IFAs reveal their asset allocation decisions

Maria Merricks reports on which asset class is best for clients in the current environment.

Investor appetite for bonds is building rapidly, as the negative outlook for economic growth has led many to shun ‘riskier’ equities.

Recent IMA data reveals Bonds was the best-selling asset class in August. For the first time since the first half of 2009, sales surpassed the £1bn mark, returning to the peak levels seen during the period from December 2008 to May 2009.

As in July, three of the top five selling IMA sectors were bond sectors, with £ Strategic Bond in fourth place, Global Bonds in third and £ Corporate Bond the best-seller, with net retail sales of £573m. No equity sectors sat in the top five.

Finding value

Despite strong inflows, commentators are not all positive about the asset class, saying there is currently not enough value in bonds.

Ben Seager-Scott, senior analyst at Whitechurch Securities, is concerned spreads have tightened a lot since last year. He believes that although this partly comes down to a fall in default rates, another factor is the number of investors being pushed up the risk scale to get any sort of returns as interest rates on cash deposits remain low.

Seager-Scott says: “In the past, a lot of investors wanting income would just sit on cash and get a return from it. Traditionally, you could get 6% or 7%. Now that has disappeared, investors are almost being pushed into higher-risk assets.

“An obvious substitute has been gilts, and unfortunately I think a lot of high-quality corporate bonds have acted as proxies for gilts. The spreads have tightened, so the yields you are getting have come in a long way.”

Meanwhile, Meera Patel, senior analyst at Hargreaves Lansdown, believes investors should not dismiss equities, saying their value make them worth the higher risk.

She says: “There are a lot of companies out there with yields on their equities higher than that of their corporate bonds. This makes a compelling buying opportunity, and in that situation, I feel equities are worth the risk: you not only get the yields but the prospect of capital growth, too.”

Investors do not get that level of growth with bonds, Patel adds: “We saw that growth last year in corporate bonds, but I do not think we will ever see that again in normal market conditions.”

The equity income opportunity

Both analysts agree that there is a strong opportunity for income and growth with Equity Income investments. Patel says this is an asset class that has been ‘unloved’ in the past couple of years, and she urges advisers to consider it again: “If you look at indices and run some graphs, you will see the low-yield index has performed really well over the past three and five years, whereas the high-yield index has not,” she says.

“When you run the same charts on a ten-  or 15-year basis, it shows that a high yield always tends to outperform low yields. What this suggests is that the income strategy, when it comes to Equity Income, is offering the best value relative to other strategies in the market.”

Seager-Scott also favours equity income over bonds. “With the government’s austerity measures and interest rates staying low, the outlook is not particularly rosy. We are not going to shoot the lights out in terms of economic growth,” he says.

“On the back of that, it is difficult to see significant capital growth of stocks from here, and so in the absence of that growth, Equity Income is attractive from both a valuation point of view and, with its solid yields, a total return perspective too.”

Portfolio diversification

With so much uncertainty surrounding the future economic picture, advisers highlight the importance of diversification within client portfolios.

Martin Bamford, managing director of Informed Choice, says no one can accurately predict the short-term movement of a particular asset class or stock, even if it appears to be over- or under-valued. For this reason, he says, advisers should not place big bets with their recommendations to clients.

He suggests small, tactical adjustments to long-term strategic models, allowing investors to capture short-term value without having dangerous levels of exposure to too few asset classes.

Within the investment models which Bamford currently uses, asset allocations are as follows: the cautious investor sees 40% in bonds and 35% in equities; moderate investors see 28% in bonds and 50% in equities; and aggressive investors see 19% in bonds and 70% in equities.

The risk model question

Mark Waters, investment manager at Skerritt Wealth Management, agrees that the key to better returns on any portfolio comes from tweaking what you invest in at any one time and from taking into account clients’ risk profiles.

When it comes to effective risk models, Waters says the fact that risk is subjective can make models difficult to follow. He says: “Risk depends on where you are at any one time and risk models never take that into account. Instead, they will look back historically, and that is why so many people were still in property in 2008: because the risk models said it was ‘low risk’.”

“We went against the traditional risk model, and had actually come out of property in February 2007, but if you do that, you had better be right.”

Meanwhile, Bloomsbury Financial Planning’s Jason Butler says asset allocation depends on the needs of the client:

“There are no silver bullets or magic solutions, as the issue boils down to what return investors need and want, and the risks they can accept. If you need a higher return than that from short-term government cash instruments, then you will simply have to accept there will be risk.”

Butler has a simple guide to determine asset allocation. He subtracts the client’s age from 100 to determine their allocation to equities: a 40-year-old would have 60%; a 70-year-old would have 30%, and so on.

“Of course, there are more sophisticated ways of getting the right allocation, but investors should always devise their investment strategy in the context of an overall financial plan, which is determined by their life goals,” he says.