Plotting a safe passage to horizons near and far

Equities provide these benefits by linking investors’ returns to the growth of the underlying company’s profits. Well-managed businesses with consistent profits growth and strong, free cash flow invariably return part of this profit to shareholders through a steadily rising dividend.

Reinvesting these dividends produces the compounding effect that is the secret behind the attraction of long-term equity investment.

Infinite time horizons

For a hypothetical investor with a substantial capital base and an infinite time horizon, a portfolio invested 100 per cent in equites will produce the best long-term results.

The key to this is the time horizon of the hypothetical investor. As the chart demonstrates, UK personal care group Unilever has outperformed wider equity markets, as well as inflation, because growing profits have been returned to shareholders via a dividend payment that has increased by more than 8 per cent a year over the 20-year period.

However, because the period in question includes both the Dotcom bubble and global banking crisis, these returns have been far from linear. Despite producing a near 1,000 per cent total return for investors, there have been short periods within the 20 years when an investor would have experienced a capital loss. 

Declining global growth, excessive market valuations, extraneous geopolitical shocks and rising interest rates are just some of the factors that create the disruptive equity markets events that lead to painful losses of capital during some periods. For investors in well-managed companies, such as Unilever, these losses will be temporary, but ill-advised investments in highly leveraged companies with weak balance sheets can and do lead to permanent loss.

For real-world investors with a finite time horizon, trying to balance the need to both protect and grow capital, an equity-only investment portfolio is almost certainly not the answer. Unless an investor can consistently demonstrate abnormal skill – or luck – in timing the entry and exit points of the equity market, most are better advised to reduce their portfolio risk by other means.

Professional investors will often refer to the diversification benefits of holding multiple, uncorrelated assets in a single portfolio. An asset is deemed to be uncorrelated – or exhibit low correlation – if its typical return differs from other assets within a portfolio under identical market conditions.

Key Points

• For a hypothetical investor, a portfolio invested 100 per cent in equities will produce the best long-term results.
• The average investor with a shorter time horizon prefers a diversified portfolio.
• Multi-asset funds are one way of getting this diversification.

Adjusting for currency

In this context, diversifying UK equities by investing in companies listed in the US or Europe, for example, achieves little, as their currency-adjusted returns are very similar. So if equities do the long-term heavy lifting in a portfolio – and most equity markets (ex currency) are highly correlated – it is the other asset classes available to an investor that can help smooth the path of returns in attempt to make them more linear.

Traditionally investment managers would use a blend of government and corporate bonds, commercial property, cash and commodities to offset the volatility of returns that come from the equity component of the portfolio.

Slower economic growth, declining interest rates and falling inflation that often disrupt equity markets can be expected to boost the returns of many of these assets, helping to offset equity market losses should they occur.

However, in the post global financial crisis world of zero interest rates and quantitative easing, the flood of liquidity that has washed across the global financial system has both increased asset class correlations and reduced opportunities to diversify.

Return characteristics

Understanding the differing return characteristics of the available asset classes and blending them together into an effective well-structured portfolio has therefore become more complex.

The growing popularity of professionally run multi-asset funds can be seen as a sensible and pragmatic response to this issue. They are now a core solution used by many firms of financial advisers, especially for clients with assets below the typical threshold for a fully bespoke discretionary managed account.

Generally created with a wide brief to invest across any asset class that provides an investor with a quantifiable return profile in a vehicle offering daily liquidity, multi-asset funds can be a flexible and proactive way of providing investors with a smoother long-term growth profile and which ensures investors remain within an appropriate risk framework.

The methodology behind multi-asset funds varies widely depending on the underlying investment manager. Some advisers work to match differing levels of equity exposure with the broadest range of other assets to create a range of investment strategies with clearly defined inflation and return targets.

Careful macro-economic modelling is required to produce a realistic range of expected asset class returns. Combined with statistical analysis of historic volatilities, this creates an efficient frontier of different strategies that matches off return expectations against the risk of loss. 

As a result, the equity weights within each multi-asset fund will vary depending on the investment objectives and risk tolerances of the underlying investor. Older clients with a shorter investment time horizon or those simply wishing to maintain the purchasing power of their capital might require as little as 20 per cent of their portfolio invested in equities to achieve their long-term goals.

Younger investors with more aggressive return targets of 4 per cent or 5 per cent above the rate of inflation would require equity weights as high as 80 per cent.

Successful portfolios

Of course, creating a successful range of multi-asset portfolios requires far more than just clever asset allocation modelling. Careful instrument selection across each of the asset classes is of equal importance. Poor manager selection can create unnecessary risk with a portfolio structure that relies on its ability to quantify and manage risk. 

To some managers the solution is the use of passive funds, such as index trackers or ETFs, which replace an active manager’s ability to create alpha with the beta of a market index.

While such solutions may make sense in the gently rising markets experienced today, the risks associated with buying the over-owned components of any index would make little sense when a market-disruptive event occurs.

Gareth Lewis is managing director, head of investment strategy, at Tilney