How much does your portfolio weigh?

The fundamental of any portfolio construction is the weights assigned to each asset in the overall portfolio. This is extremely important in the performance of the portfolio against benchmarks, as also in defining the risk characteristics of the portfolio. This principle is applicable to all class of investors — whether institutional or retail.

This principle is also not restricted to one class of assets; it is applicable to debt, equity, commodities and real estate. What would go behind assigning weights of assets to the overall portfolio? This column aims to take the reader through the process of assigning portfolio weights.

The whole idea of assigning weights is to beat benchmarks with a given amount of risk. For example, if an equity fund has defined the Sensex as its benchmark, the outperformance or underperformance should ideally come from picking stocks comprising the Sensex or stocks with market capitalisations similar to those of Sensex stocks.

Outperforming the Sensex by picking stocks in the mid-cap or small-cap segment signifies that the fund has taken higher risk on the portfolio, which might not have been the mandate of the fund. A very good example is the erstwhile US-64 scheme of the UTI, which was positioned as a balanced scheme, i.e., almost equal weights between debt and equities, but later the scheme’s risk profile completely changed with very high weights on equities.

The fund lost heavily when the market went into a downturn, and the government had to step in to protect the interest of the unit holders.

Benchmark and benchmark-determined weights

Defining benchmarks: The first step in assigning weights to assets is to define benchmarks. The benchmarks could be any well established index for a particular asset class, such as Sensex for equities, Crisil bond index for debt, Commodity index such as Reuters/Jefferies CRB futures price index for commodities or real estate index such as FTSE EPRA/NAREIT global real estate index for property. The benchmarks consist of a set of securities or assets, with each security or asset having a weight in the index. The weights of individual securities/assets in a benchmark index could be used as the yardstick for assigning weights of securities/assets in a portfolio.

Benchmark-determined weights: Once the benchmark is determined, the weight assigned to individual securities/assets is a number, which is above or below the weight of that particular security in the benchmark. For example, if Infosys has a 10.9% weight in the Sensex, the weight of Infosys, if included in a portfolio could be either 15% or 6%. This weight would depend on the outlook for the stock, whether it will outperform or underperform the Sensex in the future. Similarly, if it’s bonds, then if, say, a 7.55%, 2010 bond has a 5% weight in the index, the weight of the 7.55%, 2010 bond could be higher or lower than 5%, depending on the outlook on interest rates for that segment of the yield curve.

Other factors

Benchmarks are not the only consideration in assigning weights of a security/asset in a portfolio. There are other factors that have a considerable say in the determination. They are:

Liquidity:  Liquidity plays a large part in the assignment of weights. Many of the heavyweights, as per market capitalisation, may not be as liquid, as the free-float could be low or distribution of shareholders could be skewed. This affects liquidity and a portfolio which aims to be liquid may have to lower weights of securities that have liquidity issues.

Strength of forecasts: If there’s a lot of conviction on the performance of a security/asset, there is a good reason to assign larger weight to that security/asset in the portfolio. This is especially true if there’s enough research/due diligence done before placing a security/asset on the buy list.

This point is particularly important, as when a lot of effort goes into picking a security/asset, the fruits are commensurate with the effort involved only when it’s backed by enough weight.

Holding period: The holding period also determines weights in a portfolio. The longer the holding period, the more comfort in assigning higher weights to individual securities/ assets.

Increase/decrease in asset value: If one security/asset classes increases or decreases in value in higher proportion to the increase/decrease in value to other securities/assets in the portfolio, the weight of that security/asset moves up or down in the portfolio.

Investors, by either giving more thought on assigning weights of individual securities/ assets to their portfolios or studying the weights of securities/ assets of the funds they have invested in, are in a much better position to understand the risk-return characteristics of their investments. It forces discipline and makes it possible to take quick action when things start going wrong.