A variety performance that may leave you smiling

Diversifying your investments across cash, shares, bonds, commodities, property and hedge funds – and matching these assets to future liabilities, such as debt repayment, pension provision or children’s financial needs – can reduce the risk of price falls in any one asset class affecting your family’s future. This asset allocation approach is the investment equivalent of “not putting all your eggs in one basket” – and the key element of your overall DIY financial plan.

Developed world
equities

UK, US and European equities are traditionally recommended as the core of any growth-orientated portfolio for the long term, as shares have historically outperformed bonds and other asset classes over periods of 25 years or more. In general, the longer the timescale, the higher the allocation to equities can be – but it is advisable to reduce exposure in the years before capital is needed.

Pros: Developed world equities have produced both capital growth and rising income over the long term. According to the Barclays Equity-Gilt Study, equity returns have averaged 7.2 per cent in the past 50 years. Exposure can be gained at very low cost using index tracker or exchange traded funds (ETFs) charging 0.3 per cent, or less, a year.

Cons: UK and US equities have underperformed government bonds for long periods. Barclays’ study shows that they produced a lower real return than US Treasuries and UK gilts in the past decade. “It’s true that the average return is 7 per cent, but the S&P 500 only achieved that return 16 per cent of the time,” points out Matthew Merritt, head of investment strategy unit at Insight Investment.

Emerging market
equities

Emerging market equities are described as “a geared play” on western markets, as they move more dramatically than developed world equities. In 2008, the MSCI Brazil, Russia, India and China (Bric) index fell 54.8 per cent, against a 37.6 per cent fall in the S&P 500. But in the first four months of 2009, the Bric Index rose 21.4 per cent, outperforming developed markets.

Pros: Combining emerging and developed world equities can boost returns and reduce volatility over the long term. Graham Frost, chief investment officer at Bestinvest, says: “You would have had a bigger return with less risk if you had 50 per cent in developed markets and 50 per cent emerging markets.”

Cons: Returns from emerging markets have become increasingly correlated with developed markets, because of the export dependency of emerging economies. Actively-managed funds can outperform indices but most have total expense ratios of 1.65 per cent or more.

Government bonds

Government bonds, such as UK gilts and US Treasuries, offer a fixed-income “coupon” over a fixed term, with the return of original capital on redemption guaranteed by an AAA-rated government. So their prices are driven principally by interest rates and inflation, and their returns are generally negatively correlated to equities.

Pros: Government bonds offer diversification benefits at low cost, and a secure income. Individual gilts can be bought through a stockbroker from £12.50 a deal. Gilt tracker funds, such as the iShares FTSE All Stocks Gilt, charge as little as 0.2 per cent a year, while managed gilt funds charge from 0.5 per cent.

Cons: Higher inflation and higher interest rates will make gilts unattractive in the medium term. “If a 10-year gilt [yield] is at 8 per cent, you’ve had inflation, which means you are losing money,” argues Fredrick Nerbrand of HSBC Private Bank.

Corporate bonds

Corporate bonds also offer a fixed-income coupon over a fixed term. But as the return of original capital depends on the financial strength of the issuing company – which could default on repayment – corporate bond prices are driven more by sentiment toward the issuer. As result, the correlation between investment-grade corporate bonds and equities has risen sharply.

Pros: Bonds from financially strong issuers can offer attractive yields and the prospect for capital growth – investment-grade bonds have outperformed equities this year. Corporate bond funds charge 0.75-1 per cent a year.

Cons: Default rates on high-yield corporate bonds are expected to rise into 2010. Individual bonds are difficult to buy – minimum investments can be £10,000, and bid-offer spreads as wide as 15 per cent.

Commodities

Commodities can offer capital growth but demand is driven by economic conditions, which can lead to a high correlation to equities. Prices of all major commodities rose from 2007 to mid-2008, but have fallen sharply since: oil is down 55 per cent, copper 41 per cent and corn 53 per cent.

Pros: Agricultural commodities are set to benefit from long-term demand in emerging markets. Exposure can be gained through funds such as CF Eclectica Agriculture, charging 1.75 per cent a year, or via exchange traded commodities (ETCs) with annual charges of 0.49 per cent.

Cons: Prices have become increasingly correlated with equities. Not all ETCs are backed by physical commodities, but rely on bank
counterparties for their returns.

Gold

Gold differs from other commodities as it has historically acted as a hedge against inflation and has been negatively or lowly correlated with equities.

Pros: Gold is one of the few asset classes that can protect against inflation and deflation. Exposure can be gained via ETCs that are backed by physical gold, with annual management charges of 0.4 per cent.

Cons: Over the past 27 years, the annualised return from gold has been just 0.31 per cent. Last year, gold also failed to protect against deflation fears, falling in price in the autumn.

Property

Commercial property can offer attractive rental yields and the potential for capital gains. Between 2003 and 2007, the asset class outperformed equities and bonds, according to the IPD Index. Exposure can be gained through property funds, charging 1.75 per cent a year, or through listed real estate investment trusts (Reits), with no management charge.

Pros: Property has produced competitive long-term returns, and can provide
a yield in the short-
term. “When you add
property to a portfolio, you get paid to wait because
of the yield,” says Frost.

Cons: Valuations are driven by economic conditions and returns from property are now 0.87 correlated to equities, limiting diversification potential. Property remains an illiquid asset class, and funds can impose “lock-ins” on investors wanting to withdraw money.

Hedge funds

Hedge funds have the potential to produce positive returns in all market conditions by taking long and short positions on shares. However, a combination of market volatility and forced selling by funds needing to cut borrowings saw the average fund lose 23.2 per cent in 2008, according to Hedge Fund Research.

Pros: Hedge funds can use shorting to buy protection against market falls, and can therefore reduce the volatility of a portfolio.

Cons: Hedge funds now have a 0.97 correlation to equity markets. Individual funds charge 2 per cent a year plus a 20 per cent performance fee, but private investors can only access listed funds of hedge funds, the prices of which can fall to wide discounts to their net asset values, as well as carrying TERs of 1.5 per cent or more.