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Newly wealthy individuals can pose a challenge to investment advisers when the subject of asset allocation comes up.

“People who have been hands-on in managing their business often don’t want to put their money into an area they aren’t familiar with,” says Jeremy Marshall, chief executive of private banking at Credit Suisse. “Entrepreneurs often want co-investments in the same area, so there is a tension there with diversification. In contrast, third- or fourth-generation family members tend to be more focused on diversification and are usually more hands-off in their approach.”

Achieving a spread of assets is crucial to preserving and enhancing wealth and is important in the increasingly sophisticated field of asset allocation.

“Asset allocation is the cornerstone of our business,” says Gavin Rankin, head of products and services consulting for UBS Wealth Management in the UK. “According to research, asset allocation can account for up to 90 per cent of investment returns, with market timing and individual manager selection contributing the remainder.”

“Asset allocation is the root of each client relationship,” adds Gavin Rochussen, chief executive of Fleming Family & Partners. “If you don’t get the asset allocation right, it doesn’t matter how you manage the assets in each class; you won’t get the right returns.”

The basis for what is known as modern portfolio theory was laid in the early 1950s by Harry Markowitz, an economist at the University of California. Before the publication of Prof Markowitz’s paper, Portfolio Selection, investors focused on the risks and rewards of individual securities.

This meant an investor could decide that automobile stocks or food retailing offered the best combination of risks and reward and then create a portfolio consisting entirely of such stocks. In the late 1990s, many investors bought dotcom shares for the same reason.

Long before the market crash of 2000-2003, more thoughtful investors and researchers were questioning the theory of individual stock analysis. Markowitz formalised these ideas and drew up the mathematical formulae to optimise diversification. Modern theory calls for portfolios based on overall risk/reward characteristics instead of that of individual stocks.

“There has since been an increase in modelling and increased sophistication in calculating forward-looking assumptions, but the long-term fundamental remains diversification,” says Rankin.

How far asset allocation has developed can be seen from the composition of modern indexes. The FTSE Banking Index covers seven main asset classes but these are split into 40 sub-asset classes. The main classes are cash, equity, fixed income, alternative investments, commodities and property, with foreign exchange as an overlay strategy.

Overlay strategies probe beneath the apparent diversification of a portfolio to establish what the real exposure is to risk. A US company doing business around the world may appear to be a dollar exposure, but many costs and revenues may arise in other currencies.

Portfolios are also assessed by the risk the investor is willing to accept: low, medium or high, corresponding to income, balanced and growth strategies.

This represents a far cry from early diversification strategies that typically comprised cash, equities and bonds, possibly with a geographical element.

Investors and their advisers are also becoming more clever about the way they treat alternative investments. Originally consisting of property and commodities, they now include private equity investments and hedge funds. Some categories are now so commonly included in investors’ portfolios that they can scarcely be considered “alternative”.

Some categories are being reassessed to reflect varying performances. “There is a big difference between managers in the top and bottom quartiles in the private equity field,” says Philip Watson, head of investment advice and analysis at Citi, the investment bank. “Private equity performance divergence is greater than in all other asset classes.”

Hedge funds, similarly, must be differentiated, says Watson. “Hedge funds are not one asset class. Managers can use a range of strategies including long/short, distress investing, event-driven and arbitrage. We do not offer portfolios with the hedge fund label. We distinguish between strategies.”

The theories may have become more sophisticated, but they cannot be applied in the abstract. “You have to customise things with the client,” says Paul Sarosy, managing director and head of investment solutions at Credit Suisse.

The need for diversity and a low level of correlation between asset classes should underpin most portfolios. But the choice of investment needs to reflect the individual’s needs (generally, strategies become more conservative with age) and market developments. It may start with the novice investor learning to invest in unfam­iliar sectors but adjustments will later be necessary.

Copyright The Financial Times Limited 2017. All rights reserved.
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