Forming A Supplementary Portfolio

As previously advocated in Forming A Portfolio, we believe the bulk of an investor's portfolio should be formed in accordance to the asset class and intra-asset class weights that are best suited for him. Nonetheless, we think a small portion (about 10-20%) of his portfolio may be allocated to assets which do not fall into the asset class and intra-asset class categories in the core portion of his portfolio. In this section, we take a look at some of the ways an investor may build the supplementary portion of his portfolio (or simply put, his 'supplementary portfolio').

1. “Best Bets”

It is common for investors to possess particular favoured single-country markets (for instance China, Russia or Indonesia) or favoured sectors (for example technology, healthcare or resources) and to feel inclined to invest in funds primarily invested in these markets or sectors. While such funds may potentially deliver much more attractive returns, their valuations also tend to be much more volatile due to their low diversification characteristics as compared to global or regional funds that invest across general sectors. Given their pronounced level of risk, we advocate that such investments be kept to around 10-20% of one’s portfolio so as to reduce the impact of the losses on such investments on one’s portfolio returns, should these investments move in a different way from that anticipated. After all, markets are ever-changing and unpredictable, and history has shown that investors often overestimate the predictability of markets as well as their knowledge in markets and investment products.

2. Profiting In Volatile And/Or Uncertain Times

As long-term investors, short-term trading is not an investment strategy we advocate as a driver of our investing decisions. Yet, given that markets are dynamic and can, at times be volatile especially when a major market event has occurred, opportunities for short term profits may be abound. In addition to incorporating niche preferred investments, an investor’s supplementary portfolio may be an avenue where an investor can apply tactical strategies. For instance, an investor may invest in a particular asset immediately after an event which has caused the asset’s price to plummet has just occurred, and exit from that long position a few days later by selling the same asset after its price has appreciated as the market recovers from the initial shock from the event. At times where a specific event has resulted in uncertainty in markets, strategies such as pair trading may also be used to garner profits regardless of the direction of the market in the end!

3. Alternative Investments

Specific assets which pose a low correlation to the assets in an investor’s core portfolio may be considered as part of an investor’s supplementary portfolio. These assets are typically not the usual equities or fixed income securities which are found in one’s core portfolio, but rather, are the alternative investments which include investments in commodities, precious metals, real estate, private equity and hedge funds, to name a few. Alternative investments are widely varied and also include funds that adopt ‘exotic’ or more sophisticated investment strategies such as those that invest in other funds; those that adopt a multi-asset strategy, which allows them to alter the weights of the asset classes in their portfolios with little constraints; or those that make significant use of derivatives to garner returns; and the list goes on!
Hedge funds and private equities are often inaccessible to the average investor due to their high minimum investment sums, however, commodities, precious metals, and real estate are asset classes that are easily accessible through investment vehicles such as unit trusts and exchange traded funds (ETFs). These actively and passively managed funds invest in the said asset classes, making it no longer necessary for an investor to purchase the physical assets in order to gain exposure to them, as they would require to traditionally!
The benefits alternative investments bring to an investment portfolio are significant. Depending on the type of alternative investment, apart from posing low correlations to traditional assets, they may possess the potential to perform well during market crises (such as that seen during the Asian Financial Crisis from 1997-1998 and the Global Financial Crisis from 2007-2008) and may offer much greater diversification than traditional investments. However, investors should be mindful of the liquidity risks that come with alternative investments and should also take note to invest in them only if they have gained a good understanding of what the investment is about (its characteristics, strategy, investable universe, risks, past performance, etc)!