This is the second blog post on my investment advice process. In the first I described the three personal risk metrics that need to be assessed as part of my fact-finding of clients – the risk a client is willing to take, the risk they are able to take and the risk they need to take. I started with this because all investment advice has to be provided in the context of a client’s financial circumstances and needs, and crucially be suitable for them. For this reason I consider advice has to be tailored to the individual. Whilst of course all IFAs have the same duty of care many use off the peg solutions i.e. model portfolios. Consequently many of their clients end up with exactly the same investments and the whole of a client’s money may end up in a single portfolio.
Model portfolios typically have a set or target asset allocation but with some flexibility. For example a cautious risk portfolio might have a maximum of 50% in equities and a minimum of 30% in fixed interest and cash. An adventurous risk portfolio will have a higher allocation to equities and less in fixed interest. The portfolio itself is often a managed collection of funds rather than individual stocks.
I don’t like and don’t use model portfolios for several reasons. Firstly I think tailored individual solutions are more appropriate because everyone is different and my fees are high enough to warrant a bespoke service. To be fair I have relatively few clients and model portfolios may be more appropriate for IFAs dealing with a high volume of clients or where investment portfolios are small. My principal objection to model portfolios however is that they tend to regard the risk of various asset classes as fixed. I consider this both simplistic and dangerous. In the example above a minimum of 30% in fixed interest and a maximum of 50% in equities is predicated on the view fixed interest is always low risk and equities are always high risk.
Whilst this is generally true based on fundamentals and historic volatility measures, a fixed assessment of asset risk ignores current valuations and current threats. So in market conditions where equity valuations based on Price to Earnings (PE)* or Cyclically Adjusted Price to Earnings (CAPE)* ratios are low, risk is arguably reduced (so called value traps~ are an exception). For example global emerging market equities in general have had a torrid time in recent years, valuations are depressed and arguably most of the bad news has already been priced in. If so this means further downside risk should be low. It must be said this is not a signal to buy emerging markets. Currently although valuations are attractive I don’t see any catalyst for a change in their fortunes. My advice generally is to hold existing emerging market funds but not add to them.
Similarly many fund managers consider fixed interest currently has an asymmetric risk profile. Very low yields offer little upside potential but the risks of a sell-off especially in government bonds and investment grade corporates are high in a rising interest rate cycle. Given these observations I cannot subscribe to model portfolio asset allocation unless there is complete flexibility to go 100% in equities or 100% in cash.
To finish it is well established that getting the asset allocation right is the prime determinant of long term investment returns not selection of the best fund managers. It has been said the worst performing fund in the best performing sector will beat the best fund in the worst sector. So when I advise a client as a starting point I seek to identify the best and most appropriate asset classes in absolute terms and relative to their income or capital growth needs. That may mean a cautious risk client getting an equity dominated portfolio especially if valuations and market conditions are favourable and the client holds a high level of cash savings.
It would be fair to say getting the asset allocation correct is notoriously difficult. Looking back at the last couple of years I have got some calls right and some wrong. On the latter in 2013 and 2014 I advised clients buy commodity and resources funds after a sharp sell-off. Unfortunately I called the bottom of the market wrong, the oil price collapsed and commodity prices and equities continued to slide. Clients have lost money, on paper. So have I, I took my own advice. However as long as the losses are not crystallised there potential for a reversal of fortunes. I am pretty sure there will be a recovery sometime but I won’t try and call it this time around. Two picks that have worked are investments in smaller companies and Japanese equities.
*PE and CAPE are common measures of the valuation of stockmarkets or individual stocks. They compare the price of a stock or market to its earnings per share. A high PE or CAPE indicates a high valuation and vice versa. CAPE considers the past 10 years to even out the effects of volatility over different market conditions.
~A value trap is a sector or stock that is cheap not because it is priced below its intrinsic value. Long term factors may prevent recovery despite the apparent bargain prices.
The contents of this post are my own views and others regard risk and investment portfolio construction in a different way. It is not an invitation to invest in specific asset classes for example equities as these may not be suitable for your financial circumstances or your risk profile. You should seek individual advice before making investment decisions.