Shifting fortunes necessitate shifting funds

Diversify. That is the advice now coming from advisers and fund managers in response to rising inflation and the shaky equity market.

Investors are being warned not to flee into cash, as they will see their capital eroded by inflation and be left constantly trying to guess when the market has bottomed out.

Hugh Adlington, investment director at Rathbones, says: “For so many years we’ve had such a benign market that the benefits of diversification haven’t really been tested.”

So a good mix of equities, cash, property, bonds, and alternatives remains the most sensible option. But what exactly should the spread be? How much should a person hold in each of these asset classes?

The answer depends on the age and needs of the investor and personal
aversion to risk.

Certain rules of thumb are still widely used, however, when it comes to asset
allocation. The split between equities and bonds is still often calculated by subtracting a person’s age from 100. So a 35-year-old would have 35 per cent in bonds and 65 per cent in equities, whereas a 60-year-old would have 60 per cent in bonds and 40 per cent in equities.

But Charles MacKinnon, chief investment officer at Thurleigh Investment Managers, warns against such an approach. “I think that traditional models are horribly wrong because,
frequently, someone in their 30s has an absolute need for money, while someone in their 60s may be able to absorb the illiquidity,” he warns. And with people
living longer, the need to retain equity exposure in old age is greater than it used to be.

Asset allocation becomes even trickier when the issue of which asset classes are non-correlated is considered. Over the past year, as the credit crunch has taken hold, some asset classes that are usually thought to be non-correlated – property and equities, for example – have in fact fallen at the same time.

Dennis Hall, a financial adviser at Yellowtail, suggests that the recent convergence may be because property has been treated more as an equity, with people investing in it for capital growth rather than for its long-term rising rental yield.

So while people should still have property in their portfolios, they should just learn to view it differently. This, Hall believes, should lead to de-correlation again: “Things should begin to become less correlated as investors once again look at the fundamentals of each asset class.”

The correlation between asset classes is not always predictable. Hall points out that soft commodities, for example, are correlated with the weather. Hard commodities, though, have more of a lagging correlation with equities, gaining strength, as now, when equities begin to do badly.

Equity indices, of course, will include mining companies. So Hall recommends buying products backed by physical metals, such as the Lyxor Gold Bullion ETF.

Then there is the question of what counts as an asset class. Hedge funds do not, believes MacKinnon. They are just a way of managing money, with some carrying far more risk than others.

In contrast, private equity should be seen as a separate asset class. “Private equity companies don’t trade in the market, you can’t buy and sell them, and they don’t have to report quarterly earnings. I think that makes them much better able to make money,” says MacKinnon. He suggests gaining exposure through investment trusts such as HgCapital Trust.

Once investors have determined their asset allocation, says MacKinnon, they should decide how to gain exposure, whether directly, through an index fund, an active manager or a hedge fund.

For example, if a market is performing well, an index fund makes sense, whereas if some areas are doing well and some not so well, the best way may be through a hedge fund.

But any shift in asset allocation, says MacKinnon, should be done gradually. He is moving his clients’ portfolios over a period of two years, in order to avoid trying to second-guess the best time to transfer in.

Another strategy is to maintain exposure across asset classes simply in order to hedge.

Adlington recommends holding commodities even though he does not expect the price to go much higher, because, if prices do edge up, it will spell bad news for fixed income and equities.

As he says: “Now is not the time to be making a binary bet on the economic outcome.”