From Theory to Execution, My Portfolio

  1. European Energy fund

Aims for this piece

  1. A reminder of my portfolio theory
  2. How I calculated each potential fund’s exposure to high CAPE economies and potential as an inflation hedge
  3. Explanation of a scoring metric I use to evaluate the two aforementioned properties
  4. Individual analysis of funds
  5. Final allocation decision

A Reminder of Where We Are

My objective: Based on the MSCI World Index, create a portfolio of funds that limits exposure to high CAPE economies, whilst considering sectors that have historically performed well in inflationary periods. See the theory behind his portfolio here.

To formalise the decisions making processes of allocation in my portfolio, I decided to create a scoring metric. This metric should value inflationary hedging and CAPE exposures equally.

I will select some candidate funds to use these measures on.

Calculating the CAPE and Sector Exposure For each Fund

My metric aims to understand how each fund is valued (CAPE and inflation hedging) relative to the world equity index. So I first needed to express how much each fund achieved was exposed to CAPE or inflation hedging.

To measure CAPE exposure, first I needed a reliable and consistently updated data set for the CAPE of multiple countries, which I found in a Barclays data set: I then found the geographical exposures of each fund, which could be found in their fund fact sheet. Then, by multiplying the exposure to each country by their CAPE, I created a weighted CAPE exposure.

From my last piece, to hedge inflation whilst growing exposure to equity, I outlined my approach in gaining exposure to sectors that perform well in inflationary periods.

So I first needed to know how each fund was exposed to each sector. This was easily available in their fund fact sheet. This is where the measurement becomes a bit abstract. There isn’t an easy metric that allows me to quantify the quality of each sector’s hedge of against inflation. My best option was to subjectively score each sector according to this graph:

Being conservative with scoring, I only awarded extra weight to energy (of 1.25), all other decent performers (Utilities, Cons Staples, Industrials and financials) scored the same(score of 1). I would then create the inflationary protection measure by multiplying the sector weight by the score, indicating exposure to protectionary sectors. Notably, I didn’t include negative weighting

Overall, my data sheet looked like this:



As you can see, the two exposures (CAPE and inflation hedge)are at the bottom of each table.

Creating the Scoring Metric

Now I have exposures I should be able to quantify how valuable each fund is to me. At first, I tried to add these scores directly, but since the two values are not on the same scale (In this case inflation stability was had a maximum value of 1.25, whilst CAPE’s was 34) any maximisation was skewed to CAPE.

I calculated the CAPE and Inflation scores as the percentage difference from the World fund scores.

Deciding What Funds to Purchase

The method of score maximisation did not yield a readily-made perfect portfolio. But it did give me the order in which the funds were optimal according to the scores.

European Utility Fund

Because of the absence of US equity and exposure to the UK, Germany and Spain(These are low CAPE economies), this fund provided a good (low) weighted CAPE. In addition, the 100% exposure to utilities meant that it scored high in my inflationary hedge score. The only major issue is concentration in the sector exposure toward utilities. This is a candidate fund.

Emerging Markets Fund

Here the CAPE component dominates the inflation hedging capabilties, meaning it is unlikely to be very useful in my portfolio. Furthermore, the low CAPE is driven by EM exposure, which is something that I have not discussed yet. This fund is unlikely to be added to my portfolio any time soon.

World Energy Fund

Here we have the opposite story of the EM fund, the inflationary hedging component dominates the CAPE effect. This has the potential to be incorporated into my portfolio, but only in a minor way due to its high CAPE and concentrated sector nature.

If we evaluate a 50/50 portfolio of the World Energy Fund and the Europe Utilities Fund we get this:

This performs brilliantly in inflationary terms but drives the CAPE up unsustainably. This has limited use in my portfolio.

Global Clean Energy Fund

This offers both a good CAPE and inflation hedge. Although this is strictly dominated by the Euro Utilities Fund, it offers what we needed … sector diversification.

Although still mainly based in utilities, it does offer good exposure to industrials.

This is not a perfect diversification effort, but this could be considered with the good CAPE and Inflation hedge performances.

This is how a 50/50 portfolio with the European Utilities Fund holds up:

UK 100

This is the best CAPE for a DM economy. Offering also some sector diversification, being overweight in all inflationary hedging sectors:

Although the inflationary protection is not the best, the CAPE is great. However, were exposed to greater risk since this is just one economy, which I have not yet had a chance to express. So it will not be included now.

European Energy fund

Given the absence of decent energy with good CAPE, I went searching and found a European Energy fund. Offering a CAPE of 16.97 and an inflation hedge score of 1.25, this was a top performer by my standards. When added into a 50/50 portfolio with the Euro Utilities Fund:

This is great. It more than halves my CAPE score and increase an inflation hedge by ~ 5x.

Final Decision

To start the decision process I’ll begin by evaluating an equally weighted portfolio[1] of my three most favoured funds: the Euro Utility fund, Global Clean Energy and Euro Energy:

Overall, this is a good result. My portfolio success hedges against high CAPEs and inflation, evidenced by -15 and +.76 in CAPE and inflation hedge respectively.

This portfolio is ~21% overweight in UK exposure, indicating a high concentration. Ideally, I would like to see CAPE derived from some other lower CAPE developed economies, like Germany.

The inflation hedge is not perfect either, it is too concentrated in utilities and energy. Although these concentrations are a consequence of my constraints on the number of securities I can buy, I need to fix this ASAP.

My overall portfolio will begin as a 50/50 world equity and my hedge portfolio. Giving the exposures:

I will rebalance this next month to a 25/75 split favouring my hedging portfolio:

[1] An equally weighted portfolio is necessary, due to the constraints my broker has with minimum investments and my monthly investment budget.