Portfolio Construction - Australian Shares
Portfolio Construction - Australian Shares

In the March 2017 edition of Australian Investor, we published an article on Investment Strategy. After deciding what proportion of your portfolio you should allocate to a particular Asset Class, the next step is then to decide on the investments within that Asset Class.

In this article we look at the importance of portfolio construction for Australian Shares.

In selecting or managing a portfolio of Australian Shares, there are three primary considerations in the portfolio construction process;

  • Stock Selection -  Your benchmark and the types of Shres you will buy

  • Stock weights - The amount you are prepared to hold in a single share

  • GICS weights - The Industry Sectors

Stock selection

There are approximately 2,000 entities listed on the Australian Securities Exchange (ASX).

Some investors aim to select stocks with the objective of achieving returns comparable with the “market” over a period of time. The market is often represented by an Index such as the ASX 300 Index which includes the largest 300 companies by market capitalisation on the ASX.

The ASX 300 Index broadly comprises; large caps (the largest 50 companies on the ASX which represent about 75% of the value of the Index), mid-caps (the next 50 companies which represent about 15% of the value of the Index) and some of the small caps (the next 200 companies after the mid-caps which represent about 10% of the value of the Index). Stocks outside the ASX 300 are relatively more illiquid and represent only a small proportion of the total value of all companies listed on the ASX.

So if the aim of an investor is to achieve returns comparable with the ASX 300 Index as representative of the market return, then they will generally have the majority of their portfolio in large caps. This is because the ASX 300 Index overall return is more likely to be influenced by the performance of those stocks. This type of investor is also likely to hold a larger number of stocks.

For other investors, benchmarks for their portfolio might often include a target dividend yield and other considerations such as interest rates, the rate of inflation and reasonable capital growth over time. So for these investors, holding stock positions similar to the composition ASX 300 Index may be less relevant. Also, this type of retail investor might hold a smaller number of stocks with individuals having portfolios of 15 to 25 stocks being quite common.

Nonetheless all investors need to understand their benchmark (objective) and the universe of stocks they are prepared to buy.

Stock Weights

Having decided on the universe of stocks you can buy, a decision then needs to be made as to how much you will hold in any one stock.

For a diversified portfolio, a simplistic approach to stock weights might be;

  • Large caps. A minimum of 50% of the portfolio and a maximum holding in any one stock of 9%

  • Mid caps. Maximum holding in any one stock of 5%

  • Small caps. Maximum holding in any one stock of 3%

There are several approaches to stock weights and this is merely an example using absolute limits. As another example, a fund manager may have regard to the ASX 300 “Index Weight” of any single stock as a reference point.

Alternatively, a concentrated portfolio (higher relative risk) is one where both the number of stocks is relatively low and the holding in those stocks is then higher as a percentage of the whole portfolio.

The importance of understanding stock weights is that this represents a part of the risk management strategy of a portfolio.

GICS Weights

There are 11 GICS (Global Industry Classification Standard) Sectors by which stocks can be classified according to the industry sector in which they operate. For example;

  • Consumer Discretionary Sector. This includes JB Hi-Fi Limited (JBH).

  • Health Care Sector. This includes CSL Limited (CSL).

  • Materials Sector. This includes BHP Billiton Limited (BHP).

The largest industry sectors are Financials at around 34% and Materials at around 17% of the value of the ASX 300 Index.

Once again if the aim of an investor is to achieve returns comparable with the ASX 300 Index, they will generally have a large proportion of the portfolio in these largest GICS Sectors. As previously mentioned, this may be less relevant for investors with a different benchmark.

Having a strategy to hold stocks in at least a few of the GICS Sectors will be important if your objective is to hold a portfolio of stocks diversified across Industries as part of a risk management strategy.

Your Portfolio

Putting together stock selection, stock weights and GICS weights to build or manage your portfolio requires considerable thought.

In this article we have simply outlined some of the basics of portfolio construction. Your Wealth Adviser is able to review your current portfolio with you and discuss any adjustments that might need to be made to ensure that your portfolio is invested according to your objectives, personal situation and needs.