Find your balance on the life cycle

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If like me, you run your own Sipp, it’s all very well rabbiting on about smart asset allocation, and sensible diversification but how do you actually go about doing it on a year-by-year basis? Given that I’m several years from retirement, should I tactically reallocate, lowering my holding of emerging markets stocks from 13 per cent of the portfolio, and increasing my bonds from 4 per cent?

I reckon there is an alternative – one that I’m seriously considering for a part of my Sipp and that I think most smart readers of this column should consider as well. It’s based on a cracking US investment idea and its called Lifecycle Investing.

Here’s the idea. There’s a huge stack of evidence, most of it courtesy of Yale Professor of Finance Roger Ibbotson and his consulting firm, that diversification within a portfolio is a huge contributor to final total returns. Smart asset allocation may contribute as much as 90 per cent of long-term returns – all that stuff about smart stockpicking is, apparently, a load of old guff. This lesson is backed up by evidence from the hugely successful management of the US Ivy League university endowment funds – these have been returning at least 2 to 3 per cent above the benchmark, year on year, mainly by clever use of alternative assets and then mixing them carefully in a portfolio with core equity holdings.

There are a number of important lessons here. The first is to be open to new asset classes and invest in them diligently. The next is to get the ratios between the assets right. And the last is not to overtrade – stick with your strategy over the long term with only a few tweaks here and there. As I said, it’s a glorious idea but actually rather difficult to put into practice.

Lifecycle funds attempt to do this for you. In the US, a number of big mutual fund providers – dominated by T Rowe Price, Vanguard and Fidelity – have launched funds with snappy titles such as Fidelity Freedom that attempt to do the asset allocation stuff for you. If I were in the US, I’d probably have a close look at the Vanguard Target Retirement 2030 which is aimed, at investors aged between 39 and 43, who aim to retire in or around 2030. This $1.6bn fund allocates 13 per cent to bonds and a little over 86 per cent to equity funds, all provided by Vanguard.

These tracker funds are insanely cheap – the wrapper Target Retirement fund costs 0.21 per cent. As the years progress, the fund managers start to tweak the proportions, and hey presto, as you approach the fateful date the allocations move towards nice, safe bonds.

What’s so wonderful about the idea is that it works however old or young you are – each band of five-year target retirement dates has a different fund. There are even ultra-cheap exchange traded funds from Xshares/Amerinvest that use an index developed by research house Zack to track the same outcomes, with a total expense ratio of just 0.65 per cent a year.

Two big providers have now launched funds in the UK that mimic this structure: Fidelity and ABN Amro. The latter has even tried to tailor the product to the UK market by adding a capital guarantee element if the funds are held to retirement – although this comes at a cost, as the annual management fee is a pricey 1.75 per cent.

The Fidelity offerings – one called Wealthbuilder Target and the other aimed specifically at pensions called The Retirement Funds – are much closer to the US model and cost somewhere between 1.4 per cent and 1.85 per cent.

Quite whether Fidelity or ABN Amro are any good at making these important asset allocation decisions is too early to say – hopefully, more mainstream providers will enter the space.

My fervent hope is that someone here launches a parallel index to that provided by Zack Research, and one of the UK ETF giants – iShares, Lyxor, Deutsche or Powershares – offers a tracker fund over here.

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