A piece of cake

Various studies, most famously Ibbotson and Kaplan (2000), have concluded asset allocation is the difference between serious portfolio management and ‘playing the market’, but it’s fair to say the concept of banking profits on a 20-bagger is more exciting. There is no reason, however, why investors shouldn’t enjoy the intellectual challenge of pitting their portfolios against benchmarks and the choices of professionals.

From the industry’s point of view, there is a growing requirement to demonstrate value added with new regulations such as Mifid II (the second iteration of the Markets in Financial Instruments Directive) on the horizon, emphasising transparency and client outcomes. With this in mind, a review of leading asset managers’ allocations is long overdue. What are the approaches taken to long-term risk management, suitability and setting targets? How are market timing decisions made? What are the criteria for selecting individual investments? In addition to the professionals’ answers to these questions, we will also look at leading industry benchmarks and how performance is monitored. An Investors Chronicle portfolio has been scrutinised too and we will explore ways to optimise and flex our allocations to try and beat industry peers and benchmarks going forward.

BOSTIC – background, objectives, strategy, tactics, implementation and control

Running a portfolio can be very much like managing a business. For example, the BOSTIC acronym used by consultancy firms can provide a good framework for running money.

Firstly, you need to assess your background in terms of immediate circumstances and how these will change over time. This should include your level of earnings, other sources of income, how much you can afford to regularly invest and over what timeframe. Other considerations include current financial needs such as your mortgage/housing situation, regular cost of living and contingency plans for emergency expenses. Objectives will be the size of capital you require at the end of your time horizon or what level of income you require from a starting sum. This may be stating the obvious, but before you can decide on an appropriate investing strategy you need to be honest whether your objectives are realistic and ask if you have the capacity to take on a level of risk commensurate with the required rate of return.

Assuming individuals would have done this common sense personal survey, we asked professional investors to go into depth on their allocations for both balanced and adventurous strategies, focusing on either growth or income. This request emphasised different house styles, as some in our survey did not split models into growth and income categories, always pursuing a total returns strategy. We have therefore chosen to abandon the growth versus income distinction for now and just list a few of the balanced and adventurous portfolios here, but we’ll be adding more different allocations on the Investors Chronicle website in the coming weeks.

We spoke to traditional wealth managers and some robo advisers (they provide digital financial advice based on mathematical rules or algorithms). The new generation of robos aim to disrupt the industry by offering out-of-the-box portfolios that are cheaply constructed using exchange traded funds (ETFs). Some of these portfolios are based on quite well-known benchmarks, such as the Personal Investment Management & Financial Advice Associates (PIMFA) indices, which private investors themselves could replicate easily. One of the interesting aspects tracking performance going forward will be whether more dynamic managers deliver better risk-adjusted returns.

Of the more hands-on managers, house asset allocations are typically graded according to the level of risk. Which portfolio is used as the strategy for clients depends on their objectives and risk tolerance. Some asset managers take a starting point like this and make tactical tilts to take advantage of specific opportunities. The most dynamic styles don’t tie themselves by having limits on how far they can deviate from a strategic allocation; instead they work on risk budgets and flex portfolios to meet opportunities according to how much implied risk they are taking on.

The industry standard

With so many different portfolio styles, it can be difficult to compare performance but the most widely used standards are the Private Client Indices constructed and maintained by Asset Risk Consultants (ARC). The indices incorporate data from over 100,000 portfolios and 80 different asset managers and ARC uses the information to create industry peer group rankings. It categorises portfolios according to realised volatility relative to equities. Portfolios where the ratio is 0.8 or more are adventurous; a ratio of 0.6 to 0.8 is a steady growth portfolio; 0.4 to 0.6 is balanced and below 0.4 is cautious.

In each calendar quarter, ARC compares the performance in these risk peer groups, highlighting which quartile of their set portfolios appear. The ARC risk categories are fluid and provide a fair way to compare managers, whether they have rigid rules about tilting from strategies or if they employ more dynamic investing styles. The aggregate mean allocation to various assets is also computed to give a risk category benchmark, which provides a basis to assess how over or underweight current tactical allocations are compared with managers with a similar risk remit.

The Arc benchmark portfolios 

The Investors Chronicle General Tactical Asset Allocation Portfolio was benchmarked in the ARC GBP Steady Growth category. Our portfolio has a significant cash allocation and has a lower proportion of its assets in equities than many peers. Perhaps due to this defensive cash holding, the portfolio has narrowly underperformed the benchmark over two years, but in the ARC peer group we have ranked between the top 10 and 30 per cent of portfolios. 

How have Investors Chronicle portfolios performed?

For our comparison, we are back-testing our current general tactical asset allocation (TAA) portfolio. This is the TAA we chose back in April and it has actually underperformed peers in the last quarter, although the overall three-month total return has still been over 2 per cent. Going back two years, however, and rebalancing annually at the end of June, this allocation would have achieved total returns of over 20 per cent, placing it in the top quartile of the peer group and only a shade behind the ARC benchmark composition, which most of the portfolios in the industry underperformed by some distance.

In fairness, the current asset allocation might not have been the one that we held over the whole two years, but the back-testing shows how a relatively passive approach with a broad asset allocation would have delivered pretty good results – the compound annual growth rate (CAGR) is 9.4 per cent, which is not to be sniffed at, especially given we held 10 per cent in cash.

Our underperformance over the last couple of months coincides with a period of lower volatility that, rightly or wrongly, is now feeding into rising animal spirits in global equity markets. It is conceivable, therefore, that our cash-heavy portfolio will underperform in rising markets. The peer group is currently 53.5 per cent invested in equities, which is above our 48 per cent. We also have more invested in fixed income, with 27 per cent in bonds versus just 16 per cent for the peer group index and, unlike many professional managers, within this allocation we have a relatively sizeable exposure (12.5 per cent of the total portfolio) to developed market government bonds.

An underweight towards government bonds is one of the intriguing allocation decisions of our peer group. Central banks could be about to embark on a period of tightening after the quantitative easing/low-rate easy money taps have been in full flow. Rising interest rates would cause the capital value of bond funds to fall, a risk that is going to be acute with highly priced government debt. For this reason much of our allocation is towards lower duration gilts and only 5 per cent is invested in the global government bond index, which includes longer duration issues from other developed nations. Unlike some of the dynamic managers, who overwhelmingly favour emerging markets debt, we think it is better to have some developed markets bonds, on the chance of an equity market crash, when bonds may still behave differently – despite the worrying decline in negative correlation between returns from bonds and equities.

Our portfolio, therefore, is very much positioned for a ‘just in case’ scenario. We also have 5 per cent in gold as a truly non-correlated asset and look to global real estate as well as equities to give another way to benefit from a synchronised global economic recovery. In any case, provided we continue to beat our own returns target of 4 per cent on top of the sterling cash return, without taking excessive risks, then surely chasing the pack should not matter in the short term. Other investors may disagree with our views and there were certainly stronger or different calls to ours when we reviewed several experts’ strategic and current asset allocations.

Professional managers’ styles and their tactical asset allocations for the rest of 2017

Comparing investment houses' asset allocations is difficult as internally, groups have different ways of approaching risk. We asked for balanced and adventurous portfolios but we felt that some contributors' allocations fell between the two definitions. The category managers place their portfolios in themselves is in brackets. The table, therefore, is not so much a way of comparing which style of management might be more suitable for an investor of a given risk tolerance, rather it is simply a way to visualise how some of the professional investors that we spoke to are putting their views into practice. We are just showing strategic allocations (or the general dynamic allocation in the case of managers' to whom this isn't applicable) but tactical allocations are discussed below, too. 

We have also slightly fudged together some asset allocations for the ease of presentation. For example, some managers will split out corporate debt allocations by its duration. Others split equity allocations by market capitalisation or divide categories like emerging market equities by sub-region. This of course has a big impact on the risk profile of portfolios and we are adding our contributors' allocations in full detail on the website. 

Table: Some of our contributors' detailed asset allocations

* PSigma's Europe Allocation is part of a Global Income Fund
**SCM's Dynamic Strategy splits out the corporate bonds by duration and credit risk
Source: Investors Chronicle and listed contributors

A glimpse behind the curtain of professional money management – and the extent to which their views differ – offers some valuable insights for private investors ranging from where to use passive funds in your portfolio, how to manage currency risk, and the areas of the bond market to avoid right now.

One manager whose asset allocation technique was praised by Investors Chronicle in the first Ideal Portfolio feature back in 2012 was Alan Miller of SCM Private Capital. SCM has a very dynamic style and, interestingly, it is completely out of US equities in the portfolio it gave us to represent a balanced risk allocation. Mr Miller is sceptical about the ability of the US market to sustain current valuation levels and prefers emerging markets, Japanese, European and UK equities. He says: “We believe that you can get more bang for your buck by investing in other markets than the US. We look at valuations, and the fundamental valuation on US equities by most metrics is pretty high compared with equities around the world.”

Highlighting the so-called FAANGs (Facebook, Apple, Amazon, Netflix and Alphabet) as symbolising the expensiveness of the US market, Mr Miller thinks investors should question the wisdom of being heavily exposed to stocks trading on a very high price-earnings ratio: “People say you can’t use traditional valuation metrics to value the FAANGs but the last time I heard people arguing that was at the peak of the tech boom. Normally, in finance, when you can’t justify anything you have to invent a new way of valuing it, and if you look objectively at these FAANG stocks valuations look extremely rich.” 

This call is not uniform among managers. There is an argument to say that the FAANGs, with their dominant market positions, proven revenue streams and strategic advantages (particularly in data and technology) are quality stocks, unlike the untested business models of the growth stocks that drove the dot.com boom of the late 1990s. 

Rival manager Brewin Dolphin, takes the opposite view to SCM and has been ramping up clients’ exposure to US equities. Brewin Dolphin’s strategic asset allocation model dictates a 17.8 per cent weighting to North American equities in its balanced portfolio and 25.3 per cent weight in its more adventurous portfolio, and has tactically shifted those weights to 19 per cent and 26.5 per cent, respectively. Head of fund research Ben Gutteridge says: “Think about the comparison in business model between Netflix and Blockbuster. In terms of revenue and cost base, these new technology businesses can trade on much higher multiples than traditional industries because they have much greater margins and much lower capital intensity. We recognise that valuations are rich but we don’t believe that just because something has moved beyond an average valuation, that it must fall back down again. We have been overweight the US for about four to five years and think that more than anywhere else in the world the businesses there are innovative, disruptive, transformational technology companies.”

Unlike their views on the US, managers are converging on the appeal of European equities and emerging markets equities, in both of which the bulk of managers are now overweight. European equities are benefiting from a long-term economic recovery, improving corporate earnings and cheap valuations. Seven IM says: “European companies have just had their best period of earnings since the financial crisis. Political risks have subsided and economic data continues to impress.” Houses including Brewin Dolphin and Deutsche Bank have increased their exposure to European equities. 

Emerging markets equities are the current darling, though. Deutsche Bank has made its most dramatic move away from its strategic position in emerging markets, adding 7 per cent more exposure to emerging markets in its more adventurous portfolio and says emerging markets benefit from “an improving macro picture, (particularly for Russia and Brazil and an upgrade to China), reform implementation, a better earnings environment and supportive central banks as well as favourable valuations”.

Managers’ approaches to diversification and other asset classes

Private investors are often told that diversification is key to asset allocation, and it is generally thought that a balance of global equities is important to any portfolio. But the professionals’ equity allocations often look starkly different to global equity benchmarks. For example, PSigma has no exposure to the eurozone via Europe funds and a hefty 21.8 per cent exposure to the UK in its adventurous growth portfolio. Rory McPherson, head of investment strategy at PSigma, says: “We do have a home bias for clients and that is a preference. But a lot of the exposure we have is via large-cap equities, which are global in nature.” He says: “For the UK we think that decreases our risk because we don’t have as much exposure to the UK economy, which we think is a higher-risk area at the moment. The majority is held in large-cap equities.” He says PSigma gains exposure to Europe through its global funds, and as a result is overweight in total.

When it comes to bond allocations, the potential for interest rate rises and rising inflation to do damage to low-yielding, high duration government bonds is pushing managers into higher-risk bonds even in their cautious portfolios. SCM Direct and Seven Investment Management both have no weighting to UK gilts at all in either their balanced or adventurous portfolios and Brewin Dolphin has slashed its 11 per cent strategic allocation to a 6.5 per cent weight in its balanced portfolio. “With the very low yields on developed markets government bonds, by the time you’ve paid the costs along the investment chain I can’t see how the investor can make any money. It seems to me an astonishing decision by many asset managers to invest in something that can’t give a client any return,” says Mr Miller. SCM now has almost half of its lower-risk portfolio in emerging markets debt – more than its high risk portfolio, which has just over 40 per cent invested in that area. 

That sounds like a high-risk play – emerging markets debt defaults tend to be higher than in developed markets – but Mr Miller uses smart beta ETFs that use fundamental factors such as country indebtedness to give larger weights to more creditworthy borrowers. He uses local currency ETF, PIMCO EM Advantage Local Bond Index Source UCITS ETF (EMLP) and a sterling hedged smart beta dollar denominated debt ETF, UBS ETF Bloomberg Barclays USD Emerging Markets Sovereign UCITS ETF (hedged to GBP) (SBEG). Deutsche Bank has also been adding to hard currency emerging markets bonds via JPMorgan EM USD Bond index global core in its dynamic, higher-risk portfolio, but downsizing that position in its lower-risk portfolio.

Investment grade credit is also proving popular, with the emphasis placed on short duration bonds whose prices will not be eroded by potential interest rate hikes. Mr McPherson says investment grade credit is currently “doing the job of government bonds” in PSigma’s portfolio because they are shorter dated, higher yielding and relatively low risk, despite the fact they are hovering at expensive levels. Deutsche Bank has markedly increased its weighting to UK investment grade credit in both its cautious and more adventurous portfolios, while Brewin Dolphin has increased the weight of credit in its balanced portfolio from 7 to 9 per cent.

Money managers are more divided on the topic of high-yield bonds. Although these offer a far higher yield than government debt, they are no longer looking cheap and come with higher risk. At the moment, defaults are historically low – at 1 per cent – due in part to accommodative central bank policy. But a rise in interest rates could see a spike in defaults, which could be problematic for this area. That potentially explains Deutsche Bank’s decision to downsize that area in both its portfolios. But PSigma is more bullish, with 8 and 8.5 per cent invested in high-yield credit in its more cautious and adventurous portfolios, respectively.

More generally, houses take particular approaches to areas of risk. For example, in the case of currency risk, some managers have a policy of hedging fixed-income exposure to sterling but they retain the currency exposure in their equities holdings. Currency risk is a major hazard to any portfolio and is notoriously hard to manage. Self-directed investors have the option of buying currency-hedged share classes, which tend to be more expensive, but predicting the movement of any currency against another is a tricky, and often expensive, game to play. 

Asset managers have more tools at their disposal than private investors but still many of them choose not to hedge equities for that reason and it is far more common to hedge bonds. That is because managers rely on the yield from bonds and do not want it to be diluted or negatively impacted by currency fluctuations, while currency fluctuations can be positive drivers in overseas equity markets which managers use as a tailwind. Mr Miller says: “When investing in the equity market there is a natural hedge. In a market such as Japan, if the currency falls then the market will likely rise, but in bonds you don’t have those dynamics and in the US, for example, you may be getting a 1 per cent yield but that could easily disappear in the devaluation of the dollar against sterling.” However, he adds: “There will be times in equities where you believe that currency is grossly overvalued and you want to hedge against it.” Managers tend to use currency hedged share classes to enact currency views or hedged ETFs.

Tools used by professional investors to build their portfolios

Working out when to opt for an active fund and where to go passive is a quandary for many private investors. Wealth managers say they use passive funds as a way of tilting the assets in their portfolio towards a particular style, or even plugging gaps left by the active managers they hold. “Passive funds are good for getting exposures we want cheaply and are very easy to trade in and out of,” says Mr McPherson. PSigma is currently allocating towards passives as a way of gaining more exposure towards value stocks, which it feels are not sufficiently owned by the active managers it invests in. 

The house has a 5 per cent allocation to UK passives within its balanced portfolios in a bid to beef up its exposure to cyclical sectors. “We feel that our active strategies are under-invested in value areas such as banks, miners and oils, which we want to hold now,” says Mr McPherson. Value is one of the key ways in which SCM tilts its portfolios too. The house only uses ETFs but is utilising smart beta ETFs, which weight stocks by a factor other than market value, to shift towards value US equities in its adventurous portfolio via Powershares FTSE Rafi US 1000 UCITS ETF (PRUS).

Managers also use passive funds in markets where active funds tend to underperform and many have turned to ETFs for US exposure in the past, as a market where active managers have struggled. However, an end to the easy money pumped into the system by global central banks could turn passive outperformance on its head, say money managers. “We think that as we get less support from central banks, there will be less of a rising tide lifting all boats and the potential for active managers to outperform will be strong,” says Mr McPherson. Jon Cunliffe of Charles Stanley agrees: “The recent past has been a period of quantitative easing (QE) and an abundance of liquidity. In this environment everything rises with the tide and all you want to own is cheap beta.” He says that an end to accommodative central bank policy could bring a resurgence in active fund outperformance.

Measuring the risks of current tactical allocations

As the ARC categorisations imply, portfolio managers should be judged according to the gains they are making relative to the risks taken on. Dynamic styles choose when to add risk because they feel that conditions are right for a pay-off. For the Investors Chronicle portfolio, as well as looking at the annualised returns over time, we examined the ratio of average gains on good days, to average losses on bad days. This reward-to-risk (also known as the Omega ratio) gives an idea of whether the portfolio style has given a good trade-off in terms of gain to pain. Going forward, we will look to build a returns series for our portfolio to see how active asset allocation decisions are performing relative to the actual real life risk of losses. For now, though, we can see that the Omega ratio of the current Investors Chronicle TAA, had it been followed passively, is an impressive 1.4 times.

For more dynamic portfolios, the Omega ratio is only relevant for an actual returns series of holdings; knowing how a current allocation would have performed in the past is not really useful. Assessing the risk you are taking on when making a new allocation is worthwhile, however. ARC finds the most relevant way to do this is to look at the past peak-to-trough losses suffered by portfolios of a similar composition and how long they have taken to recover. To judge our Investors Chronicle allocation, we ran it through the software of US risk specialists Covisum.

Covisum use complex algorithms to model the average size of losses in the worst 0.5 per cent of months. This doesn’t tell us whether there will be a fall in the value of a portfolio and it can’t predict some event that could torpedo our assumptions. What it does do is give a more realistic sense-check to investors in terms of the portion of their portfolio they might lose in a really bad month. The more robust this estimate, the better we can assess whether we are comfortable with the portfolio allocation.

In our case, we are risking on average an 8 per cent loss in the worst 0.5 per cent of months. This doesn’t mean that there won’t be events that could trigger worse falls but compare that with a traditional risk model, such as Value at Risk (VaR) which assumes asset returns are normally distributed. The VaR for our portfolio would be for a 3.5 per cent loss, on average, in the worst 0.5 per cent of months. If you are sense-checking current asset allocations against how much you might lose, then the Covisum figure clearly assigns a higher probability to significant falls. So, while no system is perfect, its estimates are more likely to mirror reality and allow investors to make their decisions under no illusions about the risks they are taking on.

While the performance of our Investors Chronicle portfolio may not always match some of the dynamic styles we have examined here, we will always review any tactical adjustments that we make in terms of how much this changes our risk of loss. Over the long run, balancing these dangers with attempts to take advantage of tactical opportunities in various asset markets will be key to achieving a good rate of return with the minimal level of stress.