Stay the course
Many questions have been asked in the last few months about how valuable long-term asset allocation models have been in dealing with the extreme market downturn of the last 18 to 24 months.
To demonstrate the robustness of the model we have prepared charts showing the distribution of returns that are expected from the various model portfolios when they were originally created. Given the nature of markets recently, I have concentrated on the down-side, that is, the potential for returns below the expected average for each portfolio.
I then roll the clock forward and superimpose the results of the actual performance experienced since they were created.
Note that we are concerned here with just the performance as reflected by the various underlying market returns. I have not allowed for the additional returns achieved through active fund management nor have we made any allowance for expenses of management or tax.
The chart shows the actual performance of the 10 model portfolios in the 3 ½ year period since they were constructed at the end of 2005 to the end of the this year's first quarter, to date the bottom of the UK market.
Looking at the chart we would expect a 1 per cent chance of the returns - or worse - indicated by the green line. While the actual performance for the 10 portfolios over the period has been disappointing in absolute terms the outcomes have been in line with expectations in all but one portfolio.
In the most cautious cash portfolio and the two most aggressive portfolios, the actual returns have been well within the expected range. The most aggressive portfolios have a significant overseas exposure and the actual returns reflect to some extent the appreciation of the dollar and euro against the Sterling. The others have been close to the fifth percentile. As such the actual performance has been shown to have occurred within the range of expected outcomes that were identified at the start of the three-year period.
This asset allocation model has successfully incorporated the level of returns seen in the recent downturn. Advisers should draw comfort from this and encourage their clients to stay the course and maintain their long-term plans on the basis that their investments should recover to deliver the average expected returns over time.
If clients are considering investing, advisers should use this approach to modelling to help them understand the potential downside associated with any given risk level, which is treating a customer fairly, as well as of course the upside. It will be reassuring for investors to know that the model used by their adviser has held up in the toughest markets for a generation.
Asset modelling has not only survived the storm but emerged as a powerful tool for advisers to describe the level of investment risks and potential returns faced by their clients and as a result to support mutually profitable long term relationships.
Danny Quant is actuarial director of Distribution Technology
