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Lothian reveals his strategic asset allocation approach

Lothian reveals his strategic asset allocation approach

The importance of asset allocation cannot be overstated. Research shows 90% or more of a portfolio’s returns can be explained by its asset allocation.

A2+B Wealth and Verus Wealth have a joint investment policy committee that convenes twice a year to review our investment approach, asset allocation and fund or vehicle selection. As advocates of a passive approach to investing, we seek to capture broad market or sector returns in our portfolios at a low cost without attempting to outperform via speculative activities, such as market timing, fund manager choice or stock selection. Our asset allocation approach is strategic rather than tactical.

We maintain seven distinct model portfolios with equity allocations ranging from 0% to 100%, with the balance invested in fixed income, including a 3% allocation to cash. The tables on pages three to six show the sector and fund allocation of each of these portfolios as well as their costs, yield, expected annual return and historic volatility. The return and volatility figures were derived from back-testing the portfolios to 1994.

The above graph and the one on the next page show actual (not back-tested) return and volatility figures over the past three years. We test the portfolios monthly to monitor performance and volatility.

Fixed income exposure

Our portfolios’ fixed income exposure is equally divided between two funds: Dimensional Fund Advisor’s Global Short Dated Bond Fund and Vanguard’s Global Bond Index Fund.

We believe Dimensional’s approach to fixed income represents the optimal use of fixed interest exposure within an investment portfolio. The fund invests solely in high-quality, investment-grade, short-term fixed interest securities, which mature in five years or less, issued by governmental, quasi-governmental and corporate issuers in developed countries.

The average maturity of all holdings is 3.9 years and average credit quality AA+. Most of the assets of the fund held in foreign currency-denominated instruments are hedged back into sterling to minimise volatility.

Risk and return are related and therefore, fixed interest is likely to underperform equities over the medium and long term. Any exposure to fixed interest is there to reduce portfolio volatility at the expense of lower long-term returns. On this basis, there is no need to go significantly longer or junkier in our fixed income exposure.

If an investor seeks higher returns and is prepared to accept higher volatility, we would generally advocate increasing exposure to growth assets rather than increasing fixed income durations.

That said, our other fixed interest choice, the Vanguard fund, does help to lower costs and diversify our fixed interest exposure. With a total expense ratio (TER) of 0.25%, it holds around 7,800 individual securities, has an average maturity of 7.7 years and average credit of Aa3.


Equity allocation

Our model portfolios’ equity allocation primarily consists of UK equity, global equity and emerging markets equity. We start with a world capitalisation weighting in emerging markets (about 15%) with the balance split in three: two thirds being allocated to global equity (developed world) and the other third evenly split (ie, 1/6 each) between international equities (ex-UK) and UK equities.

Evidence indicates that tilting portfolios towards small cap and value stocks delivers returns above the market over the longer term. With this in mind, we allocate half of the global equity position to a fund that is overweight in these securities.

Again, we, and our clients, accept this will increase volatility compared with a market-neutral position, but it is an extra risk the evidence suggests is worth taking.

There is no scientific basis for our allocation to the international equity ex-UK and UK equity funds. We have done so to help reduce costs and, in the case of the FTSE All-Share tracker, in recognition of most UK investors’ preference for a home bias.

While these allocations are our starting place, our portfolios are generally client-specific, with emerging markets exposure and a small cap or value tilt being adjusted to each client’s appetite for risk.


Avoiding property due to illiquidity

Dimensional’s equity funds filter out property investment companies.

At our most recent investment committee meeting, we considered whether to include a modest exposure to commercial property in our portfolios as a substitute for some of the equity allocation. However, it was agreed not to favour physical property funds due to potential illiquidity and cost; and the alternative of global real estate investment trusts, including tracker fund options available in this sector, was not sufficiently uncorrelated to equities to make a strong enough case for its inclusion.

We also recently considered, but discounted, the possible introduction of absolute return funds and/or managed futures. While we were interested in exploring the inclusion of some exposure to emerging market debt, we decided against this for now because it does not lend itself to our preferred passive management approach.

Individual portfolio reviews

We use Finametrica’s risk-profiling process and risk group categorisation as a starting point for discussion with clients on what might be their most suitable asset allocation.

However, while appetite for risk and capacity for loss are vital considerations, lifetime cashflow modelling using our portfolios’ expected returns will reveal whether clients could take less risk than they might be prepared to accept and still achieve their lifestyle and financial objectives.

Following an annual progress meeting, clients’ portfolios are rebalanced to their original or agreed target asset allocation.

Paul Lothian is co-director at Verus Wealth, and co-director at A2+B Wealth.

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