Bloomsbury blog Getting strategic

Bloomsbury newsletter, 31 March 2016

A question we are frequently asked is how do we decide upon the asset allocation we recommend in a portfolio?

It's a good question, and while we often use this part of our quarterly newsletter to examine subjects other than investing, we thought this topic currently warranted some greater explanation.

We have recently undertaken an exhaustive asset allocation and portfolio review and, as a result of this, we will be recommending and implementing a number of small changes to portfolios.

One might legitimately ask, "I own 10,000 or so securities in my portfolio and I'm a disciplined investor who prefers not to chop and change my strategy, so why does my adviser need to undertake such a comprehensive review?"

Quite simply, our investment opportunity set keeps changing and improving. As recently as ten years ago we had a limited choice of genuinely low cost investment options, we couldn't easily invest in asset classes like emerging markets and international property, and we didn't even have access to attractively priced options for investing in New Zealand equities.

In the last ten years much of what we now invest in has been considerably enhanced or improved from the opportunity set available to us a decade ago. Today we can access markets in a much more diversified way, and at a much lower cost, by harnessing an expanding range of funds and investments offering superior mandate stability and attractive risk control features.

Over the next ten years we expect the potential opportunity set at our disposal will have advanced further still, and it is our job to consistently seek to identify and implement these improvements as they emerge. Our three yearly strategic asset allocation review is a recurring opportunity to undertake this in a highly structured way.

One of the key elements of the strategic review is to test our old ideas with new data. We consistently collect new and better data about the returns of different funds and markets, and this helps us to formulate rational, evidence based expectations for their potential long term returns.

We test any new information against our existing assumptions to see what, if anything, may have altered. If we identify any significant changes then there may be a need to reflect these in our updated asset allocation recommendations.

In the recently completed review the process of reviewing the portfolios was exhaustive, but can be explained in relatively straightforward terms. Initially we need to determine:

1. What we expect all recommended assets to earn over the long term, after all taxes and fees
2. How much we expect the returns of each investment to vary (move up and down) over time
3. How much we expect the returns of each investment to vary in relation to other investments at the same time

That's easy to write, but hard to do. Nevertheless, once we have this information we can use advanced mathematical techniques to determine combinations of different investments that lead to higher expected returns for the same or similar amounts of volatility.

Some of the outcomes of the current strategic asset allocation review are summarised below:

We are increasing our allocation to international equity

To do this we are reducing our allocation to Australian equity. The reason is that over the long run we expect international shares to offer the same or better returns than Australian equity but with a similar or lower volatility. The Australian share market represents about 3% of the value of all global listed shares but a much larger proportion of our portfolios. Therefore, we are reducing what is already a large relative holding.

We are increasing our allocation to international fixed interest

To do this we are no longer allocating to the AMP NZ Fixed Interest Fund. The reason is that in the prevailing environment international fixed interest funds generally offer a higher yield to maturity than comparable New Zealand funds, and also invest in a more diversified pool of credit worthy borrowers. On an expected returns basis this meant our opportunities for improved returns and greater risk control benefits would accrue from increasing our offshore allocations at the expense of some New Zealand allocations. This was most pronounced in the case of the AMP fund.

We are changing our recommended New Zealand equity allocation to the Harbour New Zealand Equity Advanced Beta Fund

The Harbour fund now represents the lowest cost New Zealand equity fund available to us, thanks to a special discount we have been able to negotiate with the fund manager. In addition, there are no costs to either buy or sell units in the fund compared to the minimum fee of 0.20% we currently pay to transact in New Zealand equities. Harbour will own the same securities as our existing fund (all those represented in the NZX 50 Index) so we expect total returns, before costs, to be very similar to before, but within a much more efficient fund structure.

We are increasing the allocation to the Dimensional Emerging Markets Trust

The reason is that this fund invests in inexpensive companies in emerging markets. As a result the expected return of the fund is high, although the monthly returns can be rather volatile. By increasing our exposure to this fund we can improve the overall expected returns of the portfolio.

There are other small changes, but these represent the most important ones. Overall, we expect that portfolios adopting these changes should earn slightly more each year, and the improvement in expected returns should also more than make up the for the one-off cost involved in implementing the changes.

This strategic asset allocation review is just part of the ongoing and extensive due diligence we complete on our clients' behalf. Every three months each recommended fund is painstakingly monitored to ensure that it is doing exactly what we expect, and each year we look at every asset class we recommend to determine whether any better alternatives are now available.

The majority of our clients understand that this work is undertaken regularly, professionally and carefully because they know we have their best interests at heart and we are always striving to improve the quality of our services.

We hope that by providing greater insight into why this detailed process is periodically undertaken it helps explain why, from time to time, we want to recommend changes or enhancements to our existing strategy.

Our intention is always to seek to implement changes that can have a material positive impact on the expected performance of a portfolio over time. If we can achieve that, then we are making a difference where it matters most - the ultimate achievement of our clients' long term savings and investment goals.