Part 3: Looking Inside the Box
Once the foundation of a portfolio is set, we look ‘inside the box’ to ensure every component is performing its specific role. This requires a disciplined approach to how we define defense, how we protect value, and how we select the experts who manage your capital.
1. True Defense vs. Juiced Returns
A common industry tactic is to "juice" the returns of the defensive portion of a portfolio by taking on extra credit risk, essentially lending to riskier companies to squeeze out a higher yield.
While this looks good on paper during stable times, we believe defensive must mean defensive. We categorize high-yield or private credit as ‘Growth’ assets because they carry higher risks of default and can become difficult to sell (illiquid) during a crisis.
Our defensive allocation serves two vital purposes:
Protection: It must hold its value when markets turn volatile.
Optionality: It must be liquid. If the market crashes and growth assets become ‘generational bargains’, we need the cash ready to deploy. You cannot buy the dip if your defensive money is locked away in risky loans.
2. Factors, Styles, and the "True to Label" Mandate
Investment success is often cyclical. At different times, different styles of investing—such as Value (buying cheap), Growth (buying fast-movers), or Quality (buying the best)—will be in favor.
We view these styles as different ‘fishing ponds’. To build a robust portfolio, we ensure our managers aren't all fishing in the same pond at the same time. This leads to our strictest rule: No Style Drift.
The Commitment: If we hire a manager because they are an expert in "Value" investing, we expect them to stick to that discipline, even when Value is out of favor.
The Risk of "Drifting": When a manager abandons their stated style to chase whatever is currently ‘hot’, it creates unwanted concentration in the portfolio. It breaks the balance we have carefully constructed.
At Bellmont, we value managers who are true to label. By the same token, we will not judge a manager relative to broader benchmarks, but rather to their style benchmark to determine their true skill, known as Jensen’s Alpha. We don't mind if a specific style is temporarily out of fashion; we do mind if a manager loses their process. Consistency is the only way to ensure the portfolio performs as intended through every market cycle.
3. The Mechanics of Protection: Absolute vs. Relative
We look at protection through two distinct lenses:
Absolute Protection (The Shock Absorber): We use a lever called Duration (i.e we buy bonds), the sensitivity of bond prices to interest rates. Historically, when markets panic and a recession looms, interest rates fall and bond prices rise. This creates a ‘flight to safety’ trade whereby investors seek risk free government bonds in those moments. By carefully managing duration, we ensure that when your growth assets "zig" (drop), your defensive assets "zag" (climb), cushioning the overall impact on your wealth.
Relative Protection (Diversified Alpha): This is about beating the benchmark through skill. However, skill is only useful if it is diversified. If all our managers try to win using the same strategy, they will likely all lose at the same time. We specifically look for ‘uncorrelated’ success, managers who find value in different places and in different ways.
4. Position Sizing
Position sizing will differ depending on your portfolio objectives and risk limits. It is one of the most important elements of portfolio construction. It is often said that a good fund manager only gets six out of ten calls correct. Because portfolios are rarely equally weighted and returns are rarely equal, position sizing becomes critical to ensure one bad decision doesn't override many correct ones.
The size of our active positions (i.e. how much more than your benchmark you hold) will always reflect our conviction and risk (both quantitative and 'real' risk—see Part 2 of this series) relative to any deviation from the stated benchmark. This construction is considered at the asset class level, the individual product level, and the total portfolio level when examining underlying exposures as different products combine.
Conclusion
Portfolio construction starts well before you select any investments. It is critical to properly understand objectives and risk profiles so that appropriate allocations can be made. By deeply understanding market psychology, fundamentals, and the pitfalls of traditional models, we can construct portfolios that genuinely reflect the desired risk profile of our clients.
We are conscious of human biases toward active management, so we are clinical in using data to guide us toward cost-saving passive options where it makes sense. When we do utilise active management, we ensure managers don't simply get rich by risking your money (i.e. taking all the upside with no downside), and that you retain the majority of any outperformance. Once we adhere to these overarching principles, we can address the nitty-gritty: asset allocation, manager selection, and portfolio position sizing decisions to best suit your objectives.
This post is part two of a three-part series on portfolio construction. You can read part one here and part two here.