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An informed client is a happy one

It is often said that investing is about balancing fear and greed. We all want to invest in funds producing stellar returns. But we all know there is no such thing as a sure bet. If you want higher returns, you have to accept higher risk.

The propensity to buy funds off past performance has been even more pronounced in recent years with the greater dissemination of information. Clients wanting to pick topperforming funds have a multitude of information sources.

The availability of information means that for incremental investments such as an annual Isa, a fair number of clients will feel happy making the choice themselves. Over time, this approach can lead to a fairly mixed bag of investments. As the portfolio becomes increasingly significant, the desire for professional advice is likely to grow.

The increasing number of clients in this category represents a real opportunity for IFAs to give sensible advice about portfolio construction.

The recent change in Pep regulations is a great opportunity to revisit portfolio planning with clients – particularly as changes within a Pep (or Isa) can be made without triggering any tax liability. This opportunity presents itself at a time when advisers are under increasing pressure in their traditional areas of business – both from a regulatory and a profit margin perspective.

The old adage of not putting all your eggs in one basket is understood by all, but how can this be most efficiently applied to building a portfolio?

A basic approach would involve buying a number of funds – some invested in equities, some in bonds. The choice of funds and the split between equities and bonds would be driven by the time horizon and risk appetite of the client.

Within the equity portion of the portfolio, you would look to hold a number of funds focused on different geographic areas (it being possible but difficult to construct and manage a portfolio on a purely sector-based approach). Having constructed a portfolio along these lines, you might expect to have achieved sufficient diversification. While this may be true up to a point, it is not necessarily the case.

Diversification in equities needs to be viewed from more than one or two perspectives. The primary factors driving diversification and performance within an equity portfolio are geography, market cap, style (growth, value or blend) and sector.

Looking at a specific example, a client&#39s portfolio could contain two European funds. You might think this gives a full and diversified exposure to European equities.

However, if you look under the bonnet of these funds you could find that both are run in a similar way – large cap growth for instance. At the time of purchase, both of these funds could have had a great track record. But in a year like 2000, both funds would have suffered poor relative performance.

Being aware of the similar bias of these two funds, an adviser could have ameliorated the situation by perhaps selling one of the funds and replacing it with a fund with more of a value bias, for instance.

You might say that this should not be necessary and that it is down to the fund manager to refocus their fund as market conditions change. In reality, many individual managers have a preference for managing money in a particular way. This approach may change with market conditions but not always to the extent that would be desirable.

As evidence of this, you only have to look at the performance tables to see how some star performers have fallen from grace recently. Remember, the point here is that at the time of purchase both European funds could have seemed excellent funds with highly skilled managers and good performance records. But the fact that both portfolios are managed in similar ways has compounded the risk in the portfolio in an unforeseen way.

The key to successful investing is only taking on risks that the investor is happy to live with. It is not a question of saying high risk is bad and low risk is good. Each client will have different requirements dependent on personal circumstances. A client may view a building society deposit account as a low-risk investment but, if they have a 20-year time horizon, it could be viewed as a very high risk. There is a huge opportunity cost in foregoing the potential gains from investment in equities over that period.

Making clients aware of the reasons driving your choice of funds will not only make them aware of the value you are adding but also better educate them as to what to expect from their investments in the future. A more informed client is likely to be a happier client in the long run.


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