Allocations are Forever Paul Roberts

Armed with a return objective and a risk tolerance assessment, the spectre of a strategic asset allocation decision can now be confronted.

Most of our clients are looking to select an investment combination which offers steady income, the potential for capital growth together with low to moderate price volatility. But with so many potential combinations to choose between even just the main asset classes of bonds, equities and property, where should one begin?

Starting with probably our clients’ favourite asset class, property, it tends to exhibit relatively low volatility (leaving REITs aside on this occasion) and offers the prospect of steady income payments with generally low correlation with other asset classes, making it excellent for improving diversification and reducing portfolio volatility when used in combination with other asset classes.

Property is used in many multi-asset funds for this very reason and as an asset class is no doubt popular with clients because it feels the most tangible, a physical object rather than bonds and equities which live (at least these days) in the digital realm. But it is far from being a one-way bet with prices only ever likely to increase year-on-year, as 2020 has shown. Illiquidity and high transaction costs also mean exposure to property is not an asset class that can be easily exited from, or at the right price, so an allocation here should only be made after careful consideration.

Bonds offer contractual income payments with moderate price volatility, depending on duration, but less so than equities. Bonds often form a significant part of a diversified portfolio, with steady coupons to bolster income while helping to reduce volatility at the portfolio level. Quantitative Easing (QE) has been both a blessing and a curse for bonds, pushing up prices and giving nice capital gains to existing holders while suppressing the yield and providing a relatively expensive entry-point for new investors. QE has also increased the positive correlation between bond and equity returns, reducing the diversification benefits the former can bring. However, bonds generally remain very liquid as an asset class and getting in and out of them is usually straightforward at the prevailing market price.

Investing in equities can bring significantly higher levels of income and capital growth, but at the cost of needing to accept higher levels of price volatility. Equities which pay larger dividends tend to be more mature companies in mature sectors (energy companies, airlines etc) , with some of the new kids on the block (technology) focused purely on business growth and unlikely to provide a pay-out to investors any time soon. Sectors which up until relatively recently could be relied on to provide that much-needed dividend income stream look increasingly under pressure, either from potential structural changes to how we will live and work in the future, or from investors wanting a positive social benefit from their capital rather than just positive returns. Easy to buy and sell, and despite their volatility equities remain the go-to option for investors seeking higher returns, even with the dividend outlook uncertain for some sectors.

The strategic asset allocation decision is a key one in the investment process and from the outset investors need to be satisfied that the combination selected has the risk and return characteristics that fit with their objectives. Careful planning should be taken to ensure it should meet the investment objectives over the long-term without the need for too much portfolio tinkering.

With potentially endless combinations of asset classes, mean-variance optimisation is one tool to help to devise a suitable portfolio that would offer the desired risk/return balance. We use this method to assist in the selection of funds and in our correlation analysis, offering an excellent starting point in asset selection and risk management. However, caution must be exercised given the sensitivity of the model to its inputs and the sometimes-impractical solutions it can throw out, meaning is helpful as a guide rather than a rule.

For a less technical solution, the longstanding ‘balanced’ fund combination of 60% equities and 40% bonds has been shown to have performed solidly over the past four decades. Indeed, a recent Bloomberg article (22/11/2020) highlighted that a portfolio comprising 60% US stocks and 40% bonds would have returned 13% year-to-date.

Given this, a more straightforward range of options could also be considered, accepting that no solution will be the perfect solution. Perhaps this means assessing the performance and volatility of portfolios starting from 100%/0% bonds/equities through to 0%/100% bonds/equity in steps of 20%. allocations to other assets classes can then be brought into the mix if needed.

Whichever allocation is decided upon, a rebalancing may be required at some point, for instance to manage risk or to sell out of an underperforming fund. However, regular buying, selling, or adjusting should generally be avoided and can damage returns. A significant change in circumstances may require the portfolio to change with it, but whenever possible allocations should be stuck with for as long as possible, if not forever.