TCFP’s Model Portfolio Update.

We’ve spent the last few weeks reviewing all aspects of TCFP’s investment strategy.

A full review is warranted, as opposed to tinkering with the portfolio. That would be akin to chasing return, trying to time the market and all the other bad behaviours we’re determined to help you avoid.

What now follows is a summary of our thinking process, the questions we’ve been asking ourselves, some further notes and the portfolio we arrived at and are recommending to clients.

The thinking process:

1. We know our clients’ short-term (0-3 years) needs are covered/secure due to cash and/or guaranteed pension income and/or earnings from work.
2. And that there’s a designated “Emergency” fund.
3. We agree that anything not needed in the short-term should be invested to beat inflation.
4. We accept that means a majority investment in equities, the only asset class that consistently beats inflation.
5. And we accept the volatility that this entails, the times where our resolve will be tested, etc.
6. That’s unless equities are showing signs of being in a bubble which last happened in 1999 – the “dot.com” craze.
7. In that case we would look to bonds as a safe haven.
8. The safest way to invest in equities is to buy the biggest and best companies around the world and let them get on with business.
9. That is to back the actions of millions of men and women acting in a rational manner and taking decisions with a view to making profits to share with their shareholders (you).
10. That leads us, in the main, to favour a buy and hold strategy to reduce subjective decisions and biases.
11. By buying and holding the biggest and best companies, we capture global growth which is the engine of inflation-beating returns.
12. That’s opposed to picking individual shares and/or themed investments and/or trying to time the market which is exactly the sort of misbehaviour we’re here to avoid.
13. Doing that is a significantly riskier strategy because we’re certain not to get our calls right and then have to chase our tails.
14. We water equities down by adding some bonds.
15. That helps knock the bottom of severe drops and therefore clients are more likely to stick to their plan and investment strategy (i.e., they won’t panic and sell at a loss).
16. It also provides scope for buying more equities when they look cheap.

The questions (and answers) we’ve been asking ourselves:

1. Is the portfolio too “busy”, too many fund holdings?

Yes, it’s difficult and time-consuming to manage.

Commodities and property as separate holdings feel superfluous.

We should choose simplicity over lots of moving parts.

2. Are we too exposed to the UK?

Quite possibly, there’s more growth overseas than in the UK.

So, why be overweight the UK other than to look palatable to a UK investor/fit some industry norm?

Currently we’re 21% UK equity whereas the UK share of global markets is c6%.

We’re also underweight the world in bonds, most notably the US / $$ which is, and should remain, the world’s reserve currency for as long as we’re alive.

3. Can we buy more successful companies across the world?

Definitely, if we add global smaller companies and cover world indices as per their weighting we go from c2,000 equity holdings in the current portfolio to c8,000 equity holdings.

That should mean we are capturing more of global growth.

4. Are the investment funds available to make this possible?

Yes, we’d only need 4, compared to 16 now.

5. Does fewer funds means less diversity? Do 4 funds cover the landscape?

The current 16-fund portfolio has c4,000 holdings. That’s c2,000 equities and 2,000 bonds.

The new 4-fund portfolio has c9,000 holdings. That’s c8,000 equities and c1,000 bonds.

As bonds are benign and there for a specific purpose, we are ok with fewer of them.

Also, they will mostly by US treasuries, the asset of last resort.

Ultimately, it was upping the equity diversification that we are after; that’s more, not less, diversity.

6. Does this improve the volatility / return / drawdown picture?

Back testing shows a better drawdown (how far the worst drop has been and how long it took to recover), about the same volatility and about the same return.

That was looking at the asset classes rather than the funds we’d use.

If we look at the actual funds, over the last four years the return has been 1-2% better per annum.

The prospects also feel like they should be better going forward.

Hold more equities = capture more global growth = better outcome.

But past results / back testing does not predict future results.

7. Do we end up more or less flexible?

Difficult to call.

Currently, there are lots of parts and therefore the ability to move around, but significant changes aren’t really possible as several of the holdings are in the 3-5% range.

There’d be fewer holdings and we’d really be taking whatever comes our way for large cap global equities (with a 50% holding) and bonds (a 20% holding as now).

We’re fine on the bonds, they are there for stability and to be available to go into equities when the next crash comes/good value appears somewhere.

Around the edge we’d now have global smaller companies (something like a 20% holding) and emerging markets (a 10% holding).

Our thinking is we can be more active going over and underweight these two holdings when appropriate. e.g., emerging markets have taken a hammering, now could be a good time to increase 10% to 13% by reducing bonds.

8. Is it more or less expensive?

Cheaper by about 0.5% pa or c£500 pa per £100,000 of money invested.

9. What about dividends? The UK pays more than other countries.

The expected returns of each asset class are based on the previous returns on each asset class.

The “return” figure used is the total return = capital appreciation and any income generated.

10. What about currency risk if we focus more overseas?

Hedging currency risk should be avoided to guard against UK inflation which is the loss of value of the £. 

Also, by holding Sterling as cash to cover living expenses we have mitigated a good part of this risk. 

The super long-term trend for sterling is that it is dropping in value; there’s no reason to expect a long-term reversal of this.

That’s not say we might not change our minds on that or any of the above, but things would have to be drastically skewed one way or the other for that to be considered.

11. Does greater overseas exposure affect liquidity?

No, we’re buying the big, liquid stock markets around the world.

Other options are available but we’re not interested in anything that doesn’t trade daily.

During the 2008 hiatus there was no problem with funds being able to return funds to clients.

That’s not to say never, but that’s as bad as it’s been in our lifetimes.

12. How do we see managing the new portfolio going forward?

We see us being more aggressive with moving from a fund that has done well to one that’s suffered, e.g., moving from the world index to emerging markets after they have dropped 25-30%.  And from bonds to equities in general after the next big fall has occurred.  That to us equates to trying to better catch the cycle we’re clearly in at that point.  It’s like a rebalance on steroids.

Further notes:

There’s much more art than science in any investment strategy that we might think. There are many ways to achieve, broadly, the same return.

That’s as long as we’re not being completely daft – illiquid and/or unregulated investments and/or single company shares.

Therefore, it seems to us the best solution is the one that feels best and complements our long-term goals.

In the new portfolio we are consciously using funds that track the markets rather than take active positions. This is a tacit acknowledgement that we are much better off trying to capture the total market return as cheaply as possible as opposed to beating the market. Average returns are just fine.

For your financial plan, this means we can be surer of the likely outcome whereas active managers may over- or under-perform the market for a considerable period of time, only to ultimately achieve the market average over the long-term.

Therefore it seems sensible to choose lower costs and a more likely outcome over higher costs and a less likely outcome.

The portfolio:

So, this is what the standard portfolio now looks like with cash to be mixed in to suit your individual planning needs. The money that is NOT being retained as cash should be invested as follows:

The HSBC fund tracks the major stock market indices in the same proportion as their size. This effectively means we are moving from overweight UK / underweight US to neutral across all equity markets.

The iShares Overseas Government Bond fund should provide stability and the opportunity to take advantage of large falls in equity markets. As such, we want these bond holdings to be of the highest quality and liquidity (irrespective of location). Which is what this fund does.

future proofing your finances

advice@townclosefp.co.uk 

Town Close are expert financial planners. Our goal is the same as yours – to help you do the things that are important to you in the time you have remaining.