More and more investors, both professional and private, are choosing to allocate a greater proportion of their portfolios to passive products such as tracker funds and exchange traded funds [ETFS].
For example, a recent poll of FE Trustnet readers showed that a little under two-thirds of readers have increased passive exposure, as a proportion of their total portfolio, over the past year.
Choosing between these vehicles is arguably harder than with active funds, particularly for retail investors, due to the dominance of a few major players and the most important metrics - after cost - being puzzling quantitative measures such as ‘tracking error’ and tracking difference’.
These two reasons are the driving force behind the launch of FE’s new rating service. However, while these tackle the important business of which passive fund has best mirrored the performance of a specific index; the fundamental question for investors putting together a portfolio of passives is one of asset allocation.
In other words, how much to have in equities, fixed interest and alternatives – and more specifically what areas within these broad asset classes to stash your cash in.
Asset allocation with passives also remains a daunting task for many investors, as at different times in both life and the business cycle it often proves wise to hold different types of securities.
Here we take a look at how the experts recommend to allocate for investors with a cautious, balanced and adventurous outlook at the moment.
Simeon Downes, senior analyst at wealth manager SCM backs the traditional hypothesis that a more cautious approach should broadly have greater exposure to fixed income than equities but says the current level bond markets makes this less straightforward.
In the SCM Long-Term portfolio, which aims for high growth and is therefore the firm’s most adventurous, about three quarters of exposure is to equities, 22.5 per cent in bonds and the rest in cash.
SCM Long- Term Return Portfolio breakdown
Source: SCM
“It has a higher weighting toward equities on the basis that historically they have tended to have a higher risk,” Downes said.
He says with the majority of equity allocation, about 57 per cent of the portfolio, is in large caps, it is not wholly risky but a 17 per cent slice of small and mid-caps allows the potential for faster growth compared to the core equity markets of the US and UK.
Also, occasional strategic allocations to more volatile countries or regions also offer this potential.
“Where we would select specific region or countries strategically– for example Russia, which we bought recently – we don’t hold them for very long, between one and six months. We have now sold out of Russia,” Downes said.
Regionally, the biggest weighting of equities is to the UK followed by North America which makes two-thirds of the equities followed with most of the rest equally split between Asia Pacific, Europe and Japan.
Downes says the best value is currently offered by emerging market and Asian equities, although the overweight position in UK large caps may be a beneficiary of election uncertainty as the UK goes to the polls and in the event some of the most likely outcomes.
“It will be interesting to see, should there be a UK Labour based coalition government, if there is dramatic fall in UK equities. The polls have been predicting a hung parliament for some time. Many of the largest UK blue-chips are dominated by overseas operations which could benefit were there to be a subsequent fall in Sterling”
“Much of the European discount rating has now been eradicated through recent gains and the best value is currently offered by emerging markets and Asia, in our view.”
Performance of indices in 2015
Source: FE Analytics
“Recent changes to expected corporate earnings have been mainly negative worldwide and more surprisingly, despite the strong US dollar and weak Euro, downgrades in both these markets are broadly similar.”
Investors who want UK large-cap exposure may wish to consider DB X-Trackers FTSE 100 UCITS ETF Income, HSBC FTSE 100, iShares Core FTSE 100 UCITS ETF, Lyxor UCITS ETF FTSE 100, Santander Stockmarket 100 Tracker Growth and Source FTSE 100 which all score five for their FE Passive Crown rating.
In terms of emerging markets, Vanguard Emerging Market Stock Index carries FE’s highest rating.
Fixed income is mostly made up of corporate bonds of a cyclical quality – typically A or ‘BBB’ which Standard & Poor’s rate as the debt of financially sound businesses but susceptible to adverse economic conditions.
In their balanced fund, the SCM Absolute Return Portfolio, bond allocation is ratcheted up to 36 per cent of total assets with duration risk reduced, Downes says, while equities retain their exposure in terms of cap size. Starkly, however, US stocks are almost completely removed from the portfolio.
He says while there are still US stocks in the long term portfolio, the team are not favouring a straight play on the S&P 500 due to its strong run.
“Instead of having a pure allocation to an asset weighted ETF of the S&P 500, we have used a smart beta ETF. We are trying to dampen volatility and get a more diverse investment universe because the US had a very good year last year, we want to minimise the downside risk,” he said.
The SCM Bond Reserve Portfolio is the firm’s most cautious portfolio which largely invested in the bond market with a small weighting to cash of around 3 per cent.
It has a higher weighting to government bonds than the other two portfolios but has similar geographical spread.
“If you buy a 20 year bond you have a higher risk than if you are buying something with shorter duration. Our portfolio takes that into consideration and we are reducing the duration of the bonds.”
While there is no equity exposure, Downes says by blending it with the SCM Absolute Return Portfolio to add diversification.