In RealAdviser's first Interactive Financial Adviser of 2006, we focus on building and maintaining the perfect portfolio. Cherry Reynard talks to David Coombs, head of multi-manager at Baring Asset Management and Richard Philbin, head of fund of funds at F&C, about the golden rules of portfolio construction and the use of multi-manager
CR: Are there golden rules to follow when constructing a portfolio?
RP: Have a plan set out from day one and constantly review it. One of the worst things to do is after you have built a portfolio is to not manage where it has come from and where it is going to. Clients' attitudes to risk can change, markets can change. And as time goes by you might need more income, you might want more growth, something can happen which can change your outlook and your attitude. Also, it is not about the buy decision, it is about the sell decision and being on top of it.
DC: I think the golden rule is to know where you are going to. And I think the first thing that we do is to set the long-term strategy. But we do that based on our 10-year forecast for every asset class. And we are using optimisation. We look at what the risk/reward trade off will be over those 10 years and set predefined asset allocation ranges to ensure that we have a plan in place and we are going to stick to it. Once we have done that, then we can look at where we are today and look at a more tactical level. Common mistakes are complacency or just looking back. The classic is when people invest in assets that have already gone up a long way and stipulating a benchmark as the investment objective rather than having an investment objective and then picking the benchmark.
CR: Do you include alternative asset classes within the portfolio and racier asset classes?
DC: It comes back to the long-term strategy I mentioned earlier. We take a shorter-term view to invest tactically. And we use alternative asset classes, whether it is property or hedge funds, and move in and out of as one would have done traditionally between bonds and equities. I just see them as extra tools. We look at the levels of volatility and absolute risk in the alternative asset classes and look at our forecasted returns and see if they measure up versus the more traditional classes. And if they do, if the trade off is worth taking, then we will do that.
RP: We are more than willing to put those assets in the portfolio if they are within the requirements of the client and their risk and reward profile. These assets provide diversification. We are looking to put together a fully diversified portfolio which maximises return and minimises risk.
CR: Do you have a risk budget for your funds and if so what? Presumably it is not just volatility?
DC: For every investment decision we take a look at the potential losses we might make by investing in an asset class or divesting of an asset class. If risk control is key to your investment process, then you need to look at both absolute and relative risk measures. We also target a level of volatility for the portfolios and regularly review and stress test the portfolio. Market volatility has fallen to such low levels that optimisation programmes can give you false readings. And also if you look at the statistics of your portfolio, you could be lulled into a false sense of security. The volatility on our portfolios is incredibly low and consultants will say &shouldn't you be taking more risk?& I would say no, because I think that risk will come back and find us.
CR: Is it possible to achieve absolute returns in declining equity markets?
DC: Not in the hedge fund sense - we are not saying that our absolute return funds will make positive returns in negative equity markets. In our highest risk fund, for example, we would expect the fund to fall. But we are trying to ensure that it does not fall by more than 30% of the market. In our lowest risk fund our principle objective is preservation of capital. But there is no such thing as a free lunch.
RP: We work much more in a relative environment - we want our clients to be aware of what they bought and why they bought it. We also do not think that a single fund is the answer to everyone's prayers. Multi-manager funds are great, as a core holding, but I think every client is unique and has to have something outside of that.
CR: Turning to the current environment, looking at the bigger picture, where do you stand on equities versus bonds versus property at the moment?
DC: I think the first question is the time frame. I am a long-term fan of equity, I believe capitalism works. Over the next 12 months, I would stick with that position, I would actually go equity, property, cash, fixed income at the moment.
RP: Timing, as you rightly say, is important. Very short term I think cash probably looks pretty good on a risk/reward basis. Equity markets have had such a great run that we have been reducing exposure and locking in to some of the profits from last year. I cannot see much value in fixed income. UK commercial property has had an excellent run and it makes me slightly nervous that there is a bubble there. I think hedge funds might return a little bit this year. I think we are seeing increases in market volatility. We have seen it in Japan and are starting to see it elsewhere. We are also seeing a pick-up in M&A activity in the UK. But longer term I agree that equity is king but I think returns will be relatively modest because of the inflationary environment.
CR: There has been a variety of property funds launched recently. Do you blend different types of property fund?
RP: Whenever you put an asset into a portfolio, you have got to balance and blend the risks and the rewards. I will generally hold four or five UK funds, four or five property funds, four or five fixed income funds to diversify the manager risk and the portfolio risk. We only invest in property investment trusts such as British Land or Land Securities for instance. But there are different asset classes within property. There is residential - which most property funds will avoid - but then there is industrial, commercial, retail, and whether they are inside the M25, outside the M25, in the Home Counties, Scotland, Ireland, Wales. Different geographical regions do have different income and growth objectives.
DC: We take a top-down view first when picking the managers. We run a property fund of funds and we prefer to pick generalist managers who we think know the markets better than we do. We will make a call on the geographic region. Where we attract value is buying closed-ended property funds as well as open-ended and we have been trading the discount because there are big premiums in that sector at the moment and we have taken profits.
CR:Which regions do you prefer at the moment?
RP: This creates an awful lot of debate in our office. We have seen some very, very good returns over the last couple of years. Many of the major markets are in a rising interest rate environment, whereas we believe the rates in the UK are going to fall next year, or this year even. So you are likely to see a bit of a disconnect between the markets. But the largest company in the British stock market is BP, which does not earn all its returns from the UK. So we have seen an increasing amount of globalisation. One of the major sectors that has underperformed in the last couple of years has been the US. We have been underweight the region but we are starting to close that slowly. I think Europe is a great market, it has got some world class companies, despite being plagued by politics. And it has also got the benefit of Eastern Europe as well.
CR: Are there certain types of fund in the US that look particularly promising?
RP: I would suggest that larger cap would be the area to go to. The US has been driven in the past few years by value companies. Once again the smaller companies have beaten the larger companies by quite a long way and we see a lot of opportunities emerging in large cap.
DC: We have had zero in the US for the past 18 months and we still maintain a zero weighting to the US. I do not see that changing short term, unless we become even more defensive on the outlook for global growth. We prefer to be invested in Asia and emerging markets. Although these markets are not cheap, we do believe that they will go to a premium against developed markets this year. This might seem counter-intuitive but we think there is a wall of money, particularly from the US that is going to go into those markets and a lot of investors using optimisation techniques, or backward looking data, will see that emerging markets and Asia now have volatility close to developed markets and are generating greater returns. I agree that Europe looks attractive. We particularly like peripheral Europe so Greece, Ireland, Eastern Europe.
CR: What will be the biggest risk for investors this year? Rising commodity prices, interest rates, property market bubbles or a consumer slowdown?
DC: All of the above. What is the biggest risk of the four? I think you have to go on a market by market basis. I think a consumer slowdown worries me in the developed markets. And the slowdown in the housing market in the US is another reason why we are cautious there. In the UK, I am worried that consumers are spending less. The increase in non-discretionary spending - whether it be council taxes or train fares - is going to take money out of the economy.
RP: I would have to echo every single answer. The risk for commodity prices depends what you consider commodities - hard or soft commodities or oil prices or heating bills. Consumer confidence and property prices seem to have a pretty high correlation. At the end of the day people think there is a recession if they do not have a job. I think the consumer is overstretched. We have a very low savings rate and we are all thinking that we will be okay tomorrow, we will start saving tomorrow.
Continued next month.
£300bn of liabilities
View from the front row
Transfer from occupational scheme
Appointed by FCA and PSR boards