We’re de-risking portfolios, but it’s all relative

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For adviser use only

 

Some advisers outsource portfolio construction to solutions providers like Aegon or to a DFM.  Others will provide that necessary function from within their own firm, accepting the process and governance responsibilities within the practice.

Whatever your business model, you will often need to explain to clients the thinking behind that asset allocation. With big news hitting the headlines on an almost daily basis you may find you’re spending more time talking to clients about how their portfolios are positioned to cope than ever.

To this end, I’d like to share some changes we’ve made recently to our Core Portfolios. I should add that this is part of our regular review process, not in response to Trump’s latest tweet or election fever. The changes are based on our long-term perspective of future return expectations.

In essence, we fundamentally believe that the majority of assets are fully valued, that future returns will become more limited, and that we have reached a point in the market cycle when it is prudent to take some risk off the table. 

It’s all relative

The Core Portfolios are built on the belief that asset allocation is the key driver of long-term returns.

With this as a starting point, it will be no surprise that our approach to asset allocation is strategic – working with Morningstar we take fundamental, long-term views across different sectors and asset classes.  We construct a five-year view based on their relative values.

Of course, it takes courage to move from a sector that is still performing well, to seek out relative advantage for the longer term.  Such calls can be, by their very nature, contrarian, though it is important to stress that a move from a sector is not a signal we expect that sector to run into troubles. We simply believe there are better opportunities in other areas which trigger a re-weighting across asset classes.

Why are we de-risking?

We believe many markets are fully valued by comparison to historical norms. Taking a more cautious approach seems prudent when such valuations are prevalent.

Most of this de-risking comes from removing property and increasing cash across the range. For the less risky portfolios, we also reducing equity weightings.  And at the higher risk levels, there has been a slight shift from US equities into the UK and Europe.

Below you can see an example of the changes we’ve made to the mid-risk fund in the range, the Balanced Plus Core Portfolio:

Balanced plus core portfolioOld allocationNew allocationDifference +/-
Equities
UK Equities 27.0% 27.0% 0.0%
North American Equities 10.0% 10.0% 0.0%
Continental European Equities 9.0% 9.0% 0.0%
Emerging market equities 7.0% 7.0% 0.0%
Japanese equities 6.0% 7.0% 1.0%
Pacific ex Japan equities 2.0% 3.0% 1.0%
Bonds
UK Corporate bonds 12.0% 11.0% -1.0%
Overseas government bonds 5.3% 6.4% 1.1%
Overseas corporate bonds 4.7% 5.6% 0.9%
UK gilts 3.0% 2.0% -1.0%
UK index-linked 3.0% 2.0% -1.0%
Property
Property 6.0% 0.0% -6.0%
Cash
Cash 5.0% 10.0% 5.0%

You can find details of all the Core Portfolio changes here but I’d like to explain the thinking behind the key asset allocation calls.

UK property removed

UK property - which includes direct investments in offices, industrial and retail spaces - has had a very good run since 2009, and it has come through the 'Brexit blip'. Returns have exceeded the historical mean over a sustained period. But now the opportunity for rental growth looks subdued. That, in turn, could constrain capital growth and aggregate returns.

In addition, as an income play, property may come under pressure when interest rates rise, especially if they do so more steeply than the current yield curve implies.

Finally, there is the issue of liquidity in open-ended property funds which crystallised in both 2008-09 and in 2016. We prefer the Core Portfolios to retain assets whose liquidity is more robust across the market cycle.

Cash weighting increased

As we’ve moved out of property, we’ve added to our cash holdings.

Increasing cash may seem counterintuitive in such a low-interest rate environment, but it reflects our general view that most asset classes are fully valued.

Fixed interest would ordinarily be a natural alternative asset class, however with yields currently very low by historical standards, bonds currently bear elevated capital risk.

Raising cash weightings allows us to prudently protect against volatility and downside risks.

US equity weighting reduced slightly

The US equity market has outpaced the majority of other developed markets since 2009.  But there are now elevated risks in US equity valuations versus other markets.

In particular, the dollar is stronger against the pound than it has been at any time since the 1980’s. Price-earnings ratios are also high.

Plus, on Warren Buffet’s favourite valuation measure, market cap/GDP, valuations have reached heights near the point seen in the US shortly before the Dotcom bubble of 2000.

For these reasons, we’ve dialed down the US exposure in our higher-risk portfolios in favour of UK and European equities, and in favour of cash for the lower-risk portfolios.

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Forming a strategic view

I am in the lucky position of having a team of analysts and expert support from the likes of Morningstar to assess relative values and cut through the noise of media, tweets and other distractions.  It is critical to take a long term strategic view to give the best potential for long-term growth.

Of course, there are times when tactical opportunities will present themselves and give opportunity to lock-in short term gain, but chasing such gains can be a dangerous game. 

In the end, it’s all relative.

 

Please note: the value of investments may go down as well as up. Investors may get back less than originally invested.

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