The whole investment industry in the UK is built around trying to get you to buy the latest "best idea", be it a fund, an investment strategy or a new business concept that can be floated on the stock market. Innovation is always great, but what many investors crave is a simple framework that knits lots of ideas into one straightforward portfolio that can house shares, funds and other financial instruments.
But how do you go about building a portfolio that starts to meet your own objectives and is calibrated to your level of risk? The obvious answer is to consult a professional adviser - with luck your advisor will have enough knowledge of the market, and some understanding of the academic debates about sensible portfolio construction to build a personalised approach.
But not all private investors are quite so lucky - many independent financial advisers (IFAs) are happier dealing with mainstream financial products and farm out their asset allocation analysis (the term used in the trade to describe portfolio construction) to bigger firms that rely on black box software systems to produce 'model portfolios'. These portfolios may well do the job, but the principles behind them are rarely spelled out and openly debated. This is where our new Master Portfolios come in.
Each of our Master Portfolios is built around a set of simple principles - some of them are uncontroversial, others highly debateable, but all detailed and explained. The crucial point here is that we've devised each of these portfolios to suit different types of investors:
These portfolios are not built around a clever black box system where we've fed in lots of statistics from different markets and assets and then tried to look for the best result over the past few decades. Our approach is to take whole asset classes and key stock markets where appropriate – for the UK we use the FTSE All Share index – and then leave open the way that you might capture this future return. To get us to a starting point we've looked at dozens of notional and actual portfolios published from around the world including those from big British IFA firms, the Financial Times' own survey of wealth advisers plus academic analysis of big pension funds. We've looked at the assets held - the range of holdings and the key themes - and then constructed average holdings which we've modified using our own asset allocation principles.
How you capture the asset classes or markets is up to you - you might for instance use an actively managed fund that targets the particular asset class via its benchmarking policy (many UK focussed funds use the FTSE All Share as their reference point for example). Alternatively you could use a tracker or index fund to capture that return – this could be done via a unit trust tracker or a listed exchange traded fund (ETF).
About the Master Portfolios
■ They are based on asset classes and key markets, not individual shares
■ There are never more than fifteen types of investments or asset classes
■ Easy to operate on a day-to-day basis
■ They should be easily investable. This means the asset classes can be easily tracked via a fund
■ Based on a risk profile and/or stage in a lifecycle
■ They are not optimised. Although we test backwards for the mix of assets we don’t seek the most optimised solution - just the one that works most of the time
Asset Allocation Principles
Basic principles
1. All portfolios are a trade-off of risk and return. Essential to this is the concept of the glidepath over time (when it comes to pensions) where the balance between risky assets and less risky assets changes over time
2. The better risky assets are equities rather than bonds although we accept that over certain periods of time bonds can produce higher returns.
3. Based on academic evidence we maintain that on balance a diversified portfolio is better than an undiversified portfolio, and that optimal diversification is probably achieved with a minimum of five to six asset classes
4. The data suggests that developed world markets are increasingly correlated and that there is no great advantage in diversifying within developed world markets unless there is convincing rationale that says otherwise ie to target small caps or value stocks based on portfolio assumptions.
5. International Diversification is crucial. Investors should seriously consider the importance of global diversification, particularly with reference to emerging and frontier markets
Current views
1. Emerging markets will power ahead over the long term and investors should have some bias if they're growth orientated.
2. Although we don't think inflation will be a short term issue we do believe there are heightened risks over the very long term. So the short term portfolios have low exposure to inflation-linked government bonds while the long term portfolios have more exposure to them.
3. We are careful about commodities, and don't think they fit in all portfolios, only a few. So the mid to low risk portfolios have relatively little exposure to them.
4. We've avoided too much UK equity bias and the long term portfolios have a high exposure to global indices.
5. We're very cautious about corporate bonds in all portfolios
6. We like the growth of what we call Equities Rest – utilities, infrastructure and Reits.
7. Although there is a strong argument for equity income bias within developed world equities we have chosen not to favour this over a straight UK FTSE All bias.
8. Over the long term commodities are an alternative asset alongside forex funds and hedge funds, and not necessarily correlated with equities or bonds. Alternative assets have a place within investors portfolios in all but the lower risk versions
9. Investors should not seek international diversification either within government or corporate bonds. This is based on accessibility – it's very difficult to find funds that do track global bonds – and exchange rate risk.
10. With most portfolios we simply use the default national index – in the UK the FTSE ALL. Within the UK for some portfolios we do introduce a size bias, breaking up into large, mid and small cap components and weighting towards small caps marginally.
11. We have not made any distinction in our weighting system within bonds between long and short dated gilts – it is difficult to capture this efficiently through funds
