Building a Smart Portfolio, Simplified

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Asset management can be a complex thing, but creating a portfolio follows a few easy-to-understand steps. In this post, we will lay out the fundamentals of portfolio construction and explain how it works through the example of a FinEX Asia US consumer credit portfolio.

Strategy

Just the same as every equity or fixed income fund, the first step is to identify a portfolio strategy to execute the objectives of the fund, including a quantifiable annual return target, risk appetite and maximum drawdown. To do this, it is important to understand the inherent risks of the asset class. For FinEX Asia’s US consumer credit funds, each individual borrower’s credit risk is not only to be assessed, but in fact, what we are taking on collectively, in exchange for the returns we expect to get. Diversification is important as the more individual risks we are taking on, the less exposed we are to any single one of them.

Modern portfolio theory suggests that idiosyncratic risks can be mitigated by diversification. The risk in a portfolio of diverse individual stocks will be less than the risk of holding any one of those individual stocks, as long as the risks of the various stocks are not closely correlated. FinEX Asia’s US consumer credit funds diversify loans in one of two primary ways. Our fund managers can passively diversify by mixing borrower credit gradings or actively diversify by cherry-picking single loans via the platforms’ daily auctions, employing more in-depth analysis and parameters.

As a result, the FinEX Asia consumer credit portfolio in a steady state consists of tens of thousands of loans, all run through screens. Because of the large universe of loans, manual screening across 800 variables of each single loan will be impossible, so we screen with our AI risk system. This allows FinEX Asia to limit the correlation between single loans because individual households are more idiosyncratic than instruments of most asset classes. We examine the characteristics of the aggregate portfolio (e.g. average FICO score, duration, etc.) in a similar fashion to quantitative or systematic equity portfolios.

Monitoring

Once the portfolio is built, we move into monitoring the portfolio on a daily basis. One primary difference between typical equity portfolios and FinEX Asia’s consumer credit portfolios is that there is not a secondary market at the moment, so we cannot get tick-level updates on pricing, instead relying on daily pricing information from the platforms the loans are purchased off of.

Pricing for US consumer loans is not like typical bonds or equities with dividends because repayment happens in jumps as most loans are repaid in certain weeks and not evenly disbursed across the month. This means the ‘market’ price of the portfolio is typically determined by the delinquency rates.

Cash optimization

A well-built and appropriately monitored portfolio will generate returns, and in the case of our US consumer credit portfolios, this takes the form of cash from repayment. As principal and interest are paid off, the portfolio generates cash to reinvest into the same risk profile or perhaps into higher yielding profiles. In normal circumstances, if we do not reinvest, we have a cash drag. On the other hand, if our risk model indicates that delinquency is rising, we can compensate by moving into safer profiles, and even by increasing our cash position.

The other use of cash is to make our dividend payouts. Beginning with an assumed annualized charge-off rate for our risk profile, we decide our dividend payout ratio. Working back from the charge-off rate, we can determine how much cash we need to keep in the portfolio to charge-off defaults and pay upcoming dividends. Using the international accounting standard, IFRS9, requires us to set aside a 12-month provision for charge-offs. This provision allows the fund to meet all obligations in turbulent market conditions.

Register with FinEX Asia to learn more about how we build our portfolios, as well as see fund performance and specific strategies.

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