There was a time not so long ago when a few Australian stocks, a bit of cash and a few hybrid notes would have been enough of a spread to score you an adequate to impressive investment return.
With long bull runs, high‑yielding fixed income choices and good cash rates, investors didn't need to constantly think about asset allocation. Instead, they could just pick their mix of four, sometimes even three, asset classes, then check in very occasionally to make sure the weightings hadn't become distorted.
But times have changed. We now face the prospect of lower returns for a longer period of time, partly due to slowing growth in China, uncertainty around interest rate moves and political question marks. As a consequence, investors now have to be more vigilant in their portfolio construction. For some that has meant taking on slightly more risk to elicit the same results or delving into a new school of asset classes. Both are frightening prospects if the old strategy served them well.
A survey by Financial Review Smart Investor found no investors were "very confident" about their asset mix and fewer than 15 per cent were "confident" (as scored by a 7 or 8 out of 10 on a confidence scale). As such, more than half of investors under age 65 plan to do more to diversify their portfolios this year.
The good news is that getting exposure to more options – including alternative assets, international shares and fixed income – is getting easier and in some cases cheaper, especially with the advent of exchange-traded funds on the ASX. Advocates say passive ETFs have democratised the retail investment market and provide enough choice to construct an entire portfolio, while active managers say investors need to drill a little deeper to find the opportunities. With the insights of both camps, we think it is possible to construct a portfolio to weather bad markets without sheltering your money completely.
Why it matters
Modern portfolio theory suggests if you share your investments across enough asset classes you can reduce the risk, because each asset class is exposed to different factors to affect its performance. It is those allocations, however, that may need a rethink. In a low-return world, the traditional 70/30 balanced asset mix you may have put in place six or seven years ago (70 per cent of your exposure in equities and 30 per cent in cash or fixed income) may not be enough to get you to the goal you set when you designed your portfolio, says Jeffrey Johnson, head of Vanguard's Investment Strategy Group.
For some clients, this realisation has resulted in moving towards 90/10 in search of the same results. Johnson cautions against dramatic moves up the risk curve without knowing the consequences, but says investors will increasingly have to choose their priorities.
"In a lower-return portfolio, it really forces a question for investors as to what's more important," he says. "If it's more important for an investor to achieve the level of return they've had in the past, it's possible to do that, but it may mean building a more aggressive portfolio.
"On a 10-year basis today, we think a 70/30 portfolio should return somewhere in the 5 to 7 per cent range before inflation. And we would expect, on a longer-term basis, inflation averages about 2 per cent."
While investors will have to be more active in their choices, the fundamentals of asset allocation remain unchanged, he says. That means knowing what your goal is, knowing when you want to get there, how much risk you are willing to take and, finally, controlling the controllables.
Other factors to consider
Johnson does not believe the current environment requires a move into exotic or historically higher-risk investment vehicles, such as junk bonds, but says there are other factors that can be looked at when revisiting portfolio construction. The obvious, somewhat controllable, factor is risk but others include cost and expectation. "In a lower-return environment, cost eats up a larger share of your returns. We have to be vigilant, as investors, about what we are paying for," he says.
Put another way, if you are paying someone to invest for you, you want to be sure they are delivering enough outperformance to justify the fees. Vanguard has done a lot of work around strategic asset allocation, which is broadly defined as arranging your portfolio to meet your goals and needs, and adjusting your strategy as those needs change over time. It also means reweighting from time to time when allocations fall out of sync.
Some investors would perceive this as a "buy and hold" strategy, but Johnson rejects the idea that it's passive. "In order to reach a strategic asset allocation, an investor has to make many key decisions," he says. "They need to decide how much risk they would like in a portfolio, they need to decide how much liquidity; they need to determine their home country bias; decide what sort of tilt they'd like, whether to go for high-income generating bonds; they need to decide on a rebalancing program … the list goes on."
On a goals and needs basis, there is no such thing as a perfect model because what's right for someone else won't necessarily be right for you. However, here are some ideas about how to get the diversification for various risk appetites right.
Ideal v reality
A glance at the ATO's aggregate figures for how SMSFs invested across the asset classes in 2015 may look something like this: a third in Australian shares, a quarter in cash or term deposits, 15 per cent in direct property, 15 per cent in managed funds and the rest in international stocks and other assets. However, according to Alastair Davidson, director of portfolio health-check service InvestSMART, retail investors' actual portfolios are more likely to be massively overweight either shares or property with only a small holding of cash and/or term deposits to the side.
Depending on your expectations, the above scenarios could see you either taking on too much risk or not hitting your investment targets, Davidson says. With the emergence of a more diverse mix of ETFs covering asset classes such as international equities, fixed interest and currencies, you can essentially follow the same process as a multibillion-dollar investor such as AustralianSuper, according to Davidson.
InvestSMART's portfolio examples use Morningstar asset allocation benchmarks and overlay them with an active tilt, on which investors can base their models. They are long-term portfolios, rebalanced at most on a quarterly basis. "We react to market moves, but by and large what we're doing is strategic asset allocation," he says.
He rejects the suggestion that it's a purely passive approach. "We drill into the asset class and be a bit more precise as to what you should buy. Currently we have higher weightings to emerging markets just because we believe they're undervalued on a long-term, fundamental basis," Davidson says.
Your diversification menu
In the past couple of years, there has been an explosion of new defensive options for retail investors, many of which provide access to asset classes that were previously difficult to access if you didn't have wholesale backing. Top-rated international options include iShares' Global 100 ETF, Vanguard's MSCI Index International Shares ETF and the SPDR S&P; World ex Australia Fund.
Popular infrastructure options, meanwhile, include RARE Infrastructure, Magellan Infrastructure Fund, Transurban, Sydney Airport and Auckland Airport. Those with an appetite for property may be tempted by some of the diversified A-REITS, including Scentre Group and Westfield Holdings.
A key turning point has been the inclusion of fixed-income options on the ASX, which has previously been hard to get into for smaller-end investors, according to Jon Howie, head of iShares Australia. "We really haven't had a fixed income culture [in Australia]," he says.
Given its low correlation with equities, Howie says the fixed-income options may become increasingly popular with retirees. You can build an ETF bond portfolio now if that's what you desire.
However, not all bonds are created equal, with huge variation in terms of risk and yield. Given the zero rate policies in the US, Japan and across Europe, yield has become harder to find, Vanguard's Johnson says.
Howie sees more opportunities in corporate bonds than in global sovereign bonds. But Johnson cautions against corporate bonds as they carry higher risk.
Again, it comes down to your individual risk tolerance. Options for fixed income now include the SPDR ASX Australian Bond Fund, Russell Australian Corporate Bond ETF and iShares Global Corporate Bond (AUD Hedged) ETF. Howie says iShares is working on options to improve the income offering for Australian investors via ETFs.
He stands by the academic rigour of portfolio construction theory, but says difficulties have arisen when retail investors try to put those rules into practice for a specific outcome, because they are too expensive, too inaccessible or too complicated. "When the rubber hits the road, it's sometimes difficult for investors to align that to the outcomes they are seeking; that is, 'how much am I going to be able to save for my retirement?'
"There are a number of ETF options, but if we take that traditional mean variance approach – trying to balance the amount of risk we take with the amount of reward – you actually need quite a broad range of assets," Howie says. "Up until the middle of last year, there weren't enough assets on the ASX to do that in an efficient way."
While there's little debate about the variety ETFs have brought to retail investors, the key re-emerging criticism of index investing is that while it levels out the impact of companies that are a drag on your portfolio, it also dilutes the effect of the winners.
A dynamic approach
In the other corner of current asset allocation thinking lies Nader Naeimi, portfolio manager and head of dynamic asset allocation at AMP Capital, who believes the best opportunities cannot be found by buying an index.
His fund aims to smooth out the impact of market fluctuations for investors with a higher risk tolerance (the fund aims to achieve 4.5 per cent plus CPI). He believes you have to drill down to the sector level and says you have to "buy from the pessimists" to achieve that. Volatility is not risk, he says, and sectors the market dismissed for the wrong reasons can offer the best windfalls in a diversified portfolio.
Theoretically, it means adjusting your asset allocation in anticipation of future market changes. Naeimi looks for assets that fulfil or react positively to five criteria: value; economic cycles; monetary policy; sentiment; and technical indicators (such as breadth indicators). In practice, it makes sectors such as commodities and global energy look far more attractive, he says. Because expectations were depressed, it didn't take much of a turnaround before the fund started seeing good returns from the sectors.
China ticks a lot of boxes for Naeimi. "From our point of view, volatility was high but there was increasing support from central banks, and China shifted its attention from reform to growth," he says. "From a fundamental point of view, we see signs of turnaround in China. China H shares are trading on single P/E multiples."
Another important feature of Naeimi's approach is rebalancing on a semi-regular basis, which he says is a necessary part of asset allocation in a volatile and low‑rate world. "Buy and hold worked really well in the 1980s to 2000, when there was a long bull market and you didn't need any asset allocation. [But] it's very different now. We don't have a long tailwind."