What Is Portfolio Tilting?

Portfolio Tilting

I have recently taken to more study. This is again for an investment qualification, the Investment Management Certificate via the UK Society of Investment Professionals. It's a two parter, the first of which I completed last summer.

Last summer it was UK Regulations and Markets. Ugh. Learning around 150 pages of paraphrased financial services legislation is not the world's most exciting summer pastime.

This year, part 2 sees me get to grips with investment techniques, styles, economics, portfolio management, statistics and much more. The qualification is designed as a primer for fund managers (pensions, collective investments, etc) so it is fairly in depth. I am sure it will be interesting, finding out how a bond, pension or equity portfolio manager needs to think to get the job done.

For an example of depth, here is a little quote I found a few days ago, 'The beta of a portfolio is equal to the weighted average of the betas of the individual securities within the portfolio where the weights are just the market value weights of the portfolio's securities'. Whew!! No wonder people don't get high finance!

As with any study, you stumble across facts and theories you never realised existed. Even for people like me, studying investment, I come across new ideas (at least to me) every time I study.

So here is my first, 'Portfolio Tilting'.

I'm going to guess that you have heard of the main investment styles: passive and active fund management.

Passive management is generally referred to as index tracking. You pick an index, the FTSE 100 for example, and then you program a computer to mimic or replicate the index and then buy and sell transactions (or derivatives) are used to keep the portfolio as close to the real thing as possible.

Active management is the opposite. A fund manager does his best each day to find new investment opportunities in the market(s) to help his portfolio to profits. The manager probably has a set of guiding rules to play by. This may be because he or she manages a pension fund, so the investments need to have certain characteristics. Alternatively, a trust deed may set out exactly what can and cannot be invested in (a market for example, for a fund that is aimed at North American small companies).

These are chalk and cheese.

However, it appears that in the middle of these two is a third and growing style of money management, tilting a portfolio.

A tilted portfolio is essentially an index tracker with a little 'active management'.

Lets have an example:

Imagine that we have a portfolio tracking the largest FTSE 30 companies. On 31st December 2005, BP was the biggest and Marks and Spencer the smallest of those 30. Rather than hold equal measures of each company, the fund has holdings relative to the size of each firm in our top 30. The market capitalisation of BP was roughly 12.5 times larger than Marks and Spencer, so we have lots of oil shares (especially since Shell was number two on the list) and lots less Marks and Spencer.

In the largest 30 FTSE firms, banking is big business. In this order, the index had HSBC, Royal Bank of Scotland, Barclays Bank, HBOS and Lloyds TSB. All were ranked between number 3 (HSBC) and 13 (Lloyds TSB) by size.

Drinks on the other hand, are less well represented. The main two players are Diageo (15) and Cadbury Schweppes (29).

We'll presume that our fund manager thinks that banking will underperform and drinks outperform the market. By holding relatively fewer shares in the banks (to their actual weightings) and more shares in the drinks, a manager can tilt the portfolio away from banking and towards beverages. Other than that, the rest of the portfolio still follows the index. This tilt might only be a total of 1% of the fund.

If our manager is right or wrong, it can make a real difference to the portfolio. You or I may not notice it, but he (and his boss and bonus) will!

To you or I, if the index rises by 7% and a fund rises by 8.1% there is obviously a little unexplained tracking error. However, that would actually be stellar outperformance to a tilted portfolio.

Why am I telling you all this?

Simple. I had never been able to figure out how an index tracker can outperform an index. They have dealing costs, taxation and management charges to overcome, yet still, most years a few funds will beat the index and the fees. I had always presumed at some strange anomaly or a printing error, but no, it was meant to happen!

I, for one, am happy with this knowledge. I have had about ten friends and several clients ask me about this in the past, 'How did they do it? Is it good or bad that they did?' and I could never manage an answer of note. Clearing this little matter of logic is useful and I guessed that if I didn't know, neither did you.

* This was first sent to my newsletter subscribers in May 2006 *

Further thoughts:

The world of investment has clearly moved on since the article above was written in 2006. The arena of fund management has become much more computerised and even for relatively normal mutual funds and unit trust type investments and many pension funds, much more of the decision making happens by algorithm. This is especially true for low cost index trackers and geography is no boundary - though the article uses UK companies as examples, this is equally true on Wall Street. 

Problems with tilted portfolios tend to arise when either it is done by accident or it goes wrong and the investments underperform their benchmark before funds are applied.

To try and counter this, many funds use options and futures as a way of copying the underlying index without the hassle of actually buying the stocks themselves. This seems somewhat counter intuitive since the point of investing in a fund is to own a piece of the stock market. However, this is often not the case (many ETFs, for example, have very low cost structures but hold almost no actual assets). The world of stock market investing is not simple...

For more articles about related topics, please visit:

How To Copy A Fund Manager's Asset Allocation Techniques

Asset Allocation And Portfolio Management For Individuals

What Are The Two Main Fund Management Approaches?

How To Use Strategic Asset Allocation Techniques

Assessing Fund Performance

The Concentrated Portfolio

The Competitive Advantage / Business Franchise In Investment