A model portfolio

New clients, previously with a rag-bag of holdings, and too many dud funds, have had portfolios transformed into something with a clear purpose and structure with the help of this model.

It will help you reflect on the funds you’ve accumulated over years (whether portfolio, pensions/SIPP, or PEP/ISAs), and provides a template for putting together a portfolio, perhaps for a SIPP.

If your attitude to risk has been properly identified, and then adjusted for circumstances such as your age, it should be possible to structure a portfolio full of quality funds with proven track records, and you shouldn’t need to adjust these fund choices too often.

Of course if you want to chase the funds doing well each month or quarter, this guide and its approach is not for you. Even the professionals don’t do this very well - they are either chasing an established trend of uncertain further duration, or trying to anticipate short term trends, both of which are problematical. But base your selection on sound principles that work in the long term, and you shouldn’t go too far wrong.

To this end we’ll now consider:

• what is the ideal fund?

• what should be the asset and geographical split?

• what is the objective with each part of the portfolio?

The ideal fund is one that consistently provides above average gains by taking below average risks. Some other funds may be higher risk, but provide such consistently higher rewards that they can also be recommended. Our analysis certainly helps identify both types of funds. It is not always a straightforward job, as pure statistical analysis can overlook hidden dangers, and these are the seeds of a fund’s future volatility which we also try to identify.

There are a number of approaches to the asset and geographical split. Over many years we have seen a variety of reviews that, with the benefit of hindsight of the recent past, tell us you should have “more invested overseas”, then “most invested in the UK”, or “greater sums in the US”. And computer models are increasingly used to create the chimera of a rational portfolio structure, but tell you nothing of the “accidents of history” (see section 3.2), and lack the input that only experienced practitioners can provide.

Obviously you must start by having a comfortable sum on deposit or similar – to cover emergencies, planned expenditure, and peace of mind. As you get older you should adjust this exposure, with more in lower risk choices (e.g. bonds and property), and less in stockmarket linked investments.

For example, you can apply a rule of thumb that the low risk element of your portfolio should be equal to your age. So if you’re aged 25 the low risk holdings would be 25%, and if you’re aged 75 they might be 75% of your total investments. This is only a rule of thumb, giving a structure for consideration - for example, life expectancy is somewhat higher than when this guide was introduced decades ago, so it may be too cautious for some. This might be more so if you have a secure and more than adequate guaranteed pension. On the other hand personal circumstances and your attitude to risk may make this cautious guide just right for you.

Your overall objective will be matched against the portfolio as a whole, but the objective (or expectation) with individual elements of the portfolio varies. The low risk element is the stable core, and we would expect returns at a margin over those available on deposit returns, but not a huge margin. We believe the relatively high returns from fixed interest/corporate bond investments in the 10 years to 2006 were anomalous, and the less impressive performance of 2006/7 was arguably long overdue. However, there are now considerable attractions to corporate bonds, so do not be put off by the performance of 2006/7. To provide greater balance in this element of your portfolio you should add bricks and mortar property funds, global bonds, and new opportunities as they arise, such a total return funds, infrastructure, and protected funds - remember, the expectation is lower risk as well as lower reward.

The medium risk element, at its long term core, is focussed on UK equity income funds, for reasons regularly set out in this publication. We should expect returns at a margin over corporate bond funds and inflation, and total returns (that is growth and dividends) to be in high single figures.

The high risk funds hold out the potential for double digit gains, but with somewhat greater volatility being the price. We look to generate this primarily from the Far East, emerging markets, and alternative asset classes such as commodities.

Our model is designed for a 50 year old, whose objective is growth, and who is comfortable with medium risk investments.

RISK	Monthly Risk (%)	FUND	Style (1)	Cap (2)
LOW (50%)	n/a	Artemis Strategic Bond			About	Buy
	n/a	JPM Cautious Total Return			About	Buy
	n/a	New Star Property			About	Buy
	2.2	Newton International Bond			About	Buy
	n/a	New Star Intern. Property			About	Buy
MEDIUM (30%)	4.7	Jupiter Income	value	large	About	Buy
	4.0	Invesco Perpetual Income	blend	mid	About	Buy
	4.4	Newton Higher Income	value	large	About	Buy
	5.3	M&G Recovery	blend	small	About	Buy
	5.0	Artemis UK Special Sits	value	mid	About	Buy
	5.4	Jupiter European Spec Sits	grwth	mid	About	Buy
HIGH (20%)	5.2	Schroder Tokyo	value	large	About	Buy
	7.1	First State Asia Pac. Ldrs	blend	large	About	Buy
	6.3	M&G Global Basics	blend	large	About	Buy
	6.2	Inv. Perp. HK & China	blend	large	About	Buy
	10.6	Investec Global Energy	grwth	large	About	Buy
	8.0	AXA Framl. Em Mkts	blend	mid	About	Buy
	n/a	New Star Heart of Africa			About	Buy

(1) We would also include a protected fund in this lower risk portion, but offers are for limited periods so we have not specified a fund. See more on protected funds on the next page.

It is a portfolio for someone who wants growth – about two-thirds of those who hold corporate bond funds do not take income, so this model is aimed at the majority of investors whose objective is growth.

It is a medium risk portfolio, for a 50 year old, taking at least a 5 year view, and ideally 10 years. Medium risk was defined back in section 3.3. The age is significant. Our guideline is that your portfolio should have an amount in lower risk investments equivalent to your age – so the older you get, the less risky becomes your portfolio. This portfolio therefore has 50% in lower risk investments.

It is diversified. If you look backwards there is no one “super asset” or “super fund” that delivers high, positive, above-average returns year in and year out. So diversification is required across assets (e.g. equities and bonds), across styles (value and growth), and across continents (e.g. UK and Far East), because you can never be sure where the positive growth will arise from year to year.

Those are the key elements of our model, and we anticipate some questions:

Changes since last time? The addition of JPM Cautious Total Return and Investec Global Energy added stability to the portfolio, and M&G Global Basics added performance. With the Newton Higher Income and Jupiter Income funds currently being unrated, there is an argument to replace them but, as we set out in section 5, these are the sorts of funds we are more inclined to buy on relative and absolute weakness.

Our only concern is that all of the high risk selection are exposed to similar negative risks, in particular an economic slowdown in Asia and most emerging markets. We highlighted the attractions of Africa in section 4.4, and the lack of correlation with other emerging markets and the rest of the world has obvious attractions. So we are replacing Invesco Perpetual HK and China (which has been a superb fund for many years) with New Star Heart of Africa. The map below highlights how Africa dwarfs the rest of the world, at least physically.

Should you use protected funds? Yes. In the past the lower risk portion of your portfolio has usually been thought of as corporate bonds and gilts, but there is much more to consider, protected funds in particular. From time to time products are offered by investment houses where at a given point in the future, usually after 5 or 6 years, 100% of your original capital investment will be protected.

Over the period of the investment additional growth will be based on a formula e.g. 100% of FTSE 100 index growth. As a lower risk investment these products can be very attractive, on the basis that you know what the worst outcome is likely to be (subject to the very small print) – that is the return of your capital.

These protected funds are not alternatives to normal stockmarket-linked funds, that move up and down with the market day to day. These funds are simply a different way to try and achieve returns at a margin over what you could get in the building society, the limited objective of the lower risk part of our portfolio.

Why so many “income” funds? Many analysts now believe that total returns (that is capital growth plus dividends) over the next 10 years could be just 6-8% per annum. If so, a fund investing in shares yielding, say, 4% (providing it appears reasonably secure) generates a good chunk of that total return before any capital growth comes through. The Newton Higher Income fund currently enjoys a yield of 6%.

Why so much high risk? The equity income funds are relatively conservative ways to invest into the UK stockmarket, though arguably the optimum way to do so. If the total returns from the mature stockmarkets (capital growth and dividends combined) are to be modest in the years ahead, averaging, say, 6-8% per annum, the boost to growth will come from the Far East and the developing and emerging markets.

Is it too low risk? That’s up to you. If you are aged 60 with a secure inflation-linked pension, £100,000 on deposit, and an investment portfolio of £100,000 (including PEPs/ISAs), you certainly could take on more risk than our guideline suggests, which would have 60% in lower risk investments. Would you be comfortable with more risk? That’s where our advisory service can help, as we can provide tailored assistance.

How do you measure the performance in the future? The key to this portfolio is that it is tailored to the needs of our imaginary 50 year old. Beyond this, the minimum target for future performance is that, on average from year to year, you earn more than you would have done on deposit and beat inflation. That you would achieve these apparently limited objectives used to be taken for granted – the 2000-2003 bear market has shaken any such complacency. Otherwise we will measure the performance of the individual funds within their respective sectors, to ensure they are doing what was expected of them i.e. consistent above-average performance in their respective sectors.

Why no high yielding bond funds? These funds occupy the “UK other bond” sector and there are two within the DIY selection in section 5, from Invesco and New Star. These funds tend to be more closely correlated to the stockmarket than interest rates. If there is a domestic economic slowdown these funds might drift.

Is this model like a “fund of funds” or “multi manager”? Funds of funds have become very popular in the last year or so. In essence the manager of the fund of funds decides what funds to invest into, and has a discretion in doing so. This is just like any other fund in the sense that you have no relationship with the manager, so the ongoing structure of that fund takes no account of your personal objectives. You will typically also pay extra charges for this extra layer of management. Our model is very different as it is designed solely for you (or at least our fictitious 50 year old) and it involves no extra charges to you. We have gone through a process to identify a pool of funds that we are comfortable including within client portfolios, and the model is the distillation of this for one particular person.

If you feel that your portfolio is a bit disorganised, do get in touch and we’ll give you a helping hand - ring us on 020 8467 1666

NOTES
Notes 1 and 2: “cap” refers to the average market capitalisation of the companies in which the fund invests. This is important because the behaviour of large companies differs from small ones. Style refers to the way companies are valued. Some companies appear expensive in relation to current earning power but provide excellent growth opportunities: known as growth companies. Others trade at a low multiple to current earnings but are not expected to grow: these are called value companies. The style of some funds is to invest into “value” shares, others into “growth”.

Source: www.morningstar.co.uk

Just like to say, thank you for sending the latest Top Funds Guide. It is most informative....
[read more]