The majority of investors classify themselves as “balanced”, but differing views on what a balanced portfolio should include means many people could be far more exposed to investment risk than they realise.Here, Thomas Becket, Chief Investment Officer at Psigma Investment Management, examines the issues and explains what a “genuinely Balanced” portfolio might comprise.
Given how frequently the term “Balanced” is used in the wealth management industry, it is amazing that there is no standard or accepted definition of what this moniker actually means. This is even more surprising when you consider how many investors at wealth managers consider themselves to be “Balanced”, with some sources suggesting that more than 7 out of 10 investors class themselves as such across the industry.
The truth is that two “Balanced” investors could go to two different wealth managers and end up with vastly different results and unless they discussed the specifics of each of their portfolios with each other they would be none the wiser
The truth is that two “Balanced” investors could go to two different wealth managers and end up with vastly different results and unless they discussed the specifics of each of their portfolios with each other they would be none the wiser. This is a deficiency that means that a wealth manager must ensure that an investor knows exactly what sort of risks they are taking with their “Balanced” portfolio and that investor must themselves assess whether any “Balanced” portfolio is actually what they want.
Some have valiantly attempted to create some order by providing guidelines as to what “Balanced” should mean. The most notable is probably the team at Asset Risk Consultants (ARC), who have created different bandwidths of volatility to categorise wealth management portfolios. Their “Balanced Asset” category covers any portfolio that exhibits volatility of between 40% and 60% of the relative volatility of the MSCI World Equity Index.
However, we think this is flawed for two reasons. Firstly, the measurement is entirely backward looking and only tells you about historical performance, which is irrelevant to investors when assessing future risks to their wealth.
Many investors will undoubtedly be surprised to have received a “10% quarterly drop” letter, as dictated by the MIFID regulations, from the managers of their “Balanced” portfolio in Q4 2018
Secondly, volatility is only one input into an overall risk assessment and there can be periods when volatility is unsustainably low and not a guide to how much risk your portfolio actually carries, much as we saw through the lowly volatile year of 2017 and into the extremely bumpy year of 2018. Indeed, many investors will undoubtedly be surprised to have received a “10% quarterly drop” letter, as dictated by the MIFID regulations, from the managers of their “Balanced” portfolio in Q4 2018.
Our view is that many “Balanced” portfolios were employing far too much risk as we went through 2018 and the evidence for this is clear from the returns of the last few months of 2018 where, according to ARC, the average wealth management industry portfolio suffered losses of 5.9% (source: ARC Sterling PCI Performance Report December 2018).
If we are forced to use a “Balanced” index to compare ourselves, we normally use ARC’s version, but there are other long-standing indices that investors can use as a guide, although we would warn against using them as we think they are not fit for purpose and encourage too much risk taking for the typical “Balanced” investor. Perhaps the best known is the PIMFA (formally APCIMS) WMA Balanced Index, for which one can find performance data going back to 1988. However, when one looks at the asset mix that comprises the index, one can instantly recognise that it is very risky, with 62.5% in equities. We have also found this index to constantly be playing catch-up with industry developments rather than pre-emptively shifting the asset mix to reflect what is happening in the industry.
Another commonly cited index is the old “IMA Balanced Managed Sector Index” that has been renamed the “IA Mixed Investment 40-85% Shares” sector. As the name suggests, the funds that are included in that sector can have anywhere between 40% and 85% in equities at any point in time. How anyone could realistically claim that 85% in equities is anywhere near “Balanced” is beyond us at Psigma, not least as the other 15% could be in investments such as higher-risk corporate bonds that could potentially exhibit equity-style losses in a downturn for financial markets.
So how should investors go about assessing the suitability of the range of “Balanced” portfolios on offer in the wealth management industry? The good news is that regulatory changes have put the onus upon wealth managers to be more transparent than they historically were and therefore getting access to asset allocation information and portfolio characteristics is easier than it used to be. The regulators should be applauded for trying to enforce greater transparency.
In Q3 2018 we conducted our own research into the various “Balanced” offerings from the largest wealth managers we could find investment information for (although transparency has improved it was still surprisingly challenging to get common information on each company); then we assessed their respective asset mixes and ran their portfolios through our proprietary quantitative risk systems to calculate potential portfolio characteristics and sensitivity to moves in equities.
Our analysis led to two major conclusions. The first was quite how wide the range of asset allocations were across the industry and the second (more eye-opening) was quite how much equity and high-risk investment risk most “Balanced” portfolios were taking (particularly at a time when asset valuations were as high as they had been for a very long time). Indeed, it was common for standard industry portfolios to have 64% in equities and their portfolios to exhibit 73% of equity sensitivity (one had 78.2% in equities and 91% equity sensitivity).
As long as an investment is “easy” for the client to understand, adds value to a diversified portfolio and is the right price then we will consider it
One could argue that this has been a sensible approach during the long central bank-inspired bull market of the last decade, but what would happen if 2018 was just a tremor in markets before bigger shocks for markets in the years ahead? Clearly there is the scope for “Balanced” investors to potentially suffer a far greater hit to their wealth than they might have expected. Interestingly only one of the eight “Balanced” wealth manager offerings we analysed would have had a chance of falling into ARC’s “Balanced Asset” category (and that one was debatable), which demonstrates the completely nonsensical approach that the industry has to “Balanced” investing.
It is of course very easy to question other approaches to “Balanced” investing, but do we have a solution? We think so. Our view is that “Balanced” should be “genuinely Balanced”. Typically, we use a blend of 11 different major asset classes and over the last decade have employed around 30 different sub-asset classes in our “Balanced” strategy, ranging from sovereign bonds to emerging market equities and commodities. As long as an investment is “easy” for the client to understand, adds value to a diversified portfolio and is the right price then we will consider it.
As well as shying away from over-complication (e.g. structured products) we don’t invest in anything that is not “genuinely liquid” as we don’t believe that the average “Balanced” investor wants to take on the risk of not being able to get their money back when they want/need to; this makes investments like commercial property a “no go” for our portfolios. Equities would be the largest allocation within our “Balanced” portfolio, but typically they make up 40-50% of the total asset mix. Instead of having an over-reliance upon equities we put extra effort in to sourcing “equity style returns” in various global fixed interest markets.
We also pride ourselves on helping our investors make an informed choice. At the outset of proposing a portfolio to a client we offer thorough asset allocation information, guidance to future asset mixes and detailed portfolio characteristics information. We have restrictions on the maximum equity and higher-risk fixed interest allocations within each portfolio to help us ensure that we maintain the “genuinely Balanced” approach. Clients are regularly provided with full updates on all portfolio information to help ensure that the portfolio remains suitable for the client on an ongoing basis.
The question that investors need to ask is whether the “Balanced” portfolio that they currently have is “genuinely Balanced” or whether, particularly after a long period of positive returns from asset markets, the portfolio they own is exposing them to too much risk
The question that investors need to ask is whether the “Balanced” portfolio that they currently have is “genuinely Balanced” or whether, particularly after a long period of positive returns from asset markets, the portfolio they own is exposing them to too much risk. An investor won’t find much help from standard industry definitions and the commonly used guidelines/indices are flawed, so this is a discussion you can only have with your financial adviser or wealth manager.
Our view is that a “Balanced” portfolio doesn’t need to hold complicated investments, should only incorporate liquid investments and to be “genuinely Balanced” you shouldn’t need an overreliance on equities. Financial markets are likely to be very volatile in the future and a “genuinely Balanced” approach will be vital to ensuring you meet your financial aims and aspirations.