Should your investment portfolio now be reconstructed, asks Caroline Madden, and what type of shares or bonds should dominate?

WHEN IT comes to constructing a portfolio of investment assets, conventional wisdom dictates that equities should be the dominant component, with the balance split between property, bonds and cash.

However, in light of the heavy losses sustained by investors over the past year, particularly those whose pensions are invested in Irish managed funds, is it time for a fresh approach to portfolio construction and asset management?

Most of the main insurance companies in Ireland run managed funds that offer investors and pension savers the chance to gain exposure to a portfolio of assets that they wouldn’t otherwise be able to access.

The problem with these funds is not just that the rates of return delivered have been shockingly poor, which they have (the average managed fund lost more than one-third of its value last year), but also that they have been extremely highly correlated.

This is despite the fact that the funds are – supposedly – actively managed, as opposed to simply tracking an index.

Gary Connolly, head of investments with the broker network Citadel and former chairman of the Irish Association of Investment Managers, is strongly of the opinion that the managed fund model is fundamentally flawed.

“Having been in the fund management industry for 10 years, I have recognised that the traditional model of the managed fund is dead, not just because of last year’s dire performance,” he says.

One of the main criticisms levelled at Irish managed funds in recent years is that they were over-exposed to the domestic stock market. At the beginning of 2008, the average managed fund had almost 14 per cent of its total assets invested in Irish equities, even though the Irish market made up only 0.3 per cent of the world equity market.

According to Rubicon Investment Consulting, roughly €4.6 billion was wiped off the value of Irish pension funds last year alone due to this exposure.

Connolly points out that managed funds also had a high allocation of Irish Government bonds and property. “There was a large bet within managed funds that was contingent on the Irish economy,” he says, “and the Irish economy in a global sense is very, very small. People thought they were getting diversification and they weren’t.

“But the real reason why the managed fund model is dead is they’re not actively managed,” he continues. “They’re all managed within a very tight margin of each other.”

Few fund managers are willing to stray too far from their benchmark – ie the industry average – despite being paid hefty active management fees to make independent investment decisions rather than simply follow the herd. In reality, they keep a very close eye on, and are restricted by, what their competitors are doing.

“Of the 17 managed funds ranked in a monthly survey, all but one is within 5 per cent of the average 66 per cent allocation to equities,” Connolly says.

“With such uniformity of thinking, the performance of this group is unsurprisingly clustered. The best fund in 2008 lost just under 30 per cent, the worst lost 38.8 per cent.

“You probably find that any strategy meetings of fund managers are always timed for about three to four weeks after the quarter end, so that by that time. they have the asset splits of every one of their peer group through the Mercer survey. That is the basis on which the money is managed – against the consensus average.”

The problem stems from the fact that the “risk perception” of investors and fund managers is not aligned. “From a client’s perspective, the risk is they’ll lose money,” he says. “From the manager’s perception, the risk is they’ll lose clients if they’re too far away from the average.”

He suggests that investors would, in fact, be better off simply investing in the Irish Life Consensus Fund, which replicates the average asset allocation of the Irish fund management industry, rather than paying high active management fees in a managed fund.

“Managers have shown a complete inability to allocate assets properly between equities and bonds and property,” he adds.

It is abundantly clear that the managed fund model in its current incarnation is far from perfect, but what’s the alternative?

Connolly is currently devising an investment strategy for Citadel, based on the diversified multi-asset class approach used by the endowment funds of large US universities such as Harvard and Yale.

“They have long been held up as a model that the average investor should follow in terms of allocating their portfolio, because they’ve a stunning track record,” he says.

The credit crunch took its toll last year and the Yale fund is estimated to have dropped 25 per cent in the second half of 2008 but, over the long term, these endowment funds have delivered impressive returns.

“Notwithstanding their difficulties in 2008, the investment strategy underpinning the large US endowment funds provides valuable lessons for the average investor,” he suggests.

Connolly has examined all of the large endowment funds in the industry and has taken the average asset allocation of all of those. “That’s the basis on which I think the average investor would do well in terms of managing their money,” he says. “Whilst it is not realistic for small retail investors to access the same assets as the large endowment funds, it is possible to adopt similar asset allocation principles.”

In the model portfolio he has constructed, 47 per cent is split between European, emerging and global equities; 20 per cent is allocated to “real assets” such as commodities, forestry and property; 15 per cent to absolute return funds, which aim to make money even in falling markets; 12 per cent to fixed income including sovereign and corporate bonds; and 6 per cent in cash.

He has tweaked the endowment model somewhat to make it more suitable to small retail investors. For example, listed equities have been substituted instead of private equity. He recommends absolute return funds such as the Standard Life GARS fund, whereas an endowment fund would “farm their money out” to absolute return fund managers directly rather than using an off-the-shelf product.

“It’s certainly a more robust basis on which to be advising people than people have been advised up till now,” he says.

Brian Weber, executive director of Citi Quilter’s Dublin office, suggests that a “methodical and responsive tactical asset allocation process” could have reduced equity and property exposures in asset portfolios, which, in turn, would have reduced potential losses.

Tactical asset allocation is an active management portfolio strategy that rebalances the percentage of assets held in each asset class in order to take advantage of short-term pricing anomalies.

So if, for example, a fund manager thinks that equities are overvalued relative to bonds, he rebalances the portfolio out of equities in favour of bonds.

Weber also makes the point that asset allocation models based on historical returns and correlations “would not have expected the second major bear market in a decade” as “extreme positive and negative years” occur more frequently than such models would predict.

However, he warns that strategic asset allocation should reflect the long-term needs of the client and therefore “should not be adjusted because of the extreme market movements we have seen in the last year”.