Article utilities

When you start investing, you wonder why anyone would bother with boring diversified miner BHP Billiton when they could get 1500 per cent in eight months from Sirius Resources, a gold and base metals company.

Slowly, you realise its not as easy as that, as your eyes glaze over columns of financial data and broking costs are flushed from your cash balance.

Two years later you face facts: you havent kept up with the S&P/ASX 200 index and youve spent heaps trying. In any case the blue chip index may have fallen, making your portfolio look pretty sad. And on top of all that, youve become a bore.

Should you give up and hand it all to a fund manager?

Not so fast. There is a way to stay invested and give yourself some peace of mind.

Instead of trying to act like a fund manager who may be required to be 100 per cent invested in shares at any time, you can instead copy the behaviour of multisector funds, which are much less restricted.

To do this, you invest in the same assets classes as they do, and in the same ratio.

The upside is that you dont need to worry so much about selecting the right individual securities. Instead, concentrate on the big picture.

In the language of funds management, different types of investment are casually known as buckets. The Future Fund, for example, is interested in nine buckets: Australian equities, global equities (one bucket for developed markets and another for emerging markets), private equity, property, infrastructure and timber land, debt securities, alternatives (a loose description that includes hedge funds and private equity investments) and cash.

That sounds elaborate, but the Future Fund manages $97 billion and has all options open to it. Regular investors dont need that many buckets. But its important to use a range of investment classes and to shift funds between them when the price is right.

Different types of assets are affected by different economic forces and market forces. For shares, fear can be manifested in investors slowly selling down their holdings.

For bonds, capital values will drop as interest rates rise. A portfolio concentrated on one asset class will experience all of its volatility, whereas an investor who spreads risk will experience fewer wrenching turns.

A diversified portfolio that is rebalanced as assets become expensive or cheap will follow a smoother growth trajectory, if all goes to plan. Asset allocation is powerful.

COPY THE CROWD

In 2012 global investment firm Vanguard compared the results of active funds against parallel models where the same allocations were made in passive funds over benchmarks. The researchers figured the outcome would prove whether allocation was more important than investment strategy, including stock selection, and it looked at returns for 1393 funds in the United States, Canada, the UK and Australia between 1962 and 2011.

In Australia, the researchers found 93 per cent of volatility and 106 per cent of returns can be attributed to asset allocation, and only eight out of 336 funds returned significant positive alpha (returns above the benchmark) of 1.34 per cent on average.

Put another way, managers who chase gains by whipping in and out of holdings rack up costs, which is a drain on returns. For their efforts they produce an investment which jumps around in value more than it needs to.

In the US, Vanguard found 94 per cent of volatility, and 105 per cent of returns, comes from asset allocation.

The researchers conclusion? Determination of a portfolios asset allocation should take priority over its implementation strategy.

Asset allocation is the most important factor, Vanguard says, in managing volatility and improving returns.

PICK INVESTMENT BUCKETS

AMP Capital head of dynamic asset allocation Nader Naeimi spends all day pondering whether its time to shuffle money between buckets. With $270 million to manage in the Dynamic Markets Fund, he has to focus. When it comes to picking investment buckets, Naeimi says investors should avoid exotic instruments and stick to what you know, which is probably shares, bonds and property. Add cash, and you have four buckets.

For shares, dont forget to spread your risk around the globe.

Investors with a home loan might question whether they need to hold any more in property. Listed property is still very valid, he says, but youve got to be very careful with timing.

As for an allocation today, Naeimi would start with 100 per cent cash. If youre starting from scratch, I think its important to wait for a shakeout, he says. Buy into weakness.

Markets that are undervalued, underowned and oversold tick our box, he says. The aim isnt to buy good assets and sell bad assets, but to buy assets well and sell assets well. Sometimes things can be so good theyre bad, and sometimes they can be so bad theyre good. You have to have the process and conviction, but you also have to have the art to see what matters when.

As of last week, the fund was invested 13.5 per cent in Australian shares, 26.5 per cent in shares in developed markets (favouring Europe and Japan, underweight US), 15 per cent equities in emerging markets, 4 per cent in global property trusts, 10 per cent in commodities (leaning towards energy and agriculture and away from precious metals), 9 per cent in Australian government bonds, 5 per cent global investment grade credit and 17 per cent in cash. The buckets in Naeimis fund can take up to 25 or 50 per cent of the balance and have no lower limit. You need to be able to go down to zero, he says.

There is no point being diversified into asset classes which are all overvalued, overowned and overbought. Blind diversification is destructive.

The fund isnt holding any global high-yield credit, global sovereign bonds or global inflation linked bonds, for now, although each asset class can account for up to 25 per cent of funds.

THINK ABOUT OFFSHORE

Tracking allocations over time is an interesting exercise. The first chart shows how Implemented Portfolios No. 3 Program fund spread its money over the past 10 years. The second chart shows how AustralianSupers balanced fund was rebalanced between 2006 and 2013.

The last chart is a snapshot of the average allocations of Australian multisector funds for five investor risk profiles for July, as researched by Morningstar. Its a trade-off between shares and cash as investors vacillate between being aggressive about growth and conservative.

David Bryant, head of Australian Unity Investments, argues that one of the key shortfalls in the asset mix of Australian investors portfolios is the lack of overseas equities.

Offshore shares lower the risk in a portfolio, he says. People think investing offshore increases risk, but Im sorry, [if you are wholly invested in Australia] your risks are so imbedded in your portfolio but you just dont see it.

Anyone worried about what currency fluctuations can do to balances can always use a hedged investment fund, he says, but Id recommend unhedged is a much better way to go.

Thats a tip that will no doubt be reversed if the Australian dollar plunges in months or years to come, and Bryant suggests deciding on a trigger to begin considering switching to hedged.

ECONOMIC LEADER IS US

Investors need to think about offshore like you never have before, he says, advocating a 50 per cent allocation to international markets of an entire portfolio.

Thinking in terms of buckets sounds easy but deciding what qualifies to be dropped into them is harder. All investors should have exposure to international markets, for a start, but which ones?

The clear global economic leader is the US, says Bryant.

Its deservedly the strongest place to be. Asia has many, many things to like about it, and Europes potentially going to struggle but the UKs looking OK.

He reckons the Asian share market is at least 20 per cent cheaper than the US on a price-earnings basis and about 15 per cent cheaper than Europe, so why you would pay more for Europe, I dont know. He says to include Asia, unhedged, in an offshore allocation.

Bryant describes Australian banks as a proxy for residential housing, as the value of their mortgage books relies on property values, and he says anyone who owns their house is well endowed with property already and doesnt need it in a portfolio.

Thats one less bucket to worry about.