To recap so far, I have reviewed my attitude to risk and found my new target asset allocation. I have evaluated which funds I want to keep and which ones to jettison and now I have the altogether more interesting task of reconstructing my portfolio. Last week’s post generated many comments and highlighted a few things I ought to clarify. I should put this into context: I’m in my early 30s and my priority is capital growth.
I’m using a pension product rather than an ISA because I’m a member of our company pension scheme and my employer's contributions go into a pension.
There are two principles I’m going to use to construct my portfolio that are a little different from what is traditionally taught, and I think it is worth summarising these here so my later decisions make more sense.
The first is that the asset allocation is not important. The asset-allocation model is a suggestion of the best way to achieve the target risk level – which is more important in my opinion. This is what I want to achieve and if I can find a better way of doing it than the actuaries’, then all’s well and good.
The second principle is active versus passive – I personally go for the former. This is likely to be controversial; most research shows that over the long-term active management does not produce above-market returns, with the obvious conclusion being that it isn’t worth the additional fees.
What this research fails to do however, is to take account of the additional diversification benefits of active management.
Fund managers do not all think the same and as a result they all make slightly different bets and follow slightly different strategies.
By carefully selecting offsetting styles and strategies it is possible to obtain the same exposure to the asset class, but with much less risk.
This is a topic that I have written about extensively in the trade press and will probably summarise here in future articles, but the gist of it could be thought of thusly: the additional diversification benefits of active funds are worth the extra fees alone, and any excess return is a bonus.
To pre-empt the usual comments of bias due to FE Trustnet’s reliance on advertising from active funds, I would like to point out that this piece is about how I am investing my own money and I personally don’t get any of FE Trustnet’s advertising revenue.
To address another comment from last week, this is why I don’t invest in ETFs or investment trusts. ETFs are obviously tracker products and trusts offer fewer diversification benefits due to the high correlation they have to the markets they are listed on.
To put these principles into practice, I’m going to borrow a technique that I use in the FE Research model portfolio process that forms part of the outsourced investment proposition we offer to IFAs – which constitutes my day job when I am not writing blog posts.
Using market indices I have built a dummy portfolio that exactly matches the suggested asset mix; this helps me to understand how much real world risk there should be in my portfolio.
Part of my monitoring process involves comparing the actual volatility of this portfolio to my pension in order to see how much additional risk I am taking on as opposed to what is predicted by the investment forecasting tools.
With all this in place I can now get down to the actual task of decision-making.
In the outsourced IFA service I use an optimiser to pick funds based on their diversification benefits and then tweak the weightings to meet some loose asset-allocation guidelines.
Within the confines of my pension scheme, however, that method won’t work so I need to take a different approach.
I decide my tactical asset allocation and then pick funds that have offsetting characteristics, which will hopefully diversify away the additional risk and leave me close to my target risk level.
The target asset mix suggested by the risk profiler is: 15 per cent fixed income; 40 per cent UK equity; 35 per cent international equity and 10 per cent property.
Importantly to me, the dummy portfolio representing this mix has displayed about 11 per cent annualised volatility over the last three years.
This is the number I want my new portfolio to show when I look at its past performance. FE’s research into the matter shows past volatility is a fairly good indicator of future volatility, but I think that is something I will expand on at a later date.
Right away I am binning property. In my mind it is great for income but does not have the growth prospects important to me.
Also, because physical property funds rely on the fund manager or estate agent guessing what the portfolio is worth for their valuation, they often look quite stable and then experience severe corrections.
In short, I just don’t like them. This is an emotional reaction that I would usually advise against in my professional capacity, but at the end of the day, it is my portfolio and I don’t mind it reflecting my biases, either rightly or wrongly.
If I was advising someone else, I’d probably keep quiet.
Also, I think 40 per cent UK equity is too high; just because I’m familiar with the UK market that doesn’t make it any less risky.
I suspect in France investors think French equities are safer than UK ones and so on. We can’t all be right. The UK makes up just 9.5 per cent of the FTSE All World index, which seems like a much better starting point.
On top of this I have an optimistic view of the UK outlook and, with my long time horizon, it is probably better to bet on things picking up than slowing down, as it is bound to happen eventually and I have enough time to make back any losses from getting the timing wrong.
With this in mind, I’m sticking to the 15 per cent in UK equity from my previous portfolio.
The extra 25 per cent from UK equity and the 10 per cent I have rescued from property are going to be allocated to emerging markets.
This seems like a highly aggressive move, but I think I can offset the extra volatility through clever fund selection and based on my objectives and time horizon, emerging markets are a no-brainer.
Remember my first goal is to meet the target risk level, and not to match the target asset allocation.
If when I build my portfolio I can’t implement this allocation within my risk budget, I’ll tone it down. My goal is to get the maximum exposure to growth potential in a portfolio with about 11 per cent volatility.
I’m going to try and reduce the reliance on China in the emerging markets section and boost the exposure to Latin America, which I think is going to be the stronger region over the next 10 years.
I’m quiet on eastern Europe and Russia, as I think the US shale gas industry will keep prices down and depress prospects.
Seeing as Gazprom is basically president Putin’s slush fund, I think the whole region will be destabilised by falling gas revenues.
The 15 per cent allocation to fixed income stays, but I’m going to use a mixture of index-linked and global bonds to provide the maximum amount of diversification and try to avoid the most obvious problems facing fixed corporate and government bonds at the moment – this calls into doubt the survival of M&G Strategic Corporate Bond in the portfolio – but I’ll discuss that in my next piece.
The 35 per cent in international equity also seems about right, but I think I’ll skew it more towards the US.
So my new asset allocation is: 15 per cent fixed income; 15 per cent UK equity; 35 per cent international equity and 35 per cent emerging markets.
This is based mostly on gut-feeling and some basic analysis. Like most people I do not have time to pore over GDP stats, plus I’ll end up changing again as I try and fine-tune the portfolio’s risk.
While I will probably end up getting some of these calls wrong, this is about the best I can do without making it my full-time job.
Importantly for me, I will have a portfolio that will have the sort of long-term growth prospects I require.
The decision to go more Brazil than China will have little impact over the long-term; but even if it turns out to be wrong, the decision to put more in these high-growth regions rather than in UK equities will still mean I have more to retire on.
I don’t think I’m a radical in my assumption that the growth rates in emerging markets will be higher than in the UK over the next two decades.
I like to take a bit of a punt and I’m fortunate to have time to correct for any mistakes; as I get older, I’ll lose this capacity and will probably tone down the extent of my own tactical positioning.
Tomorrow, Rob Gleeson will reveal which funds he is adding to his pension portfolio and why.