Equities 

Avoiding the pitfalls of portfolios

Avoiding the pitfalls of portfolios

Portfolio construction starts with the basis of modern portfolio theory, which is the premise that asset allocation is the main driver of portfolio returns over the long term.

The economist Harry Markowitz introduced modern portfolio theory in an essay in 1952 and his findings, which theorised the impact of risk, return, correlation and diversification on probable investment portfolio returns, are still relevant today.

As a paraplanner, we first ascertain the risk tolerance of our client and correlate this to a particular level of risk relevant to the tool being used, and this will provide a foundation asset allocation. This is the particular mix of assets that for the chosen level of risk will provide the highest probable level of return relative to the risk and is fundamentally based on historical imperial data.

A paraplanner needs to know how to construct a portfolio and, as noted above, integral to the whole investment related element of planning is the risk-profile tool and the indicative asset allocation for each risk profile.

The paraplanner will look to mirror the relative risk of these within the chosen solutions. However, if we consider a moderate investor, then typically the portfolio should be as shown in table one.

Table one: Typical portfolio allocations

Type of holding

Exposure (%)

UK equities

30

Europe ex UK equities

10

North American equities

10

Japanese equities

10

Emerging market equities

5

UK fixed interest

11

Global fixed interest

12

UK cash

12

Total

100

Source: Gallagher

Now consider two portfolios that are constructed in line with the above asset allocation: Portfolio A and Portfolio B, both of which have been constructed using the above asset allocation and eight individual funds that encompass the relevant sector.

The relative asset allocations of these portfolios are in line with the stated model, but the actual inherent risk within both is wildly different.

Portfolio A has an FE risk score of 80 compared with 41 in Portfolio B – a score of 100 is indicative of the FTSE 100 index. This results in a very different performance over a one-year period, as highlighted in tables two and three. 

Table two: Portfolio A

Name

Original holdings (%)

OCF (%)

Baillie Gifford UK Equity Alpha B Acc

30

0.57

Fidelity Institutional Long Bond Inc

12

0.32

Royal London Enhanced Cash Plus Y Acc

12

0.17

Baillie Gifford Investment Grade Long Bond B Inc

11

0.28

BNY Mellon US Opportunities Inst W Acc

10

0.82

Neptune European Opportunities C Acc

10

0.96

Neptune Japan Equity C Acc

10

0.88

Baillie Gifford Emerging Markets Leading Companies B Acc

5

0.78

Total/average

100

0.60

Source: Gallagher

Table three: Portfolio B

Name

Original holdings (%)

OCF (%)

Invesco Income Z Acc

30

0.91

Janus Henderson Institutional Short Duration Bond Z Acc

12

0.03

NFU Mutual Deposit C

12

0.55

LF Canada Life Short Duration Corporate Bond C Acc

11

0.65

Liontrust  European Enhanced Income I Hedged Acc

10

0.93

Santander Japan Equities A

10

1.08

Thesis Eldon Inc

10

1.61

F&C (BMO Emerging Markets 2)

5

0.99

Total

100

0.86

Source: Gallagher

This clearly shows a very different journey for the client depending on which funds are chosen, even though the overall asset allocation target has been met. It shows that a paraplanner needs to have an appreciation of the prevalent economic conditions and be aware of their investment surroundings: being well versed in industry news, fund manager commentary and overall economic outlook bulletins will assist a paraplanner in appreciating risk and indeed being able to justify and explain the basis of their portfolio construction.

The paraplanner needs to start with an understanding of core and satellite holdings, such that should the allocation to UK equities be 30 per cent, the majority of this will be invested in FTSE 100 or blue chip stocks and maybe 3 or 4 per cent in a more specialist equity fund, which may invest in smaller companies or concentrates on a specific sector.

This smaller holding would be deemed to be a satellite holding, as it is more aggressive and will typically carry more risk, due to the scale of companies invested in being smaller.

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