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Building an investment portfolio; Grant Thornton WEALTH PROTECTION.

Byline: By David Sweeney, director at Grant Thornton

It has been said that diversification is the only free lunch in investment - everything else has a price and yet in an industry where vast sums are spent encouraging investors to part with their cash, what are the fundamental areas which really matter?

Classic portfolio theory focuses on an analysis of risk, return and correlation (correlation is the extent to which one class of asset moves in line with another, different, class of asset).

It is possible simply to hold a range of different investments to spread risk, but it's best to use some form of modelling of past data to assess the historical risk associated with different combinations of asset classes. The results can be surprising - we have seen instances where the inherent risk in a portfolio has been halved while targeting the same expected return.

While diversification is important, once there is a range of asset classes and different investments within those asset classes, a point is reached beyond which further diversification does nothing but add complexity and costs.

If you read financial publications, there is an obsession about investing at precisely the right moment, but academic research suggests that long-term asset allocation is key - moving in or out of markets too frequently adds risk which is unlikely to be rewarded by consistently higher returns.

In part, this is due to the additional costs associated with almost any fiinancial transaction.

There is also a debate about whether the additional fees charged by fund managers - as compared with low-cost index tracking funds - are rewarded by superior performance.

Most of the research suggests in many cases it is not.

In addition, and often ignored, whereas an investor in an index tracking fund is assuming market risk, those backing the skills of a manager are assuming manager risk as well as market risk.

Fidelity has published research which shows that over a ten-year period, missing the best 10 days of stock market returns (equivalent to one day per year) has reduced annualised returns from the US and UK stock markets by around one third.

That is one day per year out of around 250 working days. As many of these best days are around peaks or troughs of markets - exactly when people try to call the market - those who advocate market timing need to ensure they do not miss these best days. In practice, of course, it is exceptionally difficult to predict market peaks or troughs.

Having determined a suitable asset allocation it is then necessary to own these using the most appropriate investment vehicle.

Each will have a considerable impact on the overall return for two reasons.

First, charges are accounted for differently under each structure. For example, under some structures, charges can be deducted from income rather than capital (reducing the effective cost by 40 per cent for higher-rate taxpayers) and some structures are subject to VAT, whereas others are not.

Second, and more obviously, different structures are taxed differently which makes a considerable difference to the after tax returns for investors. If the returns after tax and charges are properly analysed, it can be seen that in many cases what might at first appear advantageous may, in fact, be highly tax inefficient.

For example, our research has shown that using investments which simply place funds offshore and defer tax can, over the longer term, reduce the overall return net of tax and charges by up to 50per cent.

So we recommend investors first of all determine an asset allocation which is in keeping with their tolerance of investment risk. This should then form the basis of a long-term investment strategy, rather than attempting to move in and out of investments by trying to predict short-term market movements.

Having done this, the proposed asset allocation should be held in the most efficient manner, taking full account of tax and charges.

Finally, the investment managers should be selected using a core of index tracking funds complemented by active fund management where appropriate.

CAPTION(S):

Predicting market peaks and troughs is exceptionally difficult
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Title Annotation:Business
Publication:The Birmingham Post (England)
Date:Apr 29, 2008
Words:680
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