a relatively old (especially compared to telecoms), well established industry. The oligopolistic market structure is unlikely to change significantly in the foreseeable future. Other features of the market include the setting of the underlying commodity price by the organization of petroleum exporting countries (opec) which is dominated by Saudi Arabia. The market has a very effective political and public pressure (eg where Esso were forced to renounce a price increase announced by its chairman in October 2000 after a public outcry).

In general, stocks are likely to move inline with each other, since they will be affected by the same factors roughly equally, one of the principal factors obviously being the prevailing commodity market barrel price of oil.


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