The value of reviewing a current portfolio versus reviewing past returns.
By Scott Burns
By Scott Burns
Read Time: 2 Minutes
What can March Madness teach us about the most effective approach to constructing a portfolio? Quite a bit.
The tradition most associated with the annual college basketball tournament—filling out your bracket—works off a number of the same principles as investing, especially when it comes to reaping the benefits of a holdings-based style analysis over a returns-based style analysis for portfolios.
Here are the top reasons a holdings-based style analysis can serve your investments, as well as your March Madness bracket.
1. You wouldn’t look at a team’s past record to evaluate its chance of success this year; you would consider the new roster and coach.
The same is true with portfolios of investments. Whether you’re analyzing a portfolio of individual stocks and bonds or that of a fund manager, the underlying holdings are constantly evolving both in terms of representation and their reaction to different events.
Therefore, a holdings-based style analysis, which evaluates a portfolio by those holdings (or what it currently is), can be considered more relevant than returns-based style analysis, which evaluates a portfolio based on its historical returns (or what it previously did).
2. When a portfolio is outperforming, holdings-based style analysis will show you the true source of these gains so you can determine how to keep growing your client’s investments.
A returns-based style analysis would only show that the fund is outperforming, without explaining the source of these gains—which may include high-momentum stocks from the previous year.
It would be like looking at the raw numbers that make up a team’s record, rather than digging into the precise factors that contributed to those wins and losses.
3. What impact did the previous year’s highest-scoring players have on a team’s performance? And, if only some players remain on the team this year, how can we expect scores to play out?
While returns-based style analysis uses regression to estimate how currency and geography have contributed to performance overall, holdings-based style analysis evaluates how each of those factors specifically impacted the holdings.
4. Because holdings-based style analysis uncovers the details of all holdings, it reveals asset classes and the risk of derivatives up front.
A returns-based style analysis will not do this—which means in the event of index-return swaps, you and your client could be caught off guard by exposure at a different asset class.
5. Holdings-based style analysis generally produces more accurate results because it is a more stable form of analysis—just like a bracket that is built on the most current, detailed information.
Essentially, it’s important to understand that risk-factor models are at their most powerful when you use them to look into the future, rather than seek to explain the past. The past track record of returns for a fund or manager will not help you identify the current exposure of a fund’s holdings.
Constructing a portfolio without the foundational understanding of holdings-based style analysis is like only using past records to build your NCAA bracket. For both ventures, you need to take a closer look at the specific elements that make up the portfolio—or team—in order to be successful.
Scott Burns led the Morningstar Data product group.