Empire building: the diversified portfolio

25th October 2010

There are two key steps on the road to designing and building a successful portfolio of investments. The first is to work out your asset allocation, namely how much to invest in each of the different markets and asset classes. It is then a case of selecting the various funds that will give you the required exposure.

The initial asset allocation

James Davies from the IFA Chartwell says it is critical investors avoid exposing themselves to just one asset class as being diversified helps to cushion the risks. In view of this Davies suggests that you should hold a mixture of UK and overseas shares as well as fixed income.

"It's not necessarily important to have all your investments performing well at the same time as that would suggest that they are all highly correlated."

Davies says a good place to start is to look at the historic real returns of the different asset classes. "Equities come out on top with an average annual excess return of 6% or 7% over and above inflation, so the longer your investment time horizon the greater your exposure to equities should be."

An easy rule of thumb is to invest the equivalent percentage of your age in fixed interest, with the balance of the portfolio in more risky assets that are likely to generate the better returns. 

This would mean that a 40 year-old would hold 40% in bond funds with the remaining 60% in a mixture of equities, commercial property and commodities. Unfortunately this is rather a simplistic approach for arguably the most important stage in the investment process.

"Determining a suitable asset allocation really comes down to understanding how each asset class behaves and what the impact of blending different asset classes has on the overall volatility and returns of the portfolio," explains Martin Bamford, a Chartered Financial Planner at Informed Choice Ltd.

The world in numbers

The initial allocation will depend on what sort of return the investor needs, how long they plan to invest for and how much risk they are willing to take.

Bamford says that for an adventurous investor with a 15 to 20 year time horizon they would typically recommend around 25% in cash and fixed interest, with 70% in equities and 5% in commercial property.

Adrian Lowcock, a senior investment adviser at Bestinvest, says that sorting out a portfolio would usually involve talking to a financial planner who could help the investor to determine their long term goals.

"Many people don't want to pay the fees associated with that, therefore it would be best to talk to an investment adviser, who at least will be able to point them in the right direction and hopefully be able to advise on the correct asset allocation and funds."

He suggests that a cautious investor with a 15 to 20 year investment horizon would probably start out with a moderate risk portfolio and would be looking for growth. The following would be his recommended asset allocation:

 

UK Equities

26%

Europe

8%

US

10%

Japan

3%

Asia ex Japan

6%

Emerging Markets

5%

Quality Bonds

15%

High Yield Bonds

6%

Property

6%

Absolute Return Funds

9%

Commodities

3%

Cash 

3%

 

100%

 

Steady as you go

Having decided on the initial asset allocation it is then important to keep it under review so that you can modify it as and when required. How often you need to do this will depend on the size of the portfolio and how active you want to be.

Bamford says that for the majority of their clients, an annual review is what they need and keeps their portfolios suitably invested over the long-term. "More sophisticated investors and those with larger portfolios will want to review things either half-yearly or quarterly."

Davies agrees with this although he adds that you should also review things whenever you go through a major inflexion point in your life, such as when you get married, have children or retire.

Selecting the funds

There are two ways for an investor to select which funds should make up each of the exposures in their portfolio. The first is to pick those that are likely to behave in a similar way to the overall asset class.

"Using passive funds or ETFs makes sense for this as you will get a minimal tracking error and a low cost of investing," explains Bamford.

The alternative is to select single asset class funds in the correct proportions. If doing this it is important to concentrate on the actively managed ones that justify the higher fees rather than the closet trackers that do not.

"Both approaches have merit and investors might choose to use both tactics within a single portfolio to get the best results," notes Bamford.

When choosing an actively managed fund the starting point is to look at the past performance. The tables for each of the different asset classes are freely available on websites like Trustnet, which can be viewed here. But there is a lot more to it than just picking the one at the top.

"Past performance will tell you part of the story but it is important to bear in mind the reasons for the returns. The question you need to ask yourself is whether you would have expected that type of fund to perform in the way it has given the economic backdrop," explains Davies.

Some managers have a more cautious style than others and will outperform in a weak market while underperforming in a strong one. More aggressively managed funds would be expected to do the opposite.

Blending these different styles together is the final part of the jigsaw and investors who get it right can look forward to years of above market returns.

Leave a Reply

Your email address will not be published. Required fields are marked *