Thinking about what should constitute the core of a portfolio has changed radically, encouraging investors to look away from domestic equity and find their focus elsewhere. But in which alternative directions should they look? Cherry Reynard investigates
Building the core of an investor's portfolio used to be a simple matter of blending a portfolio of blue-chip domestic equities. This part of the portfolio would be large-cap, benchmark-aware and low volatility. But the theory as to what makes an effective core holding has shifted. A better understanding of risk and the resultant shift towards absolute rather than relative return, plus the effects of globalisation, have combined to make investors reconsider what lies at the heart of their portfolio. So what have emerged as alternatives?
Why are traditional blue-chip UK equities no longer considered the best option for a UK-based investor? There is no doubt they will still form the lion's share of many investors' holdings, particularly as the standard argument for investors having a large domestic holding has always been the issue of currency considerations.
But Michael Jennings, manager of the Premier Global DSR fund, says that the long-term risks of currency have been overstated. He adds: "Research has suggested that over the long term - around 10 years - if you took the MSCI World and didn't hedge out currency, the risk would come out only fractionally higher than for the FTSE All-Share."
Jennings also points out that as many of the larger UK companies generate significant earnings overseas, UK funds will have currency risk anyway. He says: "There is an idea that you take no currency risk with a UK portfolio, but blue-chips like GlaxoSmithKline, Shell and HSBC are all vulnerable to the dollar and other currencies."
The UK stockmarket has also attracted a plethora of non-UK companies, such as Kazakhstan copper producer Kazakhmys, which generate few earnings in the UK, if any.
Gavin Haynes, investment director at Whitechurch Securities, says that of the top 350 UK companies, around 70% of their earnings come from overseas. This makes country boundaries largely obsolete. He says: "If someone is looking to invest in a pharmaceutical stock, it is no good just comparing Glaxo with AstraZeneca. You need to look at how they stack up against, for example, Pfizer, to get a real idea of their competitive position. Many fund management groups have changed the structure of their research and now use global sector analysts rather than country-specific ones."
The UK market is focused on certain sectors including oils, pharmaceuticals and banking. This can bring about artificial biases in a portfolio.
Globalisation and multi-asset vehicles
So, if domestic equity funds are no longer appropriate as a core holding, where should investors look instead?
Global funds are the obvious alternative. Globalisation means that companies increasingly compete on a worldwide rather than a local scale. Performance of this type of fund has improved as companies have shifted their research structures and the sector has become more competitive.
Haynes looks for good global funds, managed on a sector or thematic basis. He likes funds that seek absolute rather than relative returns. The Threadneedle Global Select fund, for example, aims to be largely country-neutral. Manager Jeremy Podger says: "The world is globalising; capital is mobile. We aim to pick the best companies across the world and move away from the idea that a global fund is simply a collection of regional funds."
Funds that take an absolute return approach have also become more popular as a choice of core fund. Jennings' fund, for example, makes full use of the Ucits III powers and will move into cash or fixed interest instruments in difficult periods. Funds like the BlackRock UK Absolute Alpha fund, managed by Mark Lyttleton, will also short stock, and this fund has generated a positive return every month for the past year in spite of the turbulent investment climate.
Haynes says: "Managers like Lyttleton don't hide behind the index and are looking to make money irrespective of the environment."
This is the theory behind multi-asset vehicles, a popular area for new launches over the past couple of years. These funds are often benchmarked to cash, and aim to deliver a positive return year in, year out by blending alternative and traditional asset classes. The Insight Investment Diversified Target Return fund, for example, starts with cash as a basis and then looks for opportunities that will return more than cash for the right level of risk. Therefore, the portfolio can look very different from a classic balanced fund of bonds, equity and property. Manager Patrick Armstrong believes that strong returns come from having the widest possible opportunity set.
Multi-asset funds are designed to be bought and left over the longer term, which can make them an ideal core holding for those who do not wish to trade funds actively. But investors need to be careful that the funds truly merit the name 'multi-asset'. They should be looking across all asset classes to deliver returns in all market conditions, but a number of funds still invest only in a limited range of assets.
Institutional managers have used passive funds, such as exchange-traded funds (ETFs), as the core of pension fund portfolios. These funds usually win out on costs. Providers argue that few active managers outperform over the longer term and therefore active fees are a waste of money. The cost advantage of an ETF over an active fund will add up over time.
This is also part of an increasing trend towards the separation of alpha and beta. Philip Philippides, head of UK sales at iShares, says: "Traditionally, an active manager would be expected to generate 5% above the index. This still leaves 95% of the return coming from the index. The thinking has evolved, and portfolio managers now hold a core in beta holdings, which allows them to buy a lot more risk. They can then give money to an active manager and not restrict them to a benchmark."
He adds that managers will either use a basic global index like the MSCI World as a core holding, or build their own portfolio of ETFs according to their asset allocation views. The active/passive debate has been well rehearsed along with the limitations of passive investment. But with the cost of active funds rising and ETFs now available on the major indices with very low total expense ratios, passive funds remain a viable alternative for a core holding.
The amount of money that should be going into emerging markets has also exercised portfolio managers. If the Bric economies of Brazil, Russia, India and China are the super-economies of the future - surpassing the US within 15-20 years - surely they merit a larger chunk of a portfolio? But should these be making up the core of a portfolio? After all, much of the perceived 'riskiness' of these areas has been shown as spurious by the banking crisis in developed markets.
Jennings says: "These tigers are the growth engine of the future, but they still have volatile currencies and can be volatile politically." Benchmark-driven managers will struggle to include significant emerging market exposure as these regions still form a relatively small part of, for example, the MSCI World index.
Huge flows have gone into emerging markets, leaving some valuations looking stretched. Emerging markets should undoubtedly form a significant part of an investor's portfolio, but whether they should be the core holding is debatable. They will also almost certainly form part of any global or multi-asset fund.
Arguments can be made for each type of investment, but managers increasingly have a philosophical problem with the concept of core funds. For example, Robert Burdett, joint head of multi-manager at Thames River, says that rather than 'core' funds, he prefers to think in terms of stalwart funds that are always in the portfolio, though weightings may vary.
He says: "At the core of every portfolio should be funds that deliver year in, year out. There will be periods when they do better or worse, but their approach is very consistent."
The funds in the Thames River portfolios that fulfil this role include the Findlay Park US Smaller Companies fund, which invests in small and mid-cap stocks across the Nafta region (including Canada and Mexico). In the UK, Burdett looks to the Rensburg UK Managers Focus fund. He adds: "Again, this is not a typical 'core holding', but it is a reliable value-added fund."
Burdett believes that as even the best managers will have periods of underperformance, any portfolio of funds should be actively managed. The concept of a fund that can sit at the heart of a portfolio and simply remain there is now well and truly outdated, he suggests.
There are plenty of reasons why blue-chip domestic equities should no longer form the core of an investor's portfolio, but what should replace them is open to debate. If a core holding is designed to perform over the long term, each type of investment has its merits - multi-asset should deliver returns across all market conditions; emerging markets are plugged into future growth; passive investments are cheap; and global funds take a broad outlook and aim to select the best companies in the world. But none will deliver everything in one package, so in the end it will come down to a simple question of priorities.
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Retirement Planner Forum 2019