The post Trump rally continued in December with the Australian share market adding 4.4%. This brought the 2016 return (including dividends) for the market to a healthy 11.8%.

Our portfolios tracked the market higher in December. Over the course of 2016, the income portfolio returned 14.5%, outperforming the broader market by 2.7%. Our growth-oriented portfolio returned 9.8%, underperforming the broader market by 2.0%.

The purpose of these portfolios is to demonstrate an approach to portfolio construction. As the rule sets applied are of critical importance, we also provide a quick recap on these.

This is our final report for 2016. Next week, we will publish our 2017 portfolios, which while based of the 2016 portfolios, will be re-balanced and incorporate some further changes.

Portfolio recap

In January, we made some adjustments to our Australian share ‘Income Portfolio’ and ‘Growth-Oriented Portfolio’ (see here and here).

To construct the income portfolio, the processes we applied included:

• we used a ‘top down approach’ looking at the industry sectors;
• so that we are not overly exposed to a market move, we have determined that in the major sectors (financials and materials), our sector biases will not be more than 33% away from index;
• we require 15 to 20 stocks (less than 10 is insufficient diversification, over 25 it is too hard to monitor), and have set a minimum stock investment of $3,000;
• we confined our stock universe to the ASX 150;
• we have avoided stocks from industries where there is a high level of exogenous risk, such as airlines;
• for the income portfolio, we prioritised stocks that pay fully franked dividends and have a strong earnings track record; and
• within a sector, the stocks are broadly weighted to their respective index weight, although there are some biases.

The growth-oriented portfolio takes a different approach in that it introduces biases that favour the sectors that we judge to have the best medium-term growth prospects. Critically, it also confines the stock universe to the ASX 150 (there are many great growth companies outside the top 150).

Overlaying these processes were our predominant investment themes for 2016, which we expected to be:

• Continued low interest rates (yield sectors will continue to perform);
• The US Fed will be very cautious about further US interest rate rises;
• The Australian dollar at around 0.70 US cents, but with risk of breaking down;
• Commodity prices remaining weak;
• A positive lead (or at least not a negative lead)from the US markets; and
• Growth running below trend in Australia.

Performance

The income-oriented portfolio is up by 14.48% and the growth-oriented portfolio by 9.82% (see tables at the end). Compared to the benchmark S&P/ASX 200 Accumulation Index (which adds back income from dividends), the income portfolio has outperformed the index by 2.68% and the growth-oriented portfolio has underperformed by 1.98%.

All sectors up in December, materials star in 2016

All sectors were higher in December. The largest sector by market weight, the financials sector which makes up 38.2% of the index, led the market higher with a return of 5.5%. This took year-to-date gains for financials to 10.3%.

Despite bond rates heading higher, the interest rate defensive sectors real estate and utilities performed strongly in December, with returns of 6.8% and 8.7% respectively. These sectors also enjoyed above market returns for the year.

However, the standout sector for 2016 was the materials sectors, which powered to a return of 42.9%. This was largely due to the performance of the major iron ore miners BHP, Rio and Fortescue, supported by the gold miners and building materials companies.

On the negative side, the only sector to finish in the red for the year was the telecommunications sector, which lost 7.1%. Other sectors that underperformed on a relative basis were consumer staples and health care. The latter enjoyed a return of just 1.9%.

Income Portfolio

The income portfolio started the year underweight materials stocks and overweight financial stocks. Otherwise, the sector biases were relatively small.

Strong performances from some of the more defensive stocks such as Medibank and Dexus (both realised), as well as from the exposure to the materials sector through BHP, offset the losses on our holdings in AMP and Telstra. JB Hi-Fi also performed strongly, helping the portfolio to outperform the index by 2.7%.

At the end of May, we crystalized the gain on Medibank and re-invested the proceeds into $2,442 BHP and $5,000 ASX Limited. The BHP purchase reduced the underweight position in materials by lifting the sector exposure to around 12.0%.

At the end of October, in anticipation that we were moving into a period of higher interest rates and that property trusts were fully priced, we realised our profit on Dexus. The net sum of $8,344 was reinvested into $5,000 Transurban and $3,344 National Australia Bank.

The portfolio was originally forecast to generate a yield of 5.26% in 2016, franked to 84.2%. Due to lower than forecast dividends from BHP and ANZ, and some intra year portfolio changes, it delivered an income return of 4.99%. This was franked to 87.2%.

Our income-biased portfolio per $100,000 invested (using prices as at the close of business on 30 December 2016) was as follows:

* CYBG Plc demerged from National Australia Bank in Feb 16, on 1:4 basis

** Sale of Medibank at $3.20 on 31/5/16. Proceeds of $7,742 reinvested in $2,242 BHP @ $19.08 per share and $5,000 ASX @ $44.51.

*** JB Hi-Fi entitlements on 1:6.6 basis, assumed to be sold on last day of trading (23/9) at $3.02

**** Sales of Dexus at $8.94 on 31/10/16. Proceeds of $8,344 reinvested in $3,344 NAB @ $28.00 per share (cum-dividend), and $5,000 Transurban at $10.39 per share.

***** Boral 1:2.2 renounceable entitlement at $4.80 per share, assumed to be sold on last day of trading @ $0.28.

Growth Portfolio

The growth portfolio, when set up, was marginally overweight the sectors that we expected to benefit from increased consumer consumption or a lower Australian dollar; marginally underweight or index-weight the yield sectors (financials, utilities, telecommunications and consumer staples); and underweight the commodity exposed sectors (materials and energy). Despite healthcare being the best performing sector over the last three years, we elected to maintain an overweight position, as the demographic factors are so strong.

At the end of May, we crystalized the loss on our Flight Centre holding and re-invested the net proceeds of $3,170 into $2,000 BHP shares (which lifted the weighting in material stocks to 11.7%), and $1,170 into Macquarie.

During September, JB Hi-Fi completed an entitlement issue to fund the purchase of the Good Guys retailing chain. As the model portfolio is fully invested and doesn’t hold cash, we assume that the entitlement was sold on the last trading day.This also applied to the Boral entitlement issue conducted in December.

Over the course of 2016, the portfolio has underperformed relative to the broader market by almost 2.0%. Part of this has been due to an overweight position in healthcare (one of the weaker performing sectors), as well as stock selection with BT Investment Management, Seek and Westfield. The latter’s net return of 2.2% compares with a sector return (for real estate) of 12.4%.

Our growth-oriented portfolio per $100,000 invested (using prices as at the close of business on 30 December 2016) was as follows:

* CYBG Plc demerged from National Australia Bank in Feb 16, on 1:4 basis

** Sale of Flight Centre at $31.61 on 31/5/16. Proceeds of $3,170 reinvested in $2,000 BHP @ $19.08 per share and $1,170 Macquarie @ $74.87 per share.

*** JB Hi-Fi entitlements on 1:6.6 basis, assumed to be sold on last day of trading (23/9) at $3.02

**** Boral 1:2.2 renounceable entitlement @ $4.80 per share, assumed sold on last day of trading @ $0.28

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.