Traditionally advisers have had limited options for sourcing stock ideas when building Australian direct equities portfolios, but custom solutions are now available to support advisers with an unbiased independent view on stock selection and holistic portfolio design. 

Key takeaways:

• Advisers designing equities portfolios must blend licensee broker research ideas with client stock preferences—sometimes to the detriment of overall portfolio health.
• Stock selection pitfalls such as chasing yesterday’s winners or sector overweighting can compound the problem.
• A key challenge for advisers has been the absence of independent expertise to help shift client thinking around portfolio composition.
• Third party solutions are now available to provide an unconflicted critique of a proposed or current equities portfolio, enabling advisers to present a compelling value-add to their client.

Advisers whose clients have direct equities portfolios—whether SMSFs or individual investors—usually face two choices in sourcing research data and stock recommendations. They can outsource their equities research and trading to a full-service stockbroker, or they can rely on their licensee via whom they receive data and market insights from a single aligned research provider. The licensee may also provide limited portfolio construction support, usually within a framework of generic investment guardrails and broadly categorized client profiles.

In designing equities portfolios, common pitfalls can include:

• As in other spheres of life, reliance on a single source of information can result in biased opinion and a narrowing of opportunities, or result in portfolios that are very tactical and require frequent rebalancing or trading.
• An analyst’s high conviction stock recommendation may well have merit as a trading idea but won’t necessarily be a logical addition to a carefully weighted and bespoke client portfolio.

However, third party solutions are now available to partner with advisers and provide an unconflicted critique of a proposed or current equities portfolio, enabling advisers to present a compelling value-add to their client.
 

The fundamentals of equities portfolio construction

The technical details of portfolio construction theory may be endlessly analysed and debated, but it is generally accepted that the basics of portfolio composition mean having a clear investment strategy and risk management framework, and a consideration of:

• Minimum and maximum number of stocks
• Maximum stock and sector weights
• Stock and sector correlations
• Transaction size and trading frequency
• Maximum cash holdings.

With the above in mind, the following hazards can also derail the design of a well-balanced, truly diversified Australian equities portfolio, on top of the pitfalls inherent in the limited research and support options open to many advisers.
 

1. Emotional decision making

As an added headache for advisers, clients themselves can inadvertently complicate the equities portfolio construction process. Some may have strong opinions on which shares should be included, particularly with Australian equities, given clients’ familiarity with many ASX-listed brands. Of course, it’s the client’s money and so entirely reasonable they should control where it’s invested—but in favouring a certain stock it’s unlikely the client is stepping back and considering the whole of portfolio impact.

For example, a client might be bullish on banking stocks and insist on holding all four major banks, irrespective of the effect of such sector overweighting on overall portfolio health. Or a client may present a portfolio overdiversified with too many stocks which might also be too highly correlated, or conversely a client may so strongly favour a particular security they want 50 percent of the portfolio allocated to it. Either way, the outcome is a portfolio far out of alignment with the long-term risk and return objectives the client ultimately expects their adviser to deliver on.

2. Chasing past performance

Similarly, many clients (and perhaps even some analysts) are prone to chasing yesterday's winners—often fuelled by media hype around headline stocks such as cannabis or baby formula stocks, to mention just two of many examples. Another pitfall in long-term portfolio construction is the danger of favouring last year’s high dividend stocks, an often risky strategy given high dividend payouts aren’t necessarily sustainable and may even indicate that a company is in distress.1

An ideal alternative—although a challenge for advisers—is to encourage clients to take a more forward-looking approach, based on sound data and trend forecasting across a wider equities investment landscape, and one in which clients are more open to considering unloved or overlooked stocks rather than just last year’s headline success stories.

3. Beware the comforts of home

For some clients and advisers, creating a diversified direct equities portfolio positioned for long-term growth may mean having to abandon their instinctive home bias in the form of a default reliance on familiar stocks and licensee-aligned research, and instead consider a bigger investment universe.

For example, international exposure can be achieved without necessarily needing to directly hold overseas shares. A client’s Australian equities portfolio can gain overseas exposure by buying domestic companies with significant offshore operations, or more tangibly by including ASX-listed exchange traded funds (ETFs), which are available for different countries, regions, investment sectors or specific overseas stock exchange such as the NASDAQ.
 

In practice: an adviser-client case study

Grappling with the pitfalls above can place an adviser in a difficult position, being pushed and pulled between the standalone trading recommendations of their licensee-aligned research analyst and the random stock preferences of a client on whose investment success the adviser’s reputation depends.

As a hypothetical example to illustrate how some of these problems can play out in practice, we’ll assume that a financial adviser’s client is a self-managed super fund (SMSF) member or trustee with a preference for direct equities and a portfolio of around 20 shares, ETFs and listed investment companies (LICs). The client has generally taken a DIY approach to equities research and places their trades via a bank-aligned online broker.

Over time, the ad hoc addition of new stocks—often based on a compelling analyst or product pitch —and resultant shifts in the portfolio’s stock and sector weightings have finally resulted in the client turning to their adviser for help in restructuring the portfolio for sound future growth and to align with the SMSF’s objectives and risk tolerance.

The adviser’s licensee’s proposed solution might be to sell all the direct investments and reinvest in managed funds or via a managed account. There may be advantages in such an outsourced option for some clients, but in this case the client wants to stay in control with direct equities. This leaves their adviser needing an expert, reliable equities offering beyond what their licensee can support, and one that is sufficiently independent, credible and well-articulated that it might alter the client’s thinking about stock selection and portfolio weighting. Crucially, the adviser is seeking an outsourced solution that doesn’t mean having to step away from owning and managing the client relationship.

A whole of portfolio solution

As discussed, reliance on a single research source or strongly held opinion (whether by an analyst or assertive client) can result in stock or sector bias and a high-correlation portfolio that is far from diversified. Conversely, being assailed with too many data sources can be contradictory and even paralysing. For many advisers, the sweet spot might be a middle ground via a single, independent source of unbiased expertise.

Fortunately, third party solutions are available from a handful of providers in Australia that can filter and condense multiple research data points, analyst insights and forecasting models into designing an optimum equities portfolio or giving a holistic, critical overview of a client’s current holdings.

These services give advisers a truly independent view, free from research analyst or client stock biases. Some solutions can even help advisers clearly explain a review’s findings to their client, a tangible value-add in trying to alter a client’s untrenched views on stock selection.

Ultimately, the adviser will have delivered their client a truly diversified equities portfolio—meaning one with the appropriate risk and return parameters and that is best positioned to deliver on the client’s long-term financial objectives.

Like to learn more?

Desktop Broker gives advisers all the tools they need to design and manage equities portfolios on behalf of their clients, plus insights and stock ideas backed by the latest broker research from Bell Financial Group.

Bell Potter Online partners with advisers to provide specialised independent support via its Portfolio Review Service, a full review or second opinion on client portfolios irrespective of your trading platform. Learn more on our website or get in touch with our team to arrange an initial chat.  

1 The Risks of Chasing High Dividend Stocks, Investopedia, 14 September 2021

Disclaimer: Desktop Broker and Bell Potter Online do not provide personal advice to retail clients. The information in this article has been provided for information purposes only. It does not take into account the investment objectives, financial situation and needs of any particular investor. These matters should be considered when deciding whether the transaction(s) is appropriate.