The weighting game

Picture a familiar scene: a client reveals that they have been sitting on £700,000 in a building society for the last five years after falling out with their last financial adviser, and liquidated their portfolio in September 2008, taking a 40 per cent capital loss.

It’s now five years later. The £700,000 has barely grown, but inflation has been eating away at its purchasing power. So, what advice should you give? The problem to surmount is that there is no ‘right’ advice. In terms of investing people’s money, what is good for one individual may be dangerously wrong for another. The key distinction between individuals is to do with their own asset allocation and financial situation.

Asset allocation is one of those terms that has been hijacked by all sorts of groups. So let’s be clear about what we are talking about. For an individual, it is the way that they have arranged their assets: how much of their wealth is in their home, in cash and in liquid securities such as stocks and bonds. Within a portfolio, it is typically the balance between equities, bonds, alternative investments and cash.

For a client, their personal and financial situation will be the primary driver of any asset allocation decisions. Consider a client who earns £150,000 a year, owns their own house and whose children are no longer dependent on them; the correct asset allocation will be very different for a 24-year-old client who has inherited the capital and has no other assets or income.

To an extent, this all seems pretty self-evident. However, there is another key component that underpins any attempt to build a rational personal asset allocation. This relates to the client’s ability and willingness to take losses, and the important distinction between the two.

An individual’s ability to take loss is driven by several factors, the most important of which is their level of income and amount of capital the person has relative to their expected future obligations. A client with £300,000 in earnings, a £500,000 mortgage and three children in private school has a very different ability for loss than if they had no children and no debt. The important point here is not to muddle this with an individual’s willingness to take losses, which is an entirely subjective measure.

For some, such willingness will change violently from time to time, and may also be deeply influenced by losses or gains on the investment portfolio, and events in their private lives. When you are trying to construct a portfolio for a client, the asset allocation will be driven by both, and a key part of any private client practitioner’s role is to remind clients of their capacity at times when they get carried away either with enthusiasm or dejection.

Class control

At its simplest, we are faced with four client types:

• willing and able to take risk (for example, Richard Branson)

• willing but unable to take risk (a contestant on The Apprentice)

• unwilling but able to take risk (Scrooge); and

• unwilling and unable to take risk (Miss Havisham).

If you are faced with four individuals of the same age, with the same amount of capital, the most important point is to establish into which of the above four categories they fall. This is the first step in choosing their correct personal asset allocation. Once this is worked out, there is still the task of allocating the £700,000. The choices are, at their most simple, to buy shares, bonds or leave it in cash; this is making an investment asset allocation choice at the portfolio level.

Each investable asset class will contribute different characteristics to the portfolio. Within the equity portion, we are trying to balance out the conflict between investing everything in our favourite share and trying not to invest so broadly that we dilute opportunities for reward. This is important because when you have a share portfolio, even if you merely increase your number of holdings from one share to two, you dramatically reduce the severity of loss.

Once you hold more than ten different companies you have diversified away a lot of what is called the idiosyncratic or ‘non-market’ risk. In practice, this means that if you had just owned RBS shares during the financial crisis, you would have seen the share price fall from £57 to £1.99 – a 96 per cent fall. Vodafone shares, meanwhile, went from £1.96 to £1.16 over the same period – a 40 per cent fall.

Therefore, a portfolio containing equal values of the two shares at the start would have lost much less money than one only owning RBS.

Within the fixed income portion of the investments, we are looking for both capital stability and income predictability. For different clients, these two components have very different levels of importance. If the client is dependent on the income from the portfolio, the quantity and predictability of the income flows may be of prime importance. But if this is a pool of capital that will not be called on for several decades, income volatility should be of no concern.

Finally, the alternatives portion provides a less clear-cut role, given the wide range of available financial instruments, from hedge funds to property. However, a common shared characteristic is the scarcity of liquidity. Only certain clients will have the ?ability to forgo immediate access to their funds, while many more will be willing to reap the rewards of the liquidity premium.

Risky business

With all this considered, your client is still waiting for advice. What you tell them depends on your interpretation of conversations on the aforementioned topics. Similarly to the earlier classification of clients, Thurleigh tends to see individuals fall into four basic types: very low, low, medium and high risk, and construct portfolios to reflect this. If we look at the two ends of the spectrum, you can see the differences.

The very low risk model has 77 per cent in fixed interest, compared with just 9 per cent in the high risk model. (See charts below with their current holdings underneath.)

• Equity 13%
• iShares FTSE100 4%
• iShares MSCI Emerging Markets 3%
• iShares MSCI World 6%
• Absolute return funds 7%
• Newton Real Return GBP Inst Inc 3%
• Troy Trojan O Inc 4%
• Fixed interest 72%
• J.P. Morgan Strategic Bond C Inc 12%
• Jupiter Stategic Bond I Inc 10%
• M&G Strategic Corporate Bond I 10%
• Pimco Diversified Income GBP Hedged Inc 10%
• Pimco Total Return Fund GBP Hedged Inc 10%
• Pimco Unconstrained Bond Hedged Inc 10%
• iShares Markit Iboxx GBP Corporate Bond 1- 55%
• iShares Markit Iboxx GBP Corporate Bond Fund 5%
• Cash 8%

 

• Equity 73%
• Marlborough Multi-Cap Income P Inc 4%
• Marlborough Special Situations P Acc 5%
• iShares FTSE100 7%
• Allianz Continental European Fund (UK OEIC) 4%
• Jupiter European Equity I Inc 6%
• iShares FTSE China 25 Fund (FXC) 5%
• iShares MSCI Emerging Markets 13%
• Fidelity Global Real Assets GBP Acc 5%
• Fundsmith Equity T Inc 5%
• Morgan Stanley Global Brands Inc 5%
• iShares MSCI World 14%
• Private equity 2%
• HG Capital Trust 2%
• Absolute return funds 11%
• Troy Trojan O Inc 5%
• Winton Ascension GBP 6%
• Fixed interest 9%
• J.P. Morgan Strategic Bond C Inc 3%
• Pimco Diversified Income GBP Hedged Inc 6%
• Cash 5%

What is important to note is that while the asset allocation is significantly different, the actual assets we own are very similar.

The next most important aspect of asset allocation is that it should change with time, and it is this change, or the absence of change, that causes a significant proportion of the distress many investors feel. Asset allocation needs to change because the world is always changing, and so both the risks and the opportunities available in the markets change.

At present, the most significant divergence relates to the value of government bonds. These are a standard part of many investors’ asset allocation models, so investment advisers carry on buying them – this is despite the fact that their returns are the lowest in recorded history, and they are almost certain to lose money in all but the most extreme circumstances. Equally, there are times when equity market valuations reach unusual highs, and at those times it may not be prudent to allocate a significant portion of the portfolio to them.

There is significant academic ?debate about the correct frequency ?of change for asset allocation, and also with regard to how often portfolios should be rebalanced. There is no clear answer to this, other than it being essential to make changes that reflect ?the current environment.

The sandchart above shows asset allocation of Thurleigh’s low risk portfolio over the last decade. What’s
striking is that the government bonds (orange) was, over a three-year period, entirely replaced by corporate bonds. The absolute return portion (light blue) has fallen from 30 per cent to 10 per cent and been replaced by equity

Rebalancing act

In terms of rebalancing the portfolio, we (and many others) tend to do this also on a quarterly basis. In practice, this means that if we have a portfolio where we have made no asset allocation changes, when our investment outlook has not changed, but one asset has significantly outperformed another, the portfolio is now unbalanced.

For example, imagine starting with a portfolio that is composed of a 60/40 equity/bond split, and over the subsequent six months bonds have been flat but equities have gone up 10 per cent, the equity percentage will have risen to 62 per cent. There is now a choice. Do you allow equities to stay overweight? This would imply one of two things: either you expect the bond portfolio to catch up, which will act to reduce the equity overweight, or you expect equities to fall.

For many advisers, this is a classic pitfall in portfolio management. When a portfolio asset has gone up, there is a reluctance to take profits and bring it back to the target asset allocation. In many cases, managers would disagree that in not rebalancing they are, by implication, expecting equities to fall, either in absolute terms or with reference to bonds.

Rebalancing is almost more important at the individual asset level, where variabilitwy is at its ?most extreme. Whether you hold individual equities, or funds, performance will differ between them, and this will cause one position to become overweight or underweight.

Rebalancing continues to be one of the hardest aspects of portfolio management about which all parties can agree. Advisers do not like it as it creates change; investors do not like it because it often creates tax liability, and may cause increased cost and turnover. And investment managers do not like it because it seems to force them to sell their winners and buy their losers.

However, a simple quarterly rebalancing strategy would have transformed investment outcomes over the dot com boom in 2000 to 2003, and during the financial crisis of 2007/2009. In both cases, holding a stable 60/40 stocks to bonds portfolio, you would have acted to sell equities at the peaks and to buy them at the lows.

Asset allocation is a usual outcome of knowing your client, and attempting to build the most suitable and appropriate portfolio for them. What you are trying to do is balance the various risks and rewards of different asset classes, to provide a more consistent and less volatile stream of returns for your client.

However, to be effective, it is a process that continues over time, with both the assets changing, and the portfolio being rebalanced to reflect those changes and market movements.

Charles MacKinnon is CIO of Thurleigh Investment Managers</