Dynamic asset allocation is key to successful long-term investment, says Tom McGrath, fund manager at Miton Investments
It is becoming more difficult for financial advisers to create a properly diversified portfolio for their clients - one of the reasons the multi-manager approach is becoming more popular.
Historically, an adviser would have balanced a holding of UK funds with some in the US, some in Europe and so on, with the theory being that when UK shares slumped, the loss would be offset by a gain in the overseas element of the portfolio. However, globalisation, the internet and general IT boom appear to have diminished the importance of domestic factors and increased the correlation of world stock markets.
As we have witnessed recently, poor figures in the US will ordinarily result in corresponding falls in Europe and Asia. With companies listing on different markets, cross-border trading of shares and goods, corporations actively pursuing their own international diversification of income stream and finally the internet ensuring a more timely and accurate flow of information, it is easy to understand the increasing correlation.
Since the equity bear market growled in 2000, the initial and sensible response to the increased correlation in equity markets has been for bonds to be added to portfolios and over time this has been the right thing to do.
Take a look at the table below, it is not by accident that even including the halcyon days for shares, the two IMA sectors which have their equity exposure limited, Balanced (max 85%) and Cautious (max 60%) have outperformed the Active sector (no limit).
Taking the logic one step further, investors should also use all the available asset classes at their disposal, namely; cash, equities, bonds, commodities, property, currencies and 'real assets' such as art, wine or vintage cars (MG Rovers do not count).
The decision to diversify between asset classes is the first step but the next - knowing which assets to hold and when to buy or sell them - is the tricky part and there are differing opinions on the matter. Modern Portfolio Theory (MPT) is gaining prominence. It looks mathematically sound and earned its creator Markowitz a Nobel Prize in 1990.
MPT is the philosophical opposite of traditional asset allocation. It is the creation of an economist, who looks at the market as a whole, rather than asset allocators, who look for what makes each investment opportunity unique.
Investments are described statistically, in terms of their expected long-term return rate and their expected short-term volatility. The volatility is equated with 'risk', measuring how much worse than average an investment's bad years are likely to be. The goal is to identify an acceptable level of risk tolerance, and then to create a portfolio with the maximum expected return for that level of risk. Mathematicians have long been trying to understand and quantify the vagaries of the stock market and some of the most powerful computers and brightest minds on the planet have attempted every type of statistical analysis to create the optimum portfolio. Indeed should insomnia ever prove problematic, I can recommend a study of multi-variate normal distributions and the world of Generalised Autoregressive Conditional Heteroskedastic (GARCH) modelling.
All fine on paper but without a significantly time horizon this approach can have some disastrous effects, particularly in falling markets as witnessed in the early 1990s. Around the time MPT became popular, practitioners in this science demonstrated that by adding emerging market funds to a normal portfolio, potential returns could be increased and risk could be reduced (due to the regions low covariance with the rest of the world). Those that took this advice have suffered ever since. So beware of the 'new' exciting asset allocation software available online as it is likely to be based around mathematical formulas.
The lesson to be learnt is not that MPT or GARCH do not work. I am sure any investor that has a long enough time horizon will benefit from exposure to emerging markets or other volatile assets, but the point is market conditions change and that static portfolios - however scientifically they are put together - will not always work. This is where the additional services of an ongoing asset allocator comes in, or to put it in industry jargon, where a good fund of funds (Fofs) manager comes in. For advisers and clients that do not have the time, skill, resources or experience to constantly evaluate the changing market dynamics, this additional level of management is invaluable.
The role of the Fofs manager is not based on scientific formulae but rather on common sense, hard research and using experience to evaluate the ever-changing macro environment. Portfolios must be well diversified, not geographically or scientifically, but pragmatically across all asset classes and put together by an experienced team that changes weightings as circumstances dictate.
They should not fear straying from the crowd when constructing portfolios, as value lies where others cannot see it; our advice would be to stay clear of multi-managers that work to tight benchmarks. It is a salutary lesson to us all that when it feels right to buy, it has with hindsight more often than not, proved to be the time to sell
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