Although the S&P/ASX 200 added just three points in September, our portfolios finished higher.

Our income portfolio maintained its relative outperformance, despite global equity markets starting to factor in an increase in US interest rates later this year. Meanwhile, our growth portfolio reduced its relative underperformance. Year to date, the income portfolio has outperformed the index by 2.77%, while the growth portfolio has underperformed by 1.55%.

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

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;
• 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 to end September is up by 9.06% and the growth-oriented portfolio by 4.74% (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 2.77% and the growth-oriented portfolio has underperformed by 1.55%.

‘Expensive defensives’ get cheaper

With global equities markets starting to become more comfortable with an increase in US interest rates, and many investors starting to think that the Australian interest rate cycle is coming towards an end, momentum investors continued to move out of the sectors that had benefitted from lower interest rates. These so called ‘expensive defensives’ shed around 4%. The utilities sector lost 3.3%, real estate 4.0% and telecommunications (which is in the main Telstra) 4.0%.

The materials sector (see table below) continued its strong run, led by mining heavyweights such as BHP, Rio and Fortescue. The sector added 5.6% in September, to be up 32.5% this calendar year.

In an otherwise quiet month, the top 20 stocks, supported by small gains for the major banks and retailers, added 1.2% for the month, and are now marginally in the black for the year with a return of 0.8%. The market continues to be driven by the mid cap and small cap stocks – the former up by 17.1% this year, while smaller caps have returned 16.0%.

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 (realised), Sydney Airport and Dexus have offset the losses on our holdings in the major banks. JB Hi-Fi has also performed strongly, helping the portfolio to outperform the index by more than 2%.

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 12.4%.

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.

The portfolio is forecast to generate a yield of 5.26% in 2016, franked to 84.2%. Currently, it has generated an income return of 3.91%, franked to 86.6%. We expect that when the final dividends on stocks such as ANZ, NAB, Westpac and Dexus are declared, the forecast will be met.

No portfolio changes are contemplated at this point in time.

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

For a larger version of this table, click here.

* 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.

Growth Portfolio

The growth portfolio, when set up, was marginally overweight the sectors that should 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 11.8%), 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.

While the portfolio has improved its relative performance compared to the index, it is still down by 1.6%. This is partly due to its bias with top 20 stocks. Also, the stock selection of BT Investment Management, Flight Centre (realised) and Westfield (compared to the traditional A-REITS) has impacted performance.No changes are proposed at this point in time.

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

For a larger version of this table, click here.

* 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

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.