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Seven steps to a winning portfolio

A well-spread portfolio covering thousands of assets is just seven simple steps away

Seven steps to a winning portfolio

Putting together the right mix of assets is the most important job we face as investors. Unfortunately, many of us don't treat it this way. Although the principle of "not putting all our eggs in one basket" is widely known, a lot of us end up with portfolios that look more like scrambled eggs. Rather than thinking about how assets might work with each other, we typically just throw today's hottest tips randomly together with yesterday's.

It doesn't have to be this way, though. A wealth of academic research and real-life experience has shown what a successful combination of investments might look like. Putting these ideas into action doesn't call for costly advisers or complex mathematical models, either. In fact, you could very well achieve winning results with nothing more than a humble spreadsheet and a straightforward brokerage account. Meet the seven-asset portfolio.

This simple but effective allocation strategy is the brainchild of Dr Craig Israelsen, finance academic at Utah Valley University, who specialises in analysing mutual funds and designing portfolios. Dr Israelsen showed how a US portfolio made up of seven simple and easy categories that requires only annual maintenance and can produce winning returns over time.

 

Israelsen's seven-asset portfolio

 

The seven-asset portfolio he proposed was made up of same-sized holdings of US large and small-cap stock, foreign stocks, real estate, commodities, bonds and cash. Each holding therefore makes up one seventh or 14.29 per cent of the portfolio. Once a year, the portfolio is rebalanced in order to restore this split. Between 1970 and 2009, the seven-asset portfolio delivered an annualised total return of 10.5 per cent a year.

This was better than the returns from the traditional 60/40 allocation of US large-cap stocks and bonds, of 9.6 per cent yearly. Not only was the return better, but also the risks taken lower. The volatility of annual returns was 10.6 per cent against 11.9 per cent for the 60/40 approach. Based on this impressive outcome, I’ve put together an Israelsen 7-asset portfolio for the UK since 1980, using equivalent assets and similar rules.

 

UK seven-asset portfolio

 

UK large-cap stocks

Big-cap stocks are the mainstay of most equity portfolios. The original Israelsen allocation used the S&P 500, the longest running broad-based index covering the US market. The obvious choice for the UK is the FTSE 100 index, but its total return data only goes back to 1985. So, I've spliced the FTSE 100's returns together with those of its forerunner, the narrower FT 30 index.

 

UK small-cap stocks

The seven-asset allocation is quite aggressive in that it gives the same weight to small-cap and large-cap equities. Over time, small-cap equities in the US have delivered superior performance to their bigger brethren, most likely owing to their greater riskiness.

The same is true of the UK. According to Elroy Dimson of London Business School, a £1000 investment in British small caps in 1955 would have become £2.6m with dividends reinvested by 2009. The same £1000 in the large-cap dominated FTSE All-Share would have turned into only £0.5m.

This winning performance obviously came at a price of greater risk. Annualised volatility of UK small caps over the period was 19.11 per cent, compared to 16.9 per cent for large caps.

For UK small caps, I've used the Hoare Govett Small Companies index. While long-running, the major drawback of this index is that it’s not directly investible. Indeed, the lack of a decent small-cap tracker fund is an issue I will have to address going forward, although I have already found a way around this.

 

Overseas equity

Diversifying overseas is a less effective strategy than it once was. In a world where capital flows more freely than ever before, stock markets tend to move more closely together than they did in days gone by, and especially so during troubled periods.

To represent non-UK stock, I've gone with the MSCI World index, converting the returns into sterling. The MSCI World index covers some 1,600 equities from 23 developed country stock markets from Asia, Australasia, Europe, and North America.

 

Commodities

Commodities offer a great way to boost the returns and spread the risks of an equity-portfolio. The behaviour of raw materials like energy, metals and agricultural products has often been very distinct from that of the stock market. In the 1970s, commodities boomed while stocks slumped, as they did in the 2000-10 period.

Nowadays, it is simple to get widespread commodity exposure with a single fund. I’ve used the Goldman Sachs Commodity Index here, as it’s got a nice long history. The index reflects the total returns from investing in commodities, which come from price movements, as well as the costs and gains from buying new futures contracts, and also interest earned on collateral.

 

Real estate

The best way to own real estate is as directly as possible. Being an owner of a good spread of office blocks, factories, shopping centres and residential assets can deliver very worthwhile returns and lower risks over time. Naturally, such exposure is not really practical for anyone but the richest individuals and endowments. But exchange-traded funds offer a cheap and liquid way to buy into these markets with very small amounts.

The Israelsen seven-asset portfolio uses broad US REITs to represent property. For the British version of this portfolio, I have decided not to just use the UK real-estate investment trust (Reit) sector. Reits are a recent innovation in the UK, and the sector is much narrower than the American one. Therefore, I have chosen a Developed World Reit index, so as to give maximum diversification in terms of properties and countries.

 

Bonds

Despite their lower long-run returns, bonds are an absolutely key element within a balanced portfolio. For the basic version of this portfolio, I have used a copycat version of the FT Actuaries Gilt indices, which has the advantage of being long-running and also readily investible via a tracker fund. This includes government paper of different maturities, of fewer than five years and more than fifteen years. Currently, it is made up of some 41 different issues.

 

Cash

Cash has been a lousy investment in recent years, thanks to interest rates persistently running below inflation. Nevertheless, liquid funds earning interest have played a key role in balanced portfolios over time. For simplicity's sake, I've taken the returns from holding sterling and earning the three-month LIBOR rate of interest. This should be roughly equivalent to the return from an interest-bearing bank account or money-market fund.

 

The results

Since 1979, the UK version of Israelsen's original seven-asset portfolio would have earned a total annualised return of 11.3 per cent. By contrast, a bog standard, annually rebalanced holding of 60 per cent British large-cap stocks and 40 per cent British government bonds would have made 10.9 per cent a year. Not only did it produce a better return, but it did so with a bit less volatility: 9.7 per cent a year against 10.3 per cent.

 

Indices to track via ETFs for 7-Asset UK

UK equitiesFTSE 100
FTSE 250
Non-UK equitiesMSCI World
CommoditiesGSCI
Real estateFTSE EPRA Nareit Developed mkts
UK bondsUK iBoxx £ Gilts
Cash3m Libor

 

Aside from the benefits of a good spread of assets, these results also highlight the importance of regular rebalancing. Had the portfolio simply been allowed to run for the whole period, it would admittedly have produced a 0.1 per cent greater annualised yearly return. However, it would have suffered a much bigger peak-to-trough fall in value of 37 per cent at its worst moment, compared to just 27.7 per cent for the rebalanced version. Worse still, it would have ended up mainly in equities, and very little in bonds and cash, which would have been wholly wrong for a retiree after 30 years of investment.

 

 

The basic seven-asset portfolio would make a totally respectable long-term allocation for many investors, whether as a whole portfolio or as the core of one. In the accompanying table, a selection of ETFs with which one might build the UK seven-asset portfolio is shown. However, I reckon we can improve further on this performance, as Dr Israelsen has done. So, in the follow-up to this piece, I'll explore how we can maximise returns and lower risk even more.