In part 4 of her series on investing 101, Sheryl Sutherland looks at the principles of portfolio construction and asset allocation and how to move your financial plan forward.

By Sheryl Sutherland*

Each of us needs to develop a well-diversified investment portfolio customised to fit our needs. It’s not difficult once you understand the various options and how different types of investments, shares, property, fixed interest and commodities work together – or not, as the case may be. Each of these asset classes has characteristics that make it more or less appropriate for different financial goals. Frequently, too, the percentage of funds allocated to each asset class varies, dependent on your time frame and attitude to risk. This is something you will establish as we move through the process of creating your plan. Most of us invest in unit trusts. 

Unit Trusts

There are four key attributes that make unit trusts popular:

• Diversification – a single fund may hold shares from hundreds of different companies, something only a few of us could manage on our own.

• Professional management – many of us have at least two jobs: paid employment, and a home and family to organise. It’s exceedingly difficult to manage a portfolio as well. Professional managers have the time and expertise to do that job for you.

• Liquidity – shares may be sold on any business day.

• Convenience – funds these days offer a variety of services, which makes investing easier. Units may be bought and sold by mail or telephone, switched from one asset class to another and, in some cases, switched from manager to manager.

Types of Funds

There are hundreds of different funds from which to make a selection, but most fit into five basic categories.

• Cash Management Funds are linked to mortgages and fixed interest. They generally return more than at-call rates and are typically used for shorter-term goals such as home deposits, holidays, whiteware replacement, car purchases or rainy day funds.

• Bond Funds invest in government stock or longer-term corporate bonds. The value of these funds can fluctuate as interest rates change. These funds are appropriate for investors who want a higher level of current income than that paid by cash management funds, or for those who want to balance their portfolios with fixed income investments.

• Share Funds invest in shares, which represent part ownership of companies. The value can be expected to fluctuate – sometimes dramatically. Most of the profit in these funds comes from the increase in value of the shares, but some comes from dividends. These funds are appropriate investment vehicles for a long-term financial goal.

• Balanced Funds invest in a combination of asset classes – some bonds, fixed interest, shares and property. The value of these funds can be expected to fluctuate. A balanced fund may be an appropriate vehicle for an investor who wants less volatility than a full share market linked fund.

• Commodity Funds invest in commodities such as agriculturals, currencies or financial instruments. They are generally not correlated with share market or other funds and are best only for those with a high tolerance of risk. The values may fluctuate dramatically.

How Unit Trusts Make Money

An investor in these funds may make money in two ways:

• Income Returns – these may come from fixed interest from government stock or corporate debentures or dividends on shares.

• Capital Returns – when the assets held by the funds rise in value to a level higher than the price at which they were purchased, the fund has a capital gain. This remains in the fund raising the value of the units. This value remains in the fund until the investor sells shares in the fund. If the assets fall in value to below the price at which they were purchased, the units drop in value. If the investor sells units in this scenario a loss of capital will ensue.

The Importance of Costs

All unit trusts have expenses. You should be aware of all the fees charged by a fund manager. The vast majority of prospectus and investment statements are very clear. You can expect to pay an entry fee of up to 5 per cent, or an exit fee, which may be charged on redemption if it takes place within a defined period. Typically this declines over time and disappears, usually after the third year of investment. It is a good idea to compare this cost with that of buying and selling shares directly. Funds will also have operating expenses such as investment advisory fees, legal and accounting fees, postage and so on. These are known as the expense ratio, which is usually expressed as a percentage of the fund’s average net assets during the year. Currently, in some instances, this fee is tax deductible.

The graph below shows that investment returns from shares and property tend to fluctuate over a wider range (height of diamond) than cash and fixed interest. Over the short term there is a greater possibility of a negative return. Historically property and shares have, over the long term, produced better returns than cash and fixed interest.

Asset allocation

Asset allocation is the most important factor in reaching your financial goals. You now know that no one asset class consistently produces the best return year after year, you know that shares have historically given the best returns over the long term, cash provides the weakest returns, and bonds are useful to reduce portfolios volatility. So what to do? Make shares the cornerstone of your portfolio. If you are talking to an advisor or to a range of advisors, don’t be confused if asset allocations vary.

How you divide your investments among share markets, fixed interest property commodities or cash will largely determine your long-term investment returns, as will the volatility of the markets when one asset may rise in value when another is falling. This cushioning effect makes it easier for investors to continue with a long-term investment plan, even during a sharp downturn in the market.

Choosing an appropriate mix of assets for a specific financial goal is known as asset allocation. When you have several goals, you can view your investments as a collection of separate portfolios, each designed for a specific goal. When planning your asset allocation consider the following four factors:

• Your goals – what expenditure will you want to make in the future? For example, you may want a deposit for a house, or to create a retirement fund.

• Your time horizon – this is the number of years or months that you have before reaching your goal. A home purchase may be in, say, three years’ time, while retirement may be 20 years away.

• Your risk tolerance – this is the ability to endure the inevitable fluctuations that come with investing. Knowing you have some years to reach a goal may make you more comfortable with investments, such as shares, that are likely to provide higher long-term returns but also have higher volatility. You cannot avoid all investment risks; if you only select investments such as balanced funds, you run the risk of losing purchasing power to inflation.

• Your financial condition – this is the stability of your job and the state of your personal finances. Asset allocation is not an exact science, each investor needs to take the above factors into consideration and be prepared to review allocation on a regular basis.

You can select funds that best match your asset allocation plan or you can invest in a fund that combines the asset classes you have selected as most appropriate for your goals.

You may wish to start out with a conservative approach and then, as your risk tolerance increases, move through to a more aggressive approach. If you want to, you may also consider utilising commodities or property investments, emerging markets or resource funds.

You can think of your asset allocation as a pyramid. At the base of the pyramid is the stable asset class, in the middle is the medium risk investments and the top tier contains the higher risk investments.

Whatever you do, work within your comfort zone, but again refer to the exercises you have done and make unemotional decisions. 

When selecting the fund you should also consider whether to use an actively managed fund or an indexed fund. Your portfolio can be created using either actively managed funds or indexed funds holding securities in the same proportion as that of the market index in order to closely match the index’s performance. Some investors favour an actively managed fund in the hope that it will provide above-average returns. Others prefer a lower cost indexed fund, believing that few managers can beat the market consistently. Some investors who are unsure which investment approach is better, hedge their bets by using both actively managed and indexed funds.