RHP Market Talk

Why Portfolio Construction Matters.

May 11, 2021 Royal Harbor Partners Episode 8
RHP Market Talk
Why Portfolio Construction Matters.
Show Notes Transcript Chapter Markers

If you have ever wondered what your financial advisor is talking about, listen in on a revealing and informative talk about our portfolio construction. 

Glenn Royal and Natalie Picha discuss the inner workings of investment portfolios, our investment philosophy, why we stress test our portfolio and what exactly are thematics.


Get to know us at: www.royalharborpartners.com

Natalie Picha:

Hello, and welcome back to RHP Market Talk. I'm Natalie Picha and I am here today with my partner, our RHP Portfolio Manager, Glenn Royal . Good morning, Glenn. How are you?

Glenn Royal:

I'm well, Natalie. Good to see you. Glad to be here, as always.

Natalie Picha:

We're getting a little bit more comfortable with these podcasts. Our conversations kind of go in all different directions. Today, we want to really focus on why we're so passionate about markets and why we're so passionate and take so seriously, the construction of our portfolios. Because we're different here at RHP. We just don't do what everybody else does. So, we want to kind of let our listeners know ,why portfolio construction matters. I know you and Jason spend a lot of time on this stuff. I mean, you've got five screens going here in your office and I know you spend a lot of time with research and with a lot of experts and things like that. So, give us a little bit of color. Just start us out and tell us, you know, kind of how we got to where we are today and what the portfolios mean to you.

Glenn Royal:

Okay. All good questions and good thinking here. I, you know, the portfolio structure to me, is the key foundation of asset management. To understand how to put the different building blocks together, to build out a portfolio, that's really for the benefit of risk management. When things blow up, you want part of your portfolio to work. And part of it, you know, will have downdrafts with the market. So, you try to put these different building blocks that to reduce that overall risks that we have in the market. And a lot of times when we have kind of brought up this discussion. I've been talking about it, when I had this conversation a long time, is that, when you look at our statements, or you look at whatever that we present to you, or send you in the mail, it may not always make sense. You just see all these holdings of securities, or exchange traded funds, or mutual funds. And just looking at that, you see what's up, what's down, but not really knowing what we're doing over here behind the scenes at Royal Harbor Partners. So, we'll talk a little bit about that portfolio construction here. And I, I think it is , the number one thing, of all investing and for people to understand. What we have done here is we've evolved the portfolio construction. I have almost 38 years, I've gone through all different kinds of strategies. You had value managers, growth managers, growth at a reasonable price or GARP managers, which was kind of the avenue that we come into , not willing to overpay too much. But, what happened was, post 2008, you saw, so much money that come into the system from the central banks, but it wasn't enough to get general growth in excess of 2%. It was just kind of a stagnant growth. The 1.8. And that started to feed into what we call these secular growth stocks. These are the large cap tech stocks, that are making money that had the ability to make money, really any market cycle. And that wasn't providing a lot of growth. Everyone went to the tech stocks. And if I look at the tech stocks, that's 28% of the S&P 500. So, you had this embedded investment group that was the largest component of the S&P 500. It just kept getting larger and larger. You know , Apple is nearly 6% of that index now. So, it kind of forces a purchase that an asset manager has to have to stay with the market. But what we were still one that we, you know, it was a growth at a reasonable price. Sometimes it was hard to pay these high values that we saw in these tech stocks. So, what we tried to do is, we came in with this approach of how do we address this indexing phenomenon that's been going on since 2008. And when I look at that, what we decided to do is, we built this portfolio in three different blocks. That's our portfolio construction. The first two blocks to address the indexing that was going on. There's a term for that, that's kind of, if you're trying to measure the volatility of the market , versus a benchmark, your portfolio versus a benchmark, that terms called beta. So, the market is the beta, the market S&P 500, we'll call the market. That's one. So, I want to find stocks that had the same movement as the market. That same beta one. So, we're not taking outsize risk and we're participating as that market continued to go higher. So, we have about 40% of the portfolio exposed to this beta. Market exposure. And then I have about 60% currently exposed to let's call that alpha. You've heard these terms terms alpha then beta interchange so much. Alpha is basically the excess return of an investment after adjusting volatility that's normally there. It's, what you often hear is that's the outsize performance that the manager gives you to the risks that he takes. The alpha. So, what we're doing is we're combining beta market systemic risk, with alpha, the ability to outperform. And at times you'll see a switch we're 60% alpha and 40% beta. Sometimes you'll see us adjust that dial. A few years ago, I was 60% beta and 40% alpha because of the nature of that indexing that was going on so much. But it's a different market today. We're in a whole different environment. Whole different setup. So, that's caused us to go the opposite 40 beta to 60 alpha. Let's get a little bit deeper. If I can tell how we go on that beta exposure. And our two ways of doing that, are with the sectors of the S&P 500. There's 11 business sectors that make up the S&P 500. These are information technology, energy materials, healthcare, financials, and so forth. What we do in that space, is we are trying to make money. I got the little alpha again, right? We just want to try to beat the market. Is we are picking the 11 sectors. We picked the two, three or four that we think have the best outlook for earnings growth in the coming next 12 months. So we're narrowing down those sectors to the bets we want. The next section is something we call factors. Factors are pretty interesting. Factors started coming out in the several decades. There's a tremendous amount of data, the academic research on factors, and basically their identifiers of broad, persistent drivers of excess return and asset classes. That's a mouthful, right? Let me identify the five key factors. There's many, many factors, but with the advent of computation skills, the computers, and what have you, what we're able to do is we can identify these five factors. The first one is value, which is basically inexpensive companies relative to fundamentals. Pretty simple. We can screen all the, for example, the S&P 500. I can screen the 500 stocks, those that exhibit, that value factor, that inexpensive nature relative to the rest of the index. The other one is size. What we're looking for there is smaller, higher growth companies. We then go to quality, which is basically financial, healthy firms. We can screen for those, a strong balance sheets, strong cash flows, et cetera. And then we go to min vol and in that case, minimum volatility as your stable, lower risk assets , and then the fifth major factor would be momentum. Which is just simply price performance trends. When the markets are moving that's momentum, and you just basically are buying that trend. So we combine these five factors in what we were doing in there, is I can take a multi-factor approach and that's our largest holding within the portfolios . This multi-factor that combines those five factors, screens out. So for example, the S&P 500, we know, not at all companies in that index are making money or that quality, but they're good companies to make the index. We use this multi-factor model to screen out the, "we cans" out of that portfolio. So it may end up you know , 350 to 400 companies, rather than the S&P 500. That's given us, it's a beta play, right? It's us to get exposure to the market. But what's interesting about that, is using these factors is we've driven alpha about one, one and a half percent outperformance, the S&P 500 in these factors for the last three to four years, that we've been in these investments. So, they're really doing what they're supposed to do. So that kind of describes the factors and the sectors. Describes the component of the portfolio, the market exposure. Then we get down to the single stock picks , and that area too , is what we're looking to do is where do we think the earnings growth story is. The last few years it's all been technology now. With the pandemic coming to the end, the amount of stimulus money that's coming, both from the central bankers of the world, as well as federal governments. That's setting us up to where we're shifting more towards something we've seen, a theme, and we've been talking about this since November, when it first started to happen. And that's this move towards, away from stable growth stocks, as the broader economy starts to participate and lift up, those stable growth stocks are expensive. So, we're going to where the relative value is. Companies, early stage companies that we call cyclical stocks, that the benefactor of a new up c ycle i n the economy, the cyclicality of that. And also value stocks. Those stocks that are inexpensive relative to fundamentals, those cheaper stocks start to do well. So our portfolio a nd our stock picking s ide is embraced two parts. Either we get the individual names and we're top down folks. By top down, what we do is we look at the big macro picture. What's going on in the economy. The world, what's going on in corporate profits, et cetera. And then we narrow it down into areas. We want to be , if it's in the material sector, for example, or industrials, we'll go in deeper at that point and find the best companies we can, that fit that sector. So we're top down approach and do bottoms up stock picking, and the biggest twists lately, and I think that this has legs as well. We're early in on it. Is this an investing concept called thematics. You've seen it institutionally, for a very long time where , institutional investors will go into a basket of mining companies, for example, rather than trying to do the homework of which company is going to do the best in the group. They will just by the whole theme of mining companies. So, that's a recent investment that we've done in that that's done quite well for us. PICK , here, we've see that move. So, we're using thematics, using the common stocks to drive that alpha, to get the outperformance combined with that beta. It's a portfolio structure that's been in place now for us for several years. And you know , one of the things about these strategies is eventually they don't become a secret. Everybody learns about it. You start getting all the copy cats , and away you go. And then you had to perhaps change and shift strategies and go to something different. So, this is what we do today. I think it has long life. We've been doing it for several years now, and I think we'll continue this three basket approach to building out the portfolio, sectors, factors and stocks and thematic ETFs.

Natalie Picha:

So, that's a really good overview. I mean, there's so much work that happens on these portfolios on a regular basis. And we're speaking primarily right now about our equity strategy, right? So, if you work with RHP, you know, that we are very holistic and that we look at your entire financial life. And we talk about everything. And , then we look at our models, right? And so we, have balanced portfolios that incorporate this equity strategy that we're talking about today with our fixed income strategy. And we're going to kind of save the fixed income strategy discussion for a later discussion. Because, we could spend hours, if we really wanted to on just the bond side alone. Right? So, when clients come to us, and then we start talking about how we're going to help them. And we explain to them that RHP is different. You know, we speak to what fits their particular need and goal. Most appropriately with the understanding that how we really help clients is some portion of their portfolio. Like we'll have the emergency fund, that's all cash, or we'll have their legacy investments that maybe they've had since their grandfather passed away. And things like that. All of those set up for different baskets. But then the basket that we manage in the RHP portfolios might be a 60% equity exposure with a 40% fixed income exposure. We do have on our aggressive portfolio, which is exactly what you just spoke about. It's 100%, that equity portfolio, but I'm not sure clients always completely understand the difference between active managers, which is what we are. Passive manager. Indexing. Or even mutual funds. B ecause, you know, someone may come to us and say, Oh, I've been working with somebody for a very, very long time. And here's my portfolio. A nd we look at the portfolio and we go, oh, wait a minute. You've been in the same thing for 10 years. Right. Speak a little bit to what our strategy says about what our RHP does, especially in a year, like a COVID year, right. That just extreme volatility. This major shift that we're seeing right now. Because ,we are what we call an active manager.

Glenn Royal:

Yes. So, you know one, of the times that I really liked to buy the individual stocks is when the best companies get thrown out, the baby with the bathwater saying. And that happened in the COVID. So, in the early days when we were down as sharply, as the worst bear market, past deepest six days on record , since what, 29? And the recovery was the fastest. That gave us an opportunity to go in and pick a lot of the common stocks that client's see in their portfolio, we took advantage of that. So that's one of the big times you'll see individual stocks come in, is when there's a fire sale on in the market. And we, we know great quality companies are being oversold. This price. We take advantage that. And kind of in a general concept is, you know, we talked about the portfolio construction , fixed income is similar. We can talk more about that another day, but fixed income has a similar type of approach, more that duration, which duration is just a measure of basically , you know, the volatility in the portfolio. If interest rates are, you know, it's a way of determining, if I'm going to make a boatload of money, if rates are going up or I'm gonna lose a boatload of money, vice versa. But what we did with the portfolios is we've come in with five different models. And model one is the conservative bond only. It's 98% invested in bonds, a little bit, 2% cash, cash builds up the portfolio. Portfolio five is the all stock aggressive portfolio, on 8% investment stocks will be fully invested at all times. We had to move around within that portfolio to become defensive or aggressive as additions allow. And then I put the three in the middle. Your moderate conservative, which is you're basically, you're 60 bonds, 40 stocks. And then we go to your moderate, which is your old 60 bond stocks, 40 bonds. And we've got this moderate aggressive for those that don't want full equity that still like that equity, that typically targets a 70, 30 stock bond mix. Within those balanced portfolios, which, and the beauty of these models to what you were , the point you were making is that you may have a bucket need, if you will, using bucket parlance and financial planning is that this is my conservative money. I need to have it in the course of the next year or two for the purchase. I know we do that in the bond portfolio. We can use our models to plug that in. If you're looking to buy that beach house and you're saving up for it, and you're going to buy it when you retire, 10 years from now, we've got that length of time. Maybe that's the aggressive portfolio bucket, or early in a child's education or something they've got 18 years ago. We've got time in that. But sometimes, you know, people are in between and that's where those balanced portfolios come in. The two, three and four. I do want to point one thing out within those balanced portfolios, is we do take also the liberty or within our ability , to do so , I can adjust that dial of stocks. That risk dial even a little bit further within the, it's called the moderate portfolio that traditional 60, 40 portfolio. I can increase equities by plus 10%, if I'm a risk on, or I can go back to neutral. If it's a little yellow on the field. Uncertainty. Or if we've got concerns, we can reduce equities by 10% and go to the safety of fixed income. So, we are moving that for you. I think another thing we've seen clients do that this offers is that if their risk profile changes dramatically, for one reason, and that plus, or minus 10%, isn't enough for them. We can move models in entirely. So, you can do a lateral change and increase fixed income or equities , wherever that may be. But I like that. That diversity, the ability, the ease to move around, for us to be able to have the control, to increase equities or decrease the risk in the portfolio, depending on market conditions. And it's just something that makes a great deal of sense to me as we work with individual investors and trying to obtain their goals.

Natalie Picha:

Right. And I think, pointing out again that big difference, an active portfolio manager, right. Versus someone that's not maybe actively managing that portfolio. Or a client that, we'll say a client that indexes, right. Maybe it's the difference between what is passive versus active investing. When we talk about how we're structuring this portfolio and how we are continually looking for what are the opportunities in the market under current conditions. Versus just being in the S&P 500 and riding the wave, right?

Glenn Royal:

Yeah. And that's, you know , kudos to those that have done that in the last dozen years. Because it's worked really well. It's been hard to beat that index. You hear that on and on and on, but , markets change. They're not stuck in this paradigm that only indexes work. You're at a period right now, again, the technology stocks are coming out of favor and the rest of the market's going. Passive investing wouldn't capture that. It wouldn't adjust the portfolio for that. Active managers do.

Natalie Picha:

Right. Yeah. It's making those adjustments, on your behalf. Something else that we often get a question about, when we're talking about the portfolios in general, is the cash position. So, as an active manager, right. Cash is a position in that portfolio. Can you talk a little bit about how you utilize that? What, you're thinking when we have that cash position?

Glenn Royal:

Well, so in some cases, cash can be seen. And to me, it's almost a bond proxy in another way, because it's a stable asset, you know, that you earn a very meager return on, but you can earn a little bit on money market, et cetera. But, we're in an environment right now where it looks like interest rates are going to go higher by all accountability. We in the last 30 years, we've gone to zero. Now, we're , we're going the other way. So, that's going to put pressure on prices, on bonds as rates go up, prices go down. So, cash can be a component of the fixed income. If I don't want to lose money in bonds, name of the game, right. Which you can, which will surprise people, which I am actually my personal, private concern is that most investors have very long maturity bonds. That duration we spoke about. And that's a multiplier. So, as rates go up, that long duration is going to go against you. Prices are going to go on a multiplier. It's how you lose a boatload of money in the bond market when you don't expect it. Now, granted, you'll get your money back. If you hold it up to par. But if you're buying a 15 year bond , that may not be within your, you know, your needs. So, what we have done over there is we've gone to shorter maturities and I use cash as a proxy, that I'm kind of holding in there against that bond risk. Other ways we use cash, is if we do see a stock, that's hit a target value, we think is rich. And it's time to take a little money off the table. Are there some issues that have cropped up that we didn't anticipate, wants us to sell the stock? If I have a market, I don't have anything to go into immediately. I'll take that cash and park it in kind of a , we call it a proxy within the equities, an an earmark where we're waiting to find a new name to buy with it. So, sometimes it's there for a new purpose. Sometimes it's there intentionally because it doesn't go down in value. Other than it can loose to inflation. Always got that issue .

Natalie Picha:

Right. The cash position. One other question I've got for you, because I know it's something that we talk about around here a lot, and it's stress testing. So, our portfolios go through rigorous stress testing, and we talk about it all the time, right. We're talking about, what are the risks in the market? We're risk managers first. I mean, above all else. So, can you talk a little bit about what the stress testing is, that you use and you think about?

Glenn Royal:

Yes, and it's a good question. So, all this that I've talked about, how we can build this portfolio , I like to make sure that it's, you know, carries its weight, right? These strategies. So, we've incorporated a number of wall street firms that help us to analyze the portfolio. One we've been using recently is BlackRock. They have a system called Aladdin, Sovereign Wealth Funds, big pension funds. Everyone pays BlackRock for this Aladdin service to do risks testing to the portfolio. It uses IBM's Watson Supercomputer to do the analysis in the background. So, I kind of talk to you about factors and all these variables in quant , you know, variables that we can identify to identify a factor. That's kind what we do at the broader portfolios. We look at things like what if energy prices go up 10%? What if inflation spikes up? Or goes down , you know , what if we have a repeat of the 2008 financial crisis. What will these variables do when we shocked this portfolio with these hits? What do we expect based on the mathematics. Our portfolio today is set up that if inflation increases by 1%, our portfolio, our equity portfolio will be aggressive. We will be up 8%. So, we had the portfolio shocked for an inflationary environment right now. The question is, that is it sustained inflation? We're not sure, but as you start to see the inflation numbers start to come in, you're seeing it right now, all kinds of agricultural goods, shipping out, you know, producer prices, it's showing. The fed says it's temporary. And it may well be. But once we get up to 2% on the 10-year, 2 1/2% percent on the 10-year , because of inflation pressures, pricing that, I think you're going to see money managers start to shift their portfolio as though inflation pressures are coming. They're going to react and not wait to see if indeed it is transitory. So, what we're doing is we're getting ahead of it. Actually, we got in early last November and I think we're so , it was really, really a good move on our part, that I'm starting to see that trade , wake up, people are identifying it, coming our way and we're, you know, five months ahead of everybody. I'm really excited. I think it has got a long way to go.

Natalie Picha:

Okay. Yeah. I think for so many of our clients, it's hard to wrap your brain around all the math that goes into the portfolio construction. Right. That's what we brought Jason in for. All that math. So, I mean, there's so much that goes into the portfolio construction and stress testing and just marrying great portfolio management with the client, you know, the client life. What's going on in their life and how do we put what happens in their life and all the goals and family things that might be happening with what's going on in the markets and it's this really, careful dance.

Glenn Royal:

Well, that's really emblematic of the way our firm operates. So, those concerns that clients have and all that, that's what you and Michele are handling on that end of the office, the front end, you know, they're intimately their life, their needs and all that. And then with us, you're sharing that information and we're coming back with the most appropriate investment choices for that person's needs. So, our firm really works together very, very well because you have all of us working for that same individual client.

Natalie Picha:

Right ? Exactly. Well, thank you, Glenn . I mean, this is going to be interesting. I'm looking forward to seeing the responses to this podcast. We enjoy a lot of feedback from our clients and those that follow us, and it's been a lot of fun just putting these together. So, it will be interesting to see what kind of questions and ideas we get from this one.

Glenn Royal:

I do. And I welcome the questions. Please email me, feel free to reach out, call directly and we'll respond the best we can. We'll help you understand. If there was any questions you have, I'm sure there are, let us know what they are .

Natalie Picha:

Absolutely. Well, thank you all for listening to Royal Harbor Partners Market Talk. We want you to feel confident about your financial future, and we are devoted to our relationships with multi-generational families, for the creation of successful legacies. Through our one-on-one conversations, we can help you discover a clear path forward for your personal wealth management and investment journey. How different will your life look with the right advice,? Call us today, or visit our website, royalharborpartners.com to start your conversation .

Disclosure:

Royal Harbor Partners is a registered investment advisor and the opinions expressed by Royal Harbor Partners on this show are their own. All statements and opinions expressed are based upon information considered reliable. Although it should not be relied upon as such any statements or opinions are subject to change without notice. Information presented is for educational purposes only, and does not intend to make an offer or solicitation for the sale or purchase of any specific securities investment or investment strategies. Investments involve risk. And unless otherwise stated are not guaranteed. Information express does not take into account your specific situation or objectives and is not intended as recommendations appropriate for any individual listeners are encouraged to seek advice from a qualified tax legal or investment advisor to determine whether any information presented may be suitable for their specific situation. Past performance is not indicative of future performance.

Introduction
Our Portfolio Construction
Portfolio Exposure: Alpha vs Beta
Beta Exposure
What are Factors?
Thematic Investing
Our Holistic Approach
What About Individual Stocks?
Adjusting the Dial for Market Conditions
Passive vs Active Portfolio Management
Utilizing Cash As A Position
Stress Testing Our Portfolio
Portfolios and Our Clients
Disclosure Statement