Model Portfolios: Methodology
All of the detail from our investment analysts
Investing is a means to an end, not an end in itself. Or to put it another way, most of us don’t invest simply for the enjoyment of playing the market (satisfying though that can be), but rather to achieve a financial goal which is typically long term in nature and which will help us to realise some life ambition.
For example those in the middle of their careers might have the simple goal of maximising the value of their savings over the next 10 to 30 years, in order to enjoy a comfortable retirement; whereas retirees might well be more focussed on generating regular income while preserving the purchasing power of their capital for as long as possible. Indeed many of us may have more than one financial goal at any given time e.g. the retirees mentioned above might also want to pass on a legacy to their children that not only has monetary value, but which also demonstrates their commitment to providing them with an environmentally sustainable future.
The ii Model Portfolios are tools designed to help you to realise your financial goals. As such you will see no reference here to conventional ‘balanced funds’, but rather to investment strategies that are aligned to your ‘real-world’ life ambitions.
We also recognise that while many investors are keen to harvest the additional returns that actively managed funds can provide, others are more focussed on minimising the explicit cost of their investments. Consequently, each of our Model Portfolios will come in two varieties i.e.
- Active: these portfolios are constructed with actively managed funds and investment trusts, which have the potential to outperform the market but at a higher explicit cost
- Low Cost: these portfolios are constructed with index tracking funds, including ETFs, at a lower explicit cost
When it comes to constructing our Model Portfolios, we look first to the 'Super 60' list to create a universe of our highest conviction fund^ choices. However diversification is also essential to building a robust investment portfolio, therefore we may also venture outside the Super 60 list where we need to introduce other high quality funds that complement the main equity and bond allocations.
In summary the ii Model Portfolios ‘dare to be different’ from other more conventional offerings currently available in the market, in that:
- They are designed to help you realise your ultimate financial goals
- They are constructed to the high standard that would be expected of a sophisticated institutional client – in particular they have no deliberate ‘home bias’
- They are completely transparent, not just in terms of how they are constructed and maintained, but also in terms of their cost
- They comprise our highest conviction choices across the whole fund universe, with absolutely no conflict of interest in our fund selection decisions
- They are built upon a fund selection process that has proven itself over many years
^ The term ‘fund’ is used in this document to mean any type of collective investment vehicle, including Authorised Unit Trusts, OEICs, ETFs and Investment Trusts.
Our first task is to establish an investment objective for each ii Model Portfolio that is consistent with the ‘real world’ financial goal it seeks to attain.
Thus for example if your financial goal is to maximise the total value of your savings pot over the remaining decades of your working life, you might consider the ‘ii Growth Portfolio’ whose investment objective is as follows:
“The objective of the ii Growth Portfolio is to maximise investment returns over the long term, by investing primarily in growth assets e.g. equities. The risk-return profile of the ii Growth Portfolio is expected to be consistent with an asset allocation to global equities of between 80% and 100%.””
Note that each investment objective seeks to define not only the return objective of the investor, but also his/her risk tolerance. In this particular case the investor should be less concerned about short term market fluctuations given the long term goal – hence the high equivalent allocation to equities.
Each of our ii Model Portfolios is focussed on achieving a different financial goal and therefore has its own distinctive investment objective, fully aligned to that goal.
Our next task is to establish the broad mix of asset types that should be represented in the portfolio in order to maximise the likelihood that it will achieve its stated investment objective. In other words we need to ascertain its ‘optimal asset allocation’.
This is achieved through statistical modelling*, based upon a series of independently sourced assumptions about future long-term return expectations, expected risk and correlations for the main asset classes we wish to consider. The modelling exercise allows us to determine the optimal weighted combination of those asset classes i.e. the combination which maximises the likelihood of achieving the portfolio’s investment objective.
* specifically using a technique known in the industry as ‘mean-variance optimisation’
To illustrate this exercise, let’s consider again the ii Growth Portfolio. The major asset classes we consider for this model are shown in the table below, together with their optimal weightings – subject to some common-sense constraints which are imposed to ensure that the resulting mix will be sufficiently diversified and not over-emphasise any one asset class.
|International Developed Equity*||0%||50%||40%|
|Emerging Markets Equity||0%||15%||15%|
|Global Bonds (GBP hedged)||0%||10%||10%|
|Global Real Estate||5%||5%||5%|
* i.e. all global equities with the exception of UK and emerging markets
The optimal asset allocation above constitutes a ‘strategic benchmark’ for our model portfolio. The strategic benchmark will be re-optimised on an annual basis to take account of changes to the long term capital market assumptions.
It should be noted that in contrast with the majority of our competitors, the ii Model Portfolios are not constructed with a deliberate home bias. We believe that such a bias is inherently suboptimal and therefore not in the best interests of the investor. The substantial weighting to UK equities in the current strategic benchmark is purely a consequence of the particular assumptions we have used for its expected return and risk in the optimisation calculation, which results in its being preferred relative to other equity markets. This may not be the case in future years.
Each ii model portfolio will be established and subsequently rebalanced (see below) so as to follow its strategic benchmark as closely as possible i.e. there will be no attempt to add value through tactical asset allocation decisions. It must be recognised however that for those model portfolios using active funds this policy can only ever be followed approximately, given that it requires one to ‘look through’ into certain constituent funds whose own internal asset allocations are neither fully transparent nor static.
The ii Fund Selection Team now selects the specific underlying funds which will constitute each ii Model Portfolio, in accordance with the following principles:
- No Model Portfolio should invest in less than 5 individual funds or more than 10, to ensure a degree of diversification that is sufficient but not excessive.
- No individual fund should represent more than 25% of the capital value of the relevant Model Portfolio.
- The majority of the funds (by number) comprising any Model Portfolio must be Super 60 funds.
- All funds chosen must belong to a carefully filtered universe of c 260 investments from which the ii Super 60 is ultimately chosen (for more detail please see our Super 60 methodology here).
- To the extent that non-Super 60 funds are to be used in any Model Portfolio, this requires proper justification e.g. they might have been selected purely for their diversification properties, or because they belong to new asset classes not represented in the Super 60.
- Model Portfolios may employ both open-ended fund vehicles and closed-end investment trusts, however the latter should not predominate.
- Where the strategic benchmark of a Model Portfolio makes allocations to specific alternative asset classes (including Cash), any alternative fund may be employed to match those strategic allocations
Principles 3 and 4 above ensure that all funds employed by the ii Model Portfolios have been subjected to a thorough due diligence process, comprising both quantitative analysis as well as qualitative research on the managers concerned.
To illustrate the meaning of principle 7: the ii Growth Portfolio whose strategic benchmark is described above could, for example, subscribe up to 10% of its value in a dynamic multi-asset fund that generates its return from assets other than just property or commodities.
Look through analysis
Having selected the component funds for a given Model Portfolio, they must now be weighted relative to one another, such that their combined asset allocation is aligned as closely as possible to that of the strategic benchmark of the Model Portfolio. This requires us to ‘look through’ into the underlying securities of each component fund, in order to establish its internal allocation across different asset classes. Thus for example, a typical global equity fund will likely allocate most of its capital to international developed equity markets, but may well also make substantial investments into UK and/or emerging market companies. These internal allocations are then aggregated across all of the funds in the portfolio, to arrive at the true asset allocation of the portfolio itself.
Innovation… with heritage
Several of the ii Model Portfolios bear a strong resemblance to model portfolios that have been followed for many years by the readers of our sister publication, Money Observer. This is not surprising given that both sets of model portfolios follow a similar fund selection process, which is carried out by the same research team. The fact that the Money Observer portfolios have delivered on their objectives historically should therefore reassure potential users of the new ii Model Portfolios. That said, it should be borne in mind that the two sets of portfolios are not identical in terms of either their constituents or weightings, hence are expected to perform somewhat differently going forward.
The ii Model Portfolios are regularly monitored and refreshed, to ensure that they remain true to their objectives throughout the varying fortunes of both markets and managers. Specifically:
- The strategic benchmark is re-optimised on an annual basis, using a fresh set of long-term capital market assumptions for the constituent asset classes. Adjustments to the benchmark are expected to be modest in any given year and to evolve over multiple year periods.
- Portfolio constituents are also reviewed annually, immediately following the refresh of the strategic benchmark. Constituents may also be replaced intra-year if required to reflect a corresponding change to the Super 60 listing. Once again we do not expect this to lead to significant portfolio turnover, given our long term approach to fund investment.
- Each model portfolio is rebalanced on a quarterly basis, to ensure that its underlying asset allocation remains aligned with that of its strategic benchmark, intra-year. In order to prevent over-trading of the portfolio, we apply a threshold mechanism, namely:
- Tolerance thresholds are set at +/- 10% of the relevant strategic weighting for each asset class. For example if a portfolio had a strategic weighting of 25% to UK equities, we will only rebalance back to benchmark if the total allocation from all funds to UK equities exceeds 27.5% or falls below 22.5% at the quarterly rebalancing point.
- When re-allocating capital between funds as a result of an asset class weighting exceeding its tolerance threshold, sensible discretion is permitted with the goal of minimising transaction costs and/or bringing other individual funds back closer to their strategic weightings.
How to Use the ii Model Portfolios
To reiterate what we said at the outset, the ii Model Portfolios are tools designed to help you to realise your long term financial goals. It is vital, therefore, to select the model which is best aligned to your personal financial goal. Careful consideration should also be given to the risk attributes of your chosen model, as described in its investment objectives.
Your next decision is whether to select the Active or Low-Cost version of a given Model Portfolio, depending upon your preference for potential additional returns (manager ‘alpha’) or for a simple, ‘passive’ solution with the lowest possible explicit cost.
There are now a number of ways to employ your chosen ii Model Portfolio in practice. If you are a ‘hands-off’ investor with limited time or financial knowledge, you might choose to simply replicate the ii Model Portfolio within your own investment account. For those with more confidence in their own investment expertise, the Model Portfolio can still be useful as a ‘reference portfolio’, helping you to follow a defined strategic asset allocation over time to achieve your ultimate goal, but allowing you to select your own preferred underlying investments.
Please remember – we do not manage your investment portfolio. However you choose to use our Model Portfolios, it is important to check in regularly (at least quarterly), to keep abreast of any changes we might have made to model weightings or constituents. You will need to place instructions to buy (or sell) investments should you want to keep your portfolio in line with the Model Portfolio.
We will also publish quarterly performance and risk reports for each Model Portfolio, including attribution of returns against the strategic benchmark, so that you can better understand how your own portfolio is behaving and monitor its progress towards ultimately attaining your financial goal.
Please note: these are “model” portfolios only: they are not directly managed by ii on behalf of its customers. ii customers wishing to manage their own portfolios in line with these models should follow the suggested switches and rebalancing by logging in and transacting on their own account. The model portfolios do not take into account your circumstances and do not constitute a personal recommendation. If you are in any doubt as to the action you should take, please consult an authorised investment adviser.