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What a Difference a Year Makes!

Richard Urwin, CHFP Managing Director and Chair of our Investment Committee, reflects on another great year for our clients' investments....

I posted an article about the importance of diversification at roughly this time last year. I reflected on a year in which we had seen the first negative calendar year return since 2011, albeit only -3% versus the UK stock market total return of -9%. I highlighted the volatility we'd seen in markets over 2018 and the real benefits that a diverse portfolio can provide.

Fast forward to the end of 2019 and we have just seen the best year in the UK market since 2009. I began writing this just before Christmas so the charts I've included run to the 23rd December. I've taken the same start point as the year before, 1st Jan 2014.

The blue line on the chart above is the actual returns achieved by clients with the CH Medium Risk portfolio. The red line represents the UK stock market index with dividends reinvested. It isn't necessarily an appropriate benchmark for a multi asset class portfolio but it is one that most clients can relate to. There are three elements of cost in the blue line: advice, the investment platform and underlying fund management charges. Depending on portfolio size these costs amount to between 2.3-2.6% p.a. This pays for a comprehensive financial planning service including tax advice, the use of multiple tax wrappers such as GIA, ISA and Pension and professional investment advice. The index chart includes no costs, no stamp duty, no brokerage fees etc.

All investors would love to be able to travel into the future and look back with 20:20 hindsight. As we are moving into 2020 I thought it might be pertinent to look at the decade which has just come to an end. The chart below shows the period from 2010 to 2019, and again it can be seen that our portfolios significantly outperformed the stock market as a whole over that time, even after deduction of the costs of investing.

It is fair to say that there is much more to our service proposition than investment advice and I believe that putting client’s values and goals at the centre of a long term financial plan is arguably the major difference that distinguishes us from much of our competition. However not all investment processes are the same and our approach differs in some important ways from our competitors.

FE Analytics is a research tool that among other things enables one to analyse the "diversification benefit" of a portfolio. Their Diversification Report shows the weighted average risk of the underlying funds in a portfolio compared to the risk of the portfolio as a whole, with the difference expressed as the diversification benefit.

For our Medium risk model, the weighted risk score (volatility expressed as a percentage of the volatility of the FTSE 100 index) of the underlying funds is 111. This means the volatility of the average fund or security in our Medium Risk Portfolio is 111% of that of the FTSE 100. This is high and were that the level of volatility of the portfolio when all of the investments were combined, it would not be suitable for Medium Risk investors.

However the risk score of the portfolio as a whole is only 48. This means a 57% reduction in overall risk is achieved through diversification i.e. the lack of correlation between the underlying holdings (they produce their returns and suffer losses at different times).

To put this into context, we reviewed 12 Discretionary Fund Managers Managed Portfolio Services and ran diversification reports for their equivalent of a medium/balanced risk portfolio. The diversification benefit scores ranged from 20 to 32 with the average being 25. The Managed Portfolio Service with the best risk adjusted returns (as measured by the Sharpe Ratio) had a score of 30. The weighted risk score of their funds was 87 (87% of that of the FTSE 100), the portfolio risk score was 61, so they achieved a 30% reduction in portfolio level volatility as a result of diversification, compared to our 57%.

FE Analytics' guidance notes for the diversification benefit report states:

“Diversification Benefit cannot be lower than 0% and has a theoretical maximum of 100%. In reality, the ceiling is around the 50% mark which a traditional portfolio would find it difficult to exceed.”

The best of the MPSs that we analysed managed 30%. Our score of 57% is at the very top of what should be achievable.

In last years article I explained diversification in a less technical manner with an analogy involving eggs, baskets and lifts. The key to achieving strong returns, without the concomitant elevated level of risk or volatility that this might imply, is diversification.

The funds in our model are all able to produce healthy returns, it is the combination of them and their lack of correlation that reduces the portfolio level risk. This is in contrast to many multi asset portfolios where more of the reduction in risk is attributable to investment into lower risk assets to dampen overall volatility. These lower risk assets ultimately create a drag on portfolio performance because they produce low average returns.

If you populate an investment portfolio with only low-risk investments in order to reduce overall volatility, you just get low returns. We’ve created a portfolio in which the volatility is remarkably low (circa 48% of the FTSE 100 index for our Medium risk portfolio) given the volatility of the underlying holdings in isolation (weighted average circa 111%), but these investments are all capable of producing significant returns over the longer term. We achieve this by using funds that are exposed to a range of different risk factors, which results in them producing their returns at different times. At portfolio level, this smooths out returns over time and makes for a less bumpy investment journey.

The last decade has been below average for the UK stock market compared to data from the last 118+ years but, whilst there has been significant volatility, portfolios haven't been seriously tested since the GFC (Global Financial Crisis for those who have forgotten it). I will end with the last paragraph of last years article because I think, as we near a time when we may finally see an inflection point in the downward trend for bond yields, is likely to prove prescient once we are able to look in next year's rear view mirror.

"Things are made more difficult because the relationship between different asset classes does not remain the same. It is tempting to look at the correlation of investments in the past and to build portfolios based on that data. This analysis is important but on its own it is flawed. Its what I call the Jim Bowen style of investment 'look what you could have won'. What worked in the last five years may well not work in the next."

Richard Urwin

Investment Director

If you are seeking professional help in managing your investments based on a proven and effective process, why not take the first step now?


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