The blend is your friend

The creation of stable and robust portfolios for retirement requires diversification at every stage of the investment process, according to Ant Gillham, manager of the Old Mutual Generation Portfolios, Old Mutual Global Investors

The litany of changes to UK pensions regulation may seem somewhat bewildering, as officials veer between wholesale reform and what can look like tinkering. But there are some things that remain constant in retirement planning.  

At the top of this list is that investments need to provide a sustainable income, and one way to attain longevity of income is by securing capital growth.

In order to secure this there are three attributes that fund managers should strive to achieve: consistent performance; some downside cushioning, where possible; and greater diversification.  Crucially, when customers are looking to draw an income from their pots, the combination of these elements should help mitigate any negative sequence of returns that could permanently dent their capital.

The first two of these characteristics are in many ways a function of the third: a genuinely diversified portfolio should generate smoother returns and help shield performance during moments of market stress.

On the Old Mutual Global Investors multi-asset desk, we seek to imbue our portfolios with true diversification by picking a mix of assets that exhibit low levels of correlation with each other. Should a geopolitical flare-up or macroeconomic shock trigger losses in one asset class, such as equities, owning other assets that tend to move in a different direction, such as government bonds, would probably help cushion performance on the downside.

A diverse range of investments should enable portfolios to even out some of the peaks and troughs of the markets. This has a beneficial impact on retirement savings, because relatively smaller but more consistent investment returns tend to result in superior returns over the longer term. By contrast, larger moves up followed by smaller moves down tend to lead to inferior returns.

This underscores the importance taking a ‘top down’ view to instilling portfolios with diversification, at the moment of deciding their asset allocation. Yet genuine diversification can only be achieved if this approach is combined with a ‘bottom up’ view as well.

By picking a broad range of fund managers to run parts of portfolios, you can have investments across different fund-management styles, as well as in multiple regions, financial assets and industrial sectors. This is essential because we know the market does not always reward all styles, all of the time.

While cheap stocks should outperform expensive ones over the longer term, there are some periods when cheap stocks just get cheaper. So diversifying across styles is clearly important to avoid possible instability in a portfolio, with downside risks when the market frowns on a certain style.

A further level of diversification is found at the level of security selection – ensuring that there are diversifiers within asset classes.

Finding securities that provide an income is key to building portfolios for retirement; certain stocks that have a long history of paying out much of their earnings to investors are often favoured. Before the financial crisis, shares in UK banks were a favourite to meet this challenge. As the chart below makes clear, however, having too great an exposure to these stocks would have wrought havoc on a portfolio during the financial crisis. Banks’ share prices were battered, while the only payouts a number of the largest went on to make were to the government, which was forced to bail them out.

It follows that just as diversification is essential in crafting the right portfolio for retirement, it should be achieved in the right way – rather than just diversifying for its own sake.

During our strategic asset allocation process, for example, we employ a tool that takes forward-looking estimates for risk, return and correlation and produces thousands of trial portfolios. This helps us avoid ‘tippy’ portfolios – situations whereby small changes to input assumptions lead to wild variations in the outcomes.

By testing these inputs and changing them very slightly thousands of times, and allowing an average asset allocation to be taken as a result, this tool leads to more stable and robust portfolios.

So as we adjust, and re-adjust to the changing landscape of pension reform, it is worth remembering one thing: the creation of portfolios for retirement requires diversification at every stage of the investment process; or more simply, the blend is your friend.