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.
Core funds should include all of the following characteristics:
• Broad exposure across all sectors.
• Strong reference to weightings on a developed market index – the FTSE All-Share.
• Hold a high number of stocks – 100 or more.
• Generally be defined as medium to low risk.
Satellite funds may include any of the following characteristics:
• Unconstrained exposure that is not referenced to a benchmark index.
• Narrow exposure covering a particular sector, specialist market, market capitalisation or investment style, such as growth and value.
• A concentrated number of stock – 50 or less.
• Generally be defined as higher risk.
Satellite funds could therefore include dynamic, focus and style portfolios.
The key prerequisite is that the offering’s performance should have the potential to diverge significantly from general market movements to achieve returns significantly higher than the overall market.
In the current macroeconomic climate, and with the constraints of regulation and governance, there has been a very real shift towards using multi-asset funds, managed portfolio solutions and discretionary managed solutions.
For a paraplanner, the responsibility of constructing a portfolio from scratch has been diminished, but by understanding how a portfolio should be constructed and the methodology used, they can start to understand what the chosen fund managers are doing and what they are trying to achieve when they make changes. This can then be communicated to advisers and subsequently clients to enhance the client experience and relationship.
Nishit Patel is a senior paraplanner at Gallagher
