A critical part of managing your own SMSF portfolio is understanding how to manage risk by investing in different sectors of the market.
Most Australian equities fund managers use the ASX 200, or sometimes the ASX 300, as a reference point or benchmark to compare one fund manager’s performance to that of another.
Fund managers also calculate tracking error, which is a measure of how closely they follow the performance of their benchmark. Typically, this statistic reflects the standard deviation between the monthly returns of the fund and the benchmark over a period, such as three years.
[1]Funds often have limits put on them about how big a ‘bet’ or position the manager can take on a given sector, and these are benchmarked against the sector’s weighting. The composition of the ASX 200 is shown in Chart 1. Materials, including mining and building stocks, had a weight of 27.6% at the end of FY2011. A fund might have been restricted to invest 27.6% of its allocation in that sector plus or minus say 4%, in other words, 23.6% to 31.6%. But more on this in my next column.
The tighter the constraints and the smaller the tracking error, the closer the performance of the fund likely is to the index.
So why pay for such active management?
One might as well buy the exchange-traded fund (ETF) that replicates the index at a much lower cost if a manager practices so-called index-hugging. Once an investor becomes more prepared to deviate from the index, or, indeed, become ‘benchmark unaware’, the question of how much risk to take on becomes paramount.
In my previous column on What not to buy [2], I wrote about even ignoring an allocation to some sectors altogether to reduce risk.
A brief look at the sector weights for the US index, S&P 500, in Chart 2, makes it clear that the compositions of the Australian and US indexes have little in common. Indeed, information technology is the smallest sector on the ASX 200 and the biggest on the S&P 500. Given that the volatilities of returns in each sector can be quite different, taking sizable ‘bets’ – or positions – can make the returns on the fund and the benchmark quite different.
It doesn’t really matter to me how the ASX 200 is composed. It is very different from that of the US and the rest of the world. Indeed, that is one reason why many investors go global – to get more exposure to IT and global pharmaceutical companies.
But returning to risk. My own views on this topic are strong: risk comes first, returns second.
When I started investing in the stock market I kept quite close to sector weights until I started to build up an overall gain against the benchmark in my fund – which I did in case I started losing! The bigger my lead over the index, the bigger the positions I’m prepared to take. And, of course, if that lead gets eroded, I will return to a more conservative allocation.
[3]At present, 37% of my fund is made up of materials stocks – all mining stocks and no building materials stocks, etc. – compared with the 27% materials account for in the ASX 200. This is a big ‘overweight’ position but, in my mind, I have partitioned out my most successful stock, Lynas. I have already sold 40% of my position in Lynas at prices that more than cover all of my buys. In other words, I could say that I’m playing with the casino’s money in that stock.
If I didn’t do that I would have had to have sold too much Lynas at too cheap a price, in my opinion. After removing Lynas from my sectoral allocation, that leaves me a little underweight at 24% in materials. I manage my Lynas stocks separately so I can better control risk – and I will do so with any other highly successful choices.
I am now (in round terms) 25% financials, 21% industrials (all mining services), 18% health, 11% energy and 1% utilities. Zero in the rest. I won’t hug my index or anybody else’s.
Ron Bewley is the founder of Woodhall Investment Research [4].
Have you missed a part of Ron’s portfolio building series? Click here to find past articles [5].
Important information: 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. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.
Also in the Switzer Super Report
- Peter Switzer: My outlook for the market [6]
- Charlie Aitken: Stocks to buy in a sinking market [7]
- Andrew Bloore: ‘In-house assets’ and ‘related party’ investments [8]
- Tony Negline: Will one member’s gains offset another’s losses? [9]