An investment portfolio designed for all conditions

Readers may recall that the IC All-Weather Portfolio got its first airing late last year (‘An All-Weather portfolio’,16 September 2022) when we suggested its approach to investing might be as good as it gets. Certainly, the clue is in the name. It is a portfolio for all investment conditions; the ultimate buy-and-hold investment vehicle.

Nor should investors take our word for it: our all-weather portfolio is derivative and comes from a brain far better than anything we can offer, that of billionaire US hedge-fund manager Ray Dalio.

Dalio, whose firm runs about $235bn (£194bn) of client money, came up with the all-weather idea when he addressed a particular problem – who would manage his family’s wealth when he was no longer around? He needed a plan so simple any fool could follow it, but which offered equity-style returns without the volatility that equities often bring.

Much thought produced the all-weather approach, which rested on two insights. First, returns on almost any asset are driven by whether both economic growth and inflation are rising or falling relative to investors’ average expectations. While growth and inflation may be the driving factors, different assets react to them in different ways. For equities, fast economic growth is good; slowing growth bad. For conventional fixed-interest bonds, slowing growth is fine since that implies a drop in interest rates, which will drive up the value of their fixed dividends.

So mixing equities and fixed-interest bonds in a portfolio stabilises returns. But only to an extent. Come stagflation, which features slowing growth and rising inflation, both equities and conventional bonds suffer. Other assets are needed to play the offsetting role. Commodities are useful and gold should be the ultimate flight-to-safety asset whenever inflation surges. Index-linked bonds, whose dividends and return of capital are both tied to a measure of consumer price inflation, also play a balancing role when inflation rises; although that notion has been tested lately.

The second vital insight was that the focus of the average investment portfolio is on allocating capital according to the expected returns of various asset classes rather than according to their risk (or volatility). As a result, portfolios tend to be too heavily weighted to equities.

True, that has brought higher returns over the long haul and – barring catastrophe – should continue to do so in the future. However, the outperformance comes at the cost of high volatility. Research by Bridgewater shows that a typical diversified portfolio allocated 60 per cent of its capital to equities. As a result, equities – a particularly volatile asset class – accounted for almost 90 per cent of the portfolio’s risk. In other words, overexposure to equities means that other assets with less volatility, especially bonds, can do little to reduce overall portfolio volatility. And the real risk is that over-reliance on equities means portfolio value can be badly damaged just at the point where capital needs to be turned into cash.

The correct spread of assets

So what’s needed is the correct spread of assets – equities, bonds and so on – and, crucially, they should be mixed in the right proportions. Get those proportions correct and at any time – regardless of how economic growth and inflation are moving relative to expectations – enough of the portfolio will be doing well to ensure that nothing really nasty will happen to it. True, its good times won’t be as good as the best, but its worst times will be well short of, say, the equity markets’ worst. That’s what Dalio’s reasoning said should happen and it’s what back-testing of the indices and funds behind various iterations of the all-weather approach has shown does happen.

Dalio’s original approach kept things simple, but his portfolio did include some assets, such as emerging market debt, that retail investors might struggle to buy. We have side-stepped that difficulty by following a simplified approach to Dalio’s from the Lazy Portfolio ETF website. This US-based site constructs and back-tests many investing plans based on exchange-traded funds and runs a Ray Dalio All Weather Portfolio. The IC All-Weather approach adds another tweak by being wholly comprised of London-listed exchange traded funds (ETFs). Almost by definition, these are eligible for inclusion in both self-invested personal pensions (Sipps) and individual savings accounts (Isas).

Back-testing, mostly using the underlying indexes tracked by the ETFs in the prototype IC All-Weather portfolio, produced impressive results. The portfolio would have generated annualised returns averaging 6.5 per cent from December 1997 to June 2022. That is only 0.7 percentage points less than the total return for UK shares over the same period, as measured by the FTSE All-Share index, yet with much less than half the volatility. Simultaneously, the average real return – ie, in excess of inflation as measured by the retail price index – was 3.6 per cent a year.

For, as it were, the ‘live’ IC All-Weather portfolio we have made two bits of fine-tuning to the prototype. Thus the portfolio’s make-up is as shown in Table 1 – just six London-listed ETFs, to be held in the weightings shown. Hopefully, these will cover all eventualities that the thud of unexpected events can land on an unsuspecting investor. First, the exposure to equities becomes iShares MSCI ACWI (SSAC), which tracks the all-countries version of a global equities index (including emerging markets) from data processor MSCI. Our original version shadowed MSCI’s global index just for developed country equities. Our guess is that, given the choice, it is better to have exposure to emerging market equities than not. After all, consensus says emerging nations will continue to produce faster economic growth than developed ones. Over the long haul, we can expect that to be reflected in investment returns.

The logic for the second tweak is similar to the first. An ETF that tracks UK government bonds has been swapped for iShares Global Government Bond (IGLH), which does what the name says. Given the choice between having global exposure to an asset class or just UK exposure, for the purposes of this buy-and-leave fund, we would prefer global exposure. However, that argument does not apply to inflation-linked bonds since the vast majority of IC readers will want to protect themselves from the UK’s pace of inflation rather than a global rate.

While the changes from the original IC portfolio are minimal, they have the effect of slightly reducing returns over the 10 years or so for which there is data for the performance of the actual ETFs. The average annualised return for the portfolio drops from 5.3 per cent to 5.1 per cent. Simultaneously, volatility – as measured by the standard deviation of monthly returns over the 111-month period against their average – rises from 7.4 per cent to 8.1 per cent.

As Table 2 shows, that is still acceptable. The IC All-Weather Portfolio has underperformed the total return for the FTSE All-Share index for the period October 2013 to December 2022 – with an average return of 5.1 per cent versus 6.6 per cent for the total return on the FTSE All-Share index – but a gap is be expected over most decently-long periods. However, the trade-off is less volatility in returns – 8.1 per cent for the All-Weather Portfolio compared with 11.2 per cent for the All-Share. Similarly, it would have been rare for a holder of the All-Weather Portfolio to be nursing losses exceeding 10 per cent – that happened in just three months since late 2013, all of which occurred from November 2013 to January 2014. By contrast, exposure solely to the All-Share would have meant that, on average, losses of that scale crop up one month every year.

Meanwhile, now is an interesting time to be launching a portfolio that has, as one of its chief selling points, low volatility. That’s because the price of the component that functions as volatility-reducer-in-chief has just lately been... well... extremely volatile. Not just that, but all the volatility has been on the downside. The component is index-linked bonds, represented by iShares £ Index-Linked Gilts (INXG). In the 13 months to end December, the ETF lost 38 per cent of its value as year-on-year losses worsened seven months running.

For index-linked government debt, this was almost unheard of, and those losses were a big factor in the portfolio’s unusually poor performance in the past six months. However, in the bigger scheme of things, losses on the index-linked ETF have had limited effect. Exclude the past nine months in calculating the annualised average from October 2013 and returns remain at 5.1 per cent, although volatility edges up by 0.2 percentage points. Now the hope is that revised inflation expectations have been baked into investors’ thoughts and inflation-linked bonds should resume their quiet course. We should have an idea by mid-summer whether that’s proving to be the case.