Part of our role as portfolio managers is to make changes to our clients’ investments when we think it’s necessary or when opportunities arise.
Given the broad market sell-off we’ve seen over the past 12 months, coupled with the increase in yields from fixed income assets, we’ve made some changes to our growth portfolios to better position them for the current environment.
This short post outlines the changes agreed at the most recent Investment Committee meeting. We’ll be giving further information on the changes made, as well as a look into how we decide what goes into our portfolios, in our upcoming ‘Investment Philosophy’ document.
Asset allocation changes
The InvestEngine Investment Committee has decided to reduce the risk in our portfolios, by lowering our exposure to equities and increasing allocations to bonds.
Although this change will be most significant for clients with lower-risk portfolios, there will also be an increase in bond allocations for clients investing in higher-risk portfolios. This reflects a preference for bonds over equities throughout portfolios in general. These changes will allow clients, particularly on the lower end of the risk spectrum, to benefit from bonds’ more stable returns, which are considered safer than equities.
Recently, long-dated bonds have shown increased correlations with equities – i.e. their performances have been more similar. Short-dated bonds, however, tend to be better protected against large drawdowns given their shorter time to maturity and lower sensitivity to interest rate changes (also known as “duration”).
While they will not rise as much as long-dated bonds when interest rates fall, they are also unlikely to fall as far when rates rise. For example, the iShares Core UK Gilts UCITS ETF has a duration of about 10 years – in the 12 months to the end of November 2022, it fell 23%. Compare this with the iShares UK Gilts 0-5yr UCITS ETF, which has a duration of only 2 years and fell only 4%, and the difference becomes clear.
This high interest rate environment has caused short-dated bonds, in particular, to offer a more attractive risk/return profile given the higher yields on offer. As the yield curve is currently relatively flat (i.e. you only see a minor increase in yields for investing in riskier, longer-dated bonds), the risk/return opportunities are better at the shorter end of the spectrum.
As for the equities in our portfolios, we’ve increased the allocation to factor-based ETFs. Factor-based funds (also known as “smart beta” funds) are purposely tilted towards certain characteristics like lower stock prices, smaller companies, or higher quality companies, to achieve specific risk and return objectives.
Bringing more factor-based funds into our portfolios increases the potential for higher risk-adjusted returns. By diversifying risk factors, investors also reduce the risk of a single part of the portfolio underperforming for extended periods of time, which reduces the potential long-term variations in the portfolio’s value.
More information on factor investing will be released in our upcoming ‘Investment Philosophy’ article.
Fixed income changes
Clients may also notice a larger allocation to government bonds than corporate bonds. With yields having risen so dramatically this year, government bonds now offer more attractive returns, without some of the risks associated with corporate bonds. They also come with lower correlations to equities, and are more likely to provide superior protection in the event of a market downturn.
We have removed the small allocation to gold across portfolios. Despite its reputation, gold has shown very little real-world evidence of being a reliable hedge against inflation. This has been clear during the current period of high inflation, in which gold has provided disappointing returns.
For portfolios requiring a higher level of protection against unexpected spikes in inflation, inflation-linked bonds are likely to be a more reliable hedge (we have these in our portfolios). While gold has provided some cushion during past market crashes, high credit-quality bonds have also offered protection, and crucially they come with higher long-term expected returns.