Research has demonstrated that asset allocation accounts for approximately 90% of the variation in investment returns. This means that asset allocation alone is nearly ten times as important as stock selection and market timing combined in determining the performance of a portfolio. So what is asset allocation and how can the optimum asset mix be achieved?
Asset allocation is the diversification of a portfolio across different asset classes and geographical regions with the aim of maximising investment returns whilst reducing the portfolio’s overall volatility, or risk, to below that of its individual components. This is achieved by mixing assets which are ideally negatively, or at least weakly, correlated – that is, unlikely to move in the same direction to the same extent under the same market conditions. This is the key principle of modern portfolio theory, that risk reduces as the assets held by a portfolio become more diversified.
Beyond diversification
However, the art of asset allocation goes beyond mere diversification. It looks to allocate the optimum proportion of a portfolio to each asset and geographical region. At any one time, the optimum asset mix will depend on the investor’s risk and return profile, as well as how the different asset classes are expected to respond to different economic drivers. As the investment environment is constantly changing, it is vital that any portfolio’s asset allocation is regularly rebalanced to take account of prevailing market conditions, as well as any changes to the investor’s objectives, attitude to investment risk and timeframe for investment.
Under present conditions, balanced investors are generally willing to hold up to 85% of their portfolio in equities with the aim of increasing the real value over the medium-to-long term. The remainder is normally invested in fixed interest securities and property, whose long-term returns have historically been lower than equities but also generally less volatile.
How to achieve the model asset mix
There are several ways that investors can incorporate asset allocation into their financial planning, although the level of flexibility and control varies significantly between each option. In summary, the following options are available.
With-profits
Insurance company with-profits funds (see Smith & Williamson article on Standard Life post-demutualisation - who'll get the profits?) invest in a mix of equities, fixed interest securities and property with the aim of smoothing out the peaks and troughs associated with these asset classes individually.
Historically, investing in a with-profits fund was an ideal way for smaller investors to access professional asset allocation management. However, most with-profits fund reserves were severely depleted during the 2000-2003 bear market and almost all with-profits funds have now altered their asset allocation strategies.
Most with-profits funds now hold a higher than ideal proportion of their assets in fixed interest securities, property and cash, which has rendered the asset mix underlying them appropriate only for very cautious investors.
Managed funds
The advantage of using managed funds to achieve the model asset mix is that, like with-profits, the need for ongoing monitoring is reduced as each manager adjusts the fund’s overlying asset allocation as well as the underlying investments on a daily basis.
On the downside, managed funds are invested with the average investor in mind, with attempts to meet the optimum asset mix often restricted by the category of managed fund they belong to. For instance, a cautious managed fund is limited to holding a maximum 60% in equities at any time, irrespective of whether it might be preferable to hold a significantly higher proportion.
Such funds are not, therefore, appropriate for larger or more sophisticated investors who often require greater flexibility and control.
Collective sector funds
A more sophisticated option is to use an asset allocation model to manage a portfolio of collective sector funds. This gives the investor greater flexibility and control than with-profits or managed funds together with significant manager diversification, removing the reliance on the expertise of one fund manager, which is inherent in discretionary management.
The skill here is in blending the different management styles of the various collective sector funds available. The aim should not be to compile a portfolio of the current star managers but rather a blend of funds with complementary styles and strengths including income and growth funds, small cap and blue chip stocks as well as both topdown and bottom-up fund management.
Administratively it is easier if the portfolio is consolidated into a single contract with access to all collectives, not just those offered by the product provider, as this will enable the investor to select the strongest management team in each asset class and geographical region to meet the model asset mix. SIPPs for pension funds and fund supermarkets for personal portfolios are ideal for this purpose.
Fund of funds and manager of manager funds
As there are over 21,000 UK collective and offshore funds open to investment by UK individuals, selecting the optimum asset allocation as well as the best funds to achieve it can be a difficult and time consuming process. In recognition of this, many investment houses now offer fund of funds and manager of manager funds which make all asset allocation and fund selection decisions.
The fund of funds approach, which is similar to using collective sector funds, allows the overlying managers to invest in any FSA-recognised collective to meet their target asset mix. In comparison, manager of manager funds appoint external fund management groups to manage different parts of the portfolio. As manager of manager funds are not restricted to using FSA-recognised collectives they arguably have greater investment flexibility, however a lack of choice is clearly not an issue with the fund of funds approach.
Although both options mean that the investor has no control over the asset mix, fund of funds and manager of manager funds are clearly a cost-efficient way of accessing professional asset allocation management for smaller or inexperienced investors.
Discretionary management
Discretionary management is arguably the most sophisticated method of asset allocating and is appropriate for those with large portfolios who would prefer to have their assets invested directly into equities and fixed interest securities on a bespoke basis, rather than investing in collectives.
The key advantage is that the asset allocation of the portfolio is constructed and managed specifically according to the investor’s objectives, timeframe for investment and attitude to investment risk. We look at discretionary management in more detail in the article on the next page.
Over the next few issues of Financial & Tax Planning we will look at some of the other options mentioned above in more detail and consider which types of investor they might be suitable for. If you would like to consider how this or one of the other asset allocation models can be incorporated into your financial planning then please contact your usual contact at Smith & Williamson.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
