Asset allocation for 2017

This may seem overly pessimistic, but sensible asset allocation can prepare portfolios for what 2017 throws up. And it is important to remember that, provided time horizons are long enough to ride out the tough times, historically those who stay invested have avoided missing out on recovery upside and profited most overall. Of course, this does not mean portfolios can't be flexed to reflect current macro circumstances and smart tactical asset allocation is about making calculated decisions to manage risk and enhance total returns.

Two Investors Chronicle asset allocations for the new year

Two of our balanced asset allocation portfolios have been designed for the type of conditions that we may see in 2017. One is a broad strategy that, although it has reduced exposure to certain assets, does not typically seek to exit positions altogether. At its heart is optimism that risk assets will outperform over the longer term and the belief that by having a broad geographical spread, we can avoid missing the best upside. The risk is tempered by allocations to cash and traditionally less volatile asset classes such as government bonds.

The second allocation is narrower and, while not quite advocating buying vegetable seeds and a shotgun, it is designed for more turbulent times if populist policies and economics play out badly in 2017. There are some sizeable positions (such as 10 per cent in gold) in volatile investments that can hardly be described as defensive, but the tactics employed are about proactively choosing which risks we feel will be rewarded in an uncertain environment.

Source: Investors Chronicle

What are the weightings justifications for these two tactical asset allocations?

Cash

Both portfolios hold cash and to a larger extent than many institutional investors, but professionals are paid to invest - they can hardly justify their fees by parking money in the bank and getting just base rate (or should that be basement rate) returns. Self-directed investors should hold larger cash positions in uncertain times, even when inflation could rise.

The main reason, of course, is defensive; even with interest rates on the floor and sterling diminished in value next to the currencies of major trading partners, it is worth having a proportion of your money insulated in case equities are volatile.

Gilts

UK government bonds (gilts) offer a paltry yield, so for investors holding new issues to maturity there is a real prospect of negative real returns. Bond funds buy and sell stock according to the duration profile and can make capital gains as yields fall and prices rise. This does, however, raise the spectre of capital losses if yields become more volatile.

The duration of a bond is its effective maturity - the length of time until the investor breaks even given their required rate of return. The further from maturity a bond is, the higher its duration will be and the more sensitive its price to changes in interest rates. For bond funds this means that longer duration bonds, while generally offering a higher coupon, are riskier as there is a greater likelihood of capital losses.

The gilt portion of our autumn asset allocation was 17.5 per cent, split between shorter one to five year bonds (7.5 per cent) and inflation-linked bonds with a longer duration (10 per cent). For our populism stress-test portfolio 15 per cent was invested in gilts, all in inflation-linked bonds. With the price of gilts being forced up by the Bank of England's further programme of quantitative easing (QE), investors are being forced to accept the risk of longer-duration bonds to achieve higher returns. The decision to opt for inflation-linked bonds is made to protect the real value of the coupon and there may still also be scope for capital gains, as the UK faces the uncertainty of invoking Article 50 and beginning the formal process of leaving the European Union.

Corporate bonds

With returns from safer government debt looking less appealing, many investors have looked to corporate debt for yield. Corporate bonds offer a higher coupon to compensate the investor for the ostensibly higher credit risk of corporate issuers and the lower levels of liquidity.

Good-quality corporate debt makes up 15 per cent of the populism portfolio; in practice some of the larger issuers are cash-rich and creditworthy, so offer a better return than sovereign bonds with not much more risk. As more investors have sought out this source of income, investment-grade fixed income has also become expensive, so the autumn portfolio opted for higher-yielding lower-rated corporate bonds. The added credit risk of this decision is hopefully tempered by the sizeable holdings of sovereign bonds and cash in the portfolio as a whole.

UK shares

One of the main advantages of a balanced long-term asset allocation is that it reduces the onus on market timing. Both portfolios have just a 15 per cent exposure to UK shares, which means that even though valuations are looking high in absolute (sterling) terms, the positions are not hugely overweight if the UK market should deliver stagnant or negative performance in 2017.

The approaches of the two portfolios are slightly different. The autumn portfolio opted for market-capitalisation-weighted indices of large and mid-cap shares, albeit that splitting investment with half in the FTSE 100 and half in the FTSE 250 has the effect of slightly tilting towards mid-caps compared with a straight FTSE 350 tracker.

The populism portfolio, with its more pessimistic outlook, focuses on the quality UK companies that have shown a propensity to grow their dividend. Given that many quality dividend payers, now seen as 'bond proxies' by some investors, are expensive relative to other UK shares it is highly plausible that these could underperform if the UK economy does better than expected in 2017. All things considered, market-cap-weighted investing in the long term will capture elements of quality income and value performance, although any short-term pullback in UK shares will be an opportunity to buy quality dividend payers.

Overseas shares

The populism portfolio opted to track factor indices representative of a defensive global equities strategy. Combining global quality and minimum volatility factors placed the onus on steady earnings in expectation of stymied growth. In terms of country exposure the products used reflect the make-up of the global equity universe by market capitalisation, with 50-60 per cent exposure to the US. This is not really a problem in terms of diversifying risk - as the 2008-09 financial crisis demonstrated, there are strong correlations between developed global equity markets, so more of a geographical split is unlikely to offer significant additional protection from any fall in global equities.

The benefits of spreading investments more evenly outside of the US is more likely to be felt if the global economy gathers momentum in 2017. According to many measures US equities have looked expensive for a number of years, so if growth picks up in other regions, such as Europe and Asia, there will be relatively more upside to be had here. Again, the autumn portfolio has more of a cap-weighted and region-by-region approach, with 7.5 per cent each invested in the US S&P 500, the broad FTSE Japan Index and European large-cap equities.

Both portfolios look to emerging markets to add some growth over the longer term. The populism stress test portfolio opted for a minimum volatility strategy, whereas the autumn allocation just went for a broad emerging market index. With risky assets such as emerging markets, minimum volatility may offer a degree of protection against fluctuations in sentiment but, as we should have already accepted risk as the trade-off for potentially higher returns over time, it is perhaps best to opt for an index that gives the best opportunities to profit from the regional industries and growth themes we find most attractive.

The equity styles followed in the populism portfolio are reflective of the defensive and income-focused strategies that investors have favoured in the low-growth environment. With valuations looking stretched for these styles, there is a belief that value stocks could perform relatively better in 2017. For companies that have been unloved or overlooked, there needs to be some change that makes investors believe assets they have previously not valued will become productive and generate added returns. Improved economic growth might provide this impetus to value investments in 2017 and, if there are positive signs, it could be worthwhile devoting a proportion of developed equity allocation to a value-style ETF.

Property and infrastructure

Donald Trump's election to the White House, the UK's vote for Brexit and dissent towards austerity policies across Europe has been a wake-up call to the ruling classes and resulted in a drastic fiscal rethink. This may mean inflationary pressures in the longer term, but in the shorter term expect to see higher capital infrastructure spending. This presents an opportunity to diversify risk with infrastructure funds.

More generally, commercial and residential property has been among the chief beneficiaries of monetary easing. The UK's leave vote may have shocked property funds in the immediate aftermath of the EU referendum, but then the cheap pound presented overseas investors with an irresistible opportunity to snap up property in what, by comparison with many parts of the world, remains a safe (and tax friendly) country to place capital. Global real estate can potentially suffer high volatility, but is another diversifier - certainly in the hunt for upside if the global growth outlook improves in 2017, and we retained a 10 per cent allocation in the autumn portfolio.

Gold

It may be a 'Marmite' investment, but for many investors gold has a place in any diverse portfolio allocation. The downsides are that it is a volatile asset class in its own right and offers no income. In a world where equity and bond prices are now positively correlated, gold's low level of co-movement with other asset prices provides genuine diversification.

A higher than usual 10 per cent of the populism portfolio was invested in gold, in readiness for a worst-case scenario where recession and inflation combined to create stagflation reminiscent of the 1970s. For the autumn portfolio a more modest 5 per cent in gold could help provide a temporary boost to the portfolio in any difficult periods for equities or bonds.

Which strategy will be best to follow in 2017?

For UK investors 2017 will be a year of challenges, not least when the UK government (following parliamentary scrutiny) invokes Article 50 to start the formal process of leaving the EU. The Trump presidency also provides preconditions for some of the most negative outlooks for global trade. Whether or not the general effect is as bad as some stress tests predict, mixed asset allocations give investors the best hope of mitigating uncertainty.

Choosing between the two, the preference at this time would be for the populism portfolio. The high degree of correlation in developed markets suggests that, in the case of a fall in equities, geographical diversification will not insulate investors from losses. This is not to say equity investing shouldn't be international, but in the case of the populism portfolio diversification is achieved by investing in international style indices. The minimum volatility and quality indices reflect that the US is the world's largest equity market, but go in search of companies that match their criteria, regardless of listing location.

To hedge equity exposure more, we can add some global value to the populism portfolio. Quality and minimum volatility may still be safer investments in a populist scenario, but with the US market (which makes up a large portion of equity allocation) expensive, the possibility that some ignored stocks start to perform well should not be overlooked. Taking 5 per cent from the UK Dividend ETF and making a slight reduction to the quality and emerging market allocations frees up capital for a 10 per cent global value position. Overall, this leaves the portfolio 55 per cent in equities, 30 per cent in bonds, 10 per cent in gold and 5 per cent in cash.

How risky do our portfolios look?

Analysing the likelihood of severe losses for the populism portfolio using extreme tail loss software from PrairieSmarts (this models risk based on empirical fat-tail distributions of returns), the loss expected in the worst 0.5 per cent of months is on average 3.5 per cent. Overall, the portfolio holdings diversify away 71 per cent of the risk of the individual funds and, over time, it is predicted to offer rewards 1.5 times greater than the risk experienced.

The autumn portfolio is projected to offer an exceptionally good reward-to-risk ratio of 2.77 times, but is riskier in absolute terms, with an average loss of 10.5 per cent predicted in the worst of months. This is acceptable and 55 per cent of individual funds' risk is diversified away, which is also good. However, for those investors who fear a volatile 2017, the post-populism portfolio, with its lower expected tail loss, looks best.

Optimistic portfolio alternative suggestions - Kate Beioley

Shaun Port, chief investment officer at Nutmeg, and Ben Seager-Scott, director of investment strategy and research at Tilney Bestinvest, want to reduce gold and cash exposure and reallocate that to equities, as both are highly defensive for an optimistic outlook. Mr Port would reallocate a chunk of cash to iShares S&P Small Cap 600 UCITS ETF (ISP6) and likes the current selection of VUSA, VJPN and EMIM.

Mr Port also feels gold is unnecessary with the other inflation-protected ETF in the portfolio. He would reduce exposure to index-linked ETFs. He says: "Index-linked bonds may not do what they say on the tin. In an optimistic scenario, real bond yields will rise much further and even if inflation expectations rise from already high levels in the UK, this will cause losses on linkers." He would reallocate to investment-grade credit. He says: "Our pick would be iShares £ Corporate Bond 0-5yr UCITS ETF (IS15), as it provides diversified access to shorter duration UK GBP corporate bonds, at a peer group leading total cost of ownership. Mr Seager-Scott also suggests greater exposure to corporate bonds due to improving credit conditions instead of index-linked bonds. He says: "They might mitigate risks from unexpected inflation, but they won't help against rising real interest rates."

He adds iShares Core £ Corporate Bond ETF (SLXX), "which gives exposure to sterling corporate bonds, while the crossover iShares € Corporate BBB-BB UCITS ETF (ISBB) gives exposure to euro-denominated credit that is at the 'sweet spot' that many strategic bond fund managers favour."

Mr Seager-Scott would add about 15-20 per cent in equities and boost emerging market equities. He says: "I'd also consider using the iShares Edge MSCI EM Minimum Volatility UCITS ETF (EMMV) for both the optimistic and pessimistic portfolios as it tends to have less exposure to the large state-owned enterprises that tend to dominate emerging market indices and are often run for political rather than economic reasons."

He would also add a global factor ETF, "such as the iShares Edge MSCI World Value UCITS ETF (IWFV) or even the iShares Edge MSCI World Momentum factor ETF (IWMO) - particularly at the moment when there is a clear shift from growth to value at a global level, which could benefit from a more upbeat outlook". He prefers the former at the moment as it is lower risk.

Mr Port wants to switch the current Europe ETF to Vanguard FTSE Developed Europe Ex UK UCITS ETF (VERX), as it is a more diverse option, although notes that this could also be a good area to use currency hedging. He likes db x-trackers S&P 500 GBP hedged UCITs ETF 2C (XDPG) for currency-hedged US equity exposure. He would also reduce the FTSE 250 exposure.

For fixed income, Mr Port says: "In high-yield bonds we prefer the US-focused BofA Merrill Lynch 0-5 Year High Yield index so would favour the PIMCO Short-Term High Yield Corporate Bond Index Source UCITS ETF (GBP hedged) (STHS) which offers compelling value on a total cost of ownership basis despite its higher management fee." For short duration, he prefers Lyxor FTSE Actuaries UK Gilts 0-5Y (DR) UCITS ETF (GIL5). It has a much lower total cost of ownership than competitors, and a slightly shorter duration.

Alternative suggestions for the pessimistic portfolio

Alan Miller, founder of SCM Private says: "Our view is that the cash and gold would be better employed via adding to the bonds or equities or a middle ground alternative such as iShares UK Property UCITS ETF (IUKP). Gold is normally a terrible long-term investment and can suffer prolonged periods of weakness."

He is suspicious of the concentration in smart beta too. He says: "Many smart-beta ETFs are characterised by being too concentrated in terms of sectors or stocks, too expensive and often highly variable in terms of adding value against their much cheaper market-cap-weighted alternatives." He would replace SPDR S&P Dividend with the SPDR FTSE UK All Share (FTAL). An exception is value-tilted ETFs "as these stocks are out of favour and undervalued at present".

He also questions the level of exposure to the US, given high valuations and proposes adding to 'plain vanilla' ETFs in other markets instead of the iShares MSCI World Min Volatility ETF, with 64 per cent in US equities. He says: "Within Europe, mid-cap stocks look undervalued and are less exposed to the risks of holding the large European bank stocks. The iShares EURO STOXX Mid ETF (DJMC) looks interesting. There is a hedged Japanese equities ETF that invests in more shareholder-friendly companies - Lyxor Nikkei 400 daily hedged ETF (JPXX) - and safeguards against any further yen weakness."

He would get rid of the 15 per cent exposure to index-linked bonds "which are absurdly overvalued". He says: "We would not recommend any exposure at current prices as the bonds have a very long maturity (24 years) and already price in inflation of 3.5 per cent a year. We would suggest a mixture of shorter-term UK corporate bonds via iShares £ Corp Bond 0-5yr (IS15), short-term US higher-yield bonds hedged into sterling via PIMCO Short-Term High Yield Corporate Bond Index Source Ucits ETF (GBP hedged) (STHS) and emerging market bonds hedged into sterling (UBS Sovereign Emerging Markets GBP hedged (SBEG)).

Christopher Aldous, head of asset management at Charles Stanley Pan Asset, suggests diversifying away from a concentration in iShares towards other providers. He says: "The weightings look reasonable in terms of size of each holding and there is good diversification as a result of the large number of underlying holdings in each ETF.

He advocates switching from iShares Edge MSCI World Value Factor to Vanguard Global Value Factor (VVAL), which has a lower ongoing charge at 0.22 per cent and has better returns, as well as a more diverse equity exposure.

Lynn Hutchinson, assistant director at Charles Stanley Pan Asset, suggests switching from iShares Core £ Corporate Bond UCITS ETF (SLXX) to SPDR Barclays 0-5 year sterling corporate bond (SUKC), with the same ongoing charge but shorter duration. She also suggests switching from iShares £ index-linked gilts to Lyxor FTSE Actuaries UK Gilts inflation-linked UCITS ETF (GILI). She says: "The ongoing charge is only 0.07 per cent vs 0.25 per cent in iShares. Assets under management is small at £23m, but it recently changed to physical replication and lowered its ongoing charge, so I would expect to see the assets grow over time."

Source: Investors Chronicle & contributers

How do the alternative portfolios compare with ours on a risk-adjusted basis?

There is sound logic behind our guest contributors' variations on the Investors Chronicle portfolios, but how do they compare in terms of expected tail risk and reward? Many of the ETFs, in all of the portfolios, do have a relatively short trading history, but PrairieSmarts' risk algorithms increase the risk figures to reflect limited data and can model back to create statistically valid risk-return representations for investment strategies back to 2006. This helps to allow for the type of extreme events that we saw in 2008-09, so estimates should be robust.

Looking first at the portfolios for a more pessimistic outlook, the rate of return from our allocation for populism-induced market stress was expected to be 1.54 times the losses. This is a reasonable balance especially as the absolute losses in the worst 0.5 per cent of months is only predicted to be, on average, 3.5 per cent.

The SCM Portfolio is more than twice as risky; thanks to positions in high-yield debt, property and emerging market equities in the worst months it could lose, on average, 7.5 per cent. The expected reward-to-risk ratio is only 1.03, so on first reflection it looks as though the Investors Chronicle portfolio is the better option. However, the potential rewards are possibly understated by a backwards looking model. The most important number is the expected tail risk which, at 7.5 per cent is still low and SCM's tactical selection of assets that still offer value could well outperform the Investors Chronicle allocation in 2017.

Tweaking the Investors Chronicle fixed-income positions, including ditching linkers, has really worked for the Charles Stanley portfolio. Its projected reward-to-risk ratio is 2.08 on a slightly higher expected tail risk of 5.11 per cent.

When it comes to the more optimistic portfolio choices, the Investors Chronicle selection comes out on top if judged on reward-to-risk. Our portfolio exposes us to potential tail losses of 10.49 per cent in the worst months but, over time, the rate of return is expected to reward downside risk by 2.77 times.

However, forecasting returns is even more difficult than quantifying risk. You only have to look at the demise of defined-benefit pension schemes and with-profits life products to understand the perils of pegging your strategy on an expected rate of return. The portfolios chosen by Nutmeg and Bestinvest have respective reward-to-risk ratios of 1.54 and 1.36, but it is more circumspect to make portfolio decisions according to what is an acceptable level of absolute risk, and on this basis both selections look good.

The estimated tail risk for Nutmeg's portfolio is 8.58 per cent and for Bestinvest the figure is 8.92 per cent. Like the Investors Chronicle Autumn portfolio, this is not an unacceptable level of risk. As said, basing expectations of future returns on past data is much more precarious than estimating losses, so, in spite of its high backward-looking reward-to-risk ratio, we should not expect the Investors Chronicle selection to outperform either of these portfolios in the future. The important thing is that the tactical calls on macro themes going into 2017 have been properly risk-assessed for what might be lost if the new year turns out to be worse than we hope. It will be interesting to revisit all of these portfolios throughout 2017 to see which is delivering the best upside.

How the portfolios compare according to PrairieSmarts' tail risk metrics

Source: Investors Chronicle, contributors & PrairieSmarts