The investment consulting process is also a very important step in the Portfolio Construction..so the previous 2-3 posts (I mean chronologically) are also a part of this series.

Though I do know many people (like me) who have created a portfolio without much thought or process, you realize that it is necessary to have a process. So some of us who started ad hoc investing in the 1970s/80s suddenly got process driven and far more focused. Today I have reduced concentration risk, increased Indian companies in the portfolio. Added many Indian pharma companies – some in the core – and am not dependent only on Pfizer and GSK. These happen with time. Similarly while choosing fund managers (i mean fund houses, or schemes, not the individual)..it helps.

Investment Decision Making through a well defined process helps yoy in avoiding the Pitfalls:

A good portfolio construction process can help you meet your goals. It can strike a balance between risk and return. Good portfolio construction should maintain your strategic asset allocation:

Selecting the “hot” manager
It is tempting (and very commonly done) to sort a performance report and select the investment manager that has the strongest performance numbers. This comes from our natural inability to look at complex things. So we pick up one parameter like ‘5 star rating’ or something like that to make a LONG TERM INVESTMENT decision. For me Franklin India Prima has been a great example of high standard deviation and poor performance for long periods of time. However if you see its long term returns, I have no regrets holding it for more than a decade.

Empirical data indicate that top-percentile performance is unstable over time. All heroes go through a bad patch – immaterial of whether it is Sachin Ramesh Tendulkar, Rahul Dravid, Prashant Jain or Naren. Typically the result of style or market capitalization exposure or even outsized or disproportionate risk taking.

Remember: “If it seems too good to be true, it probably is.”

Failing to identify the source of the manager’s returns

Most of us cannot distinguish the manager’s returns between skill, luck and risk taking. Out-performance is often the result of an investment manager (actively) trying to beat a benchmark through individual security concentration or relative over-weighting or under-weighting of industry, sector, style or market capitalization. Risk, does not always lead to reward!! To prevent an unpleasant surprise in the future, be sure that you understand the source of the manager’s out performance. Remember skill can be repeated, not luck.

Choosing managers with overlapping exposures

If you select multiple managers that have outperformed in the recent three-, five- or seven-year time period, without considering which investment style(s) (e.g., growth v. value or large cap vs mid cap) was/were in favor during that period, you may end up with an allocation to multiple managers with the same/ similar portfolio or style. So in a bull market your Large caps may have done better than say Midcaps. So if you allocate money to Franklin India Bluechip, Kotak K 30, Icici Prudential Focus Bluechip, SBI Bluechip, …the chances are that the diversification did not help at all. Remember that if at one point in time all your schemes are in the green and doing very well, you are not diversified enough.

Ignoring differences in asset classes, styles and sub-styles

A value manager (like I Pru Value Discovery fund or Templeton India Growth fund) has a different return pattern than a relative value manager. (no I do not have any Indian fund manager with a stated objective of value or deep value)

A GARP (growth at a reasonable price) manager (Prashant Jain)  should have a different return pattern than a high or aggressive growth investment manager. I must credit Hdfc that they do not say that they are ‘value’ or ‘growth’ but given their many schemes I would classify Hdfc Prudence more as value than as GARP like Hdfc Equity.

If, you want a core manager that is broadly diversified within a given asset class, you cannot choose a concentrated strategy. Most styles can add value to a portfolio, but you must keep in mind that different styles and sub-styles play different roles in the context of a broad portfolio. In fact I am of the view that for most of us a portfolio like Hdfc Prudence (70% at least in equity) can work just as well. However some variants like I Pru Dynamic or the newly launched Idfc Dynamic equity can add some flavor too. However your overall return is a function of how much you will be willing to put in these satellite funds.