For some investors, stockpicking is the fun part of investing, but for the long-term wealth builder it is the less glamorous process of asset allocation that is most important. A well-known study in 2000 concluded that up to90 per cent of the variability of portfolio returns is down to the weightings given to equities, bonds, property, cash and alternative investments.
The right asset allocation for you is personal, as investors’ objectives, time frames and risk appetites differ enormously. When taking a holistic view of wealth you also need to consider tax when deciding on a strategy, but for an Isa portfolio we can dismiss these concerns.
One framework for appraising strategic asset allocation is offered by ARC Research. Its Private Client Indices compile data from more than 130,000 professionally-managed portfolios to create a group of indices categorised by risk. ARC takes the individual client return series submitted by the data contributors and places portfolios in the following categories.
- Cautious: below 40 per cent of world equities risk.
- Balanced: 40 to 60 per cent of world equities risk.
- Steady growth: 60 to 80 per cent of world equities risk.
- Equity risk: 80 to 110 per cent of world equities risk.
The average return in each category is calculated to create the corresponding private client index. Risk is based on the relative volatility of the portfolio to world equities, irrespective of the chosen asset allocation or implementation method, to enable a like-for-like comparison of performance across a wide range of investment styles.
ARC’s Suggestus Portfolio Peer Review places portfolio performance into the context of the private client index peer group and considers risk not just as the standard deviation of returns, but also on the length and depth of past bear market drawdowns.
Although the ARC private client indices are constructed independently of any asset allocation constraints, ARC has developed a set of reference indices that seek to replicate the long-term performance characteristics of these using a basket of exchange traded funds (ETFs). These ETFs cover the primary asset classes, including developed and emerging markets equities, government and corporate bonds, commodities and hedge funds.
These indices can be used as benchmarks in portfolio peer review reports to enable investors to compare their asset allocation with one that has provided private client index-like returns. The benchmark it created for one of the Investors Chronicle portfolios that falls into its Steady Growth category is used here as an example of a strategic asset allocation for investors who are prepared to take a fair amount of risk.
The benchmark created by Suggestus uses ETFs. This makes it investable and it could be copied for a low-cost passive portfolio. There is, however, a case for using a blend of active and passive funds as the unprecedented monetary policy decisions of central banks since 2008 are being unwound.
In the decade since the financial crisis, passive funds have done very well by tracking indices weighted by capitalisation, catching upside beta from markets buoyed by the rising tide of quantitative easing (QE). However, as central banks retreat from ultra-loose policy there will be more dispersion between the returns of stock market sectors and different investing styles, so there is a strong case for using some good active funds to build your asset allocation.
If you class yourself as a fairly adventurous investor, have a long-term investment horizon and the capacity to take a bit more risk with your Isa allowance, the Steady Growth asset allocation benchmark suggested for us by ARC could be a place to start.
And for the management of your portfolio, this Isa guide provides some fund suggestions for getting exposure to the styles and regions you choose. For example, you might think that a passive global equity instrument is too highly exposed to the US and that you’d rather choose a blend of funds that weights your 35 per cent global equity (see Steady Growth asset allocation chart) relatively more towards, say, Europe and Japan.
Of course, we are just using steady growth as an example. If you are a more cautious investor, it is worth checking out one of the less aggressive models. As well as ARC, there are a range of asset allocation models on the Personal Investment Management and Financial Advice Association (PIMFA) website. Indices for the PIMFA strategies are maintained by MSCI, although unlike the ARC model there has not been quantitative analysis of risk to establish categories.
For the rest of our 50 Isa ideas and other associated Isa articles see below:
10 smart ways to boost your Isa
10 investment trusts for your Isa
The cheapest DIY platforms on which to hold your Isa
