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Emma Wall: Hello, and welcome to the Morningstar series, 'Ask the Expert.' I'm Emma Wall and here with me today is Shaun Port, Chief Investment Officer for Nutmeg.
Hello Shaun.
Shaun Port: Hello.
Wall: So, welcome to our financial planning week.
Port: Thank you very much.
Wall: Today is portfolio day. So, I thought we talk about how to construct a portfolio. We all know what a model portfolio should look like. It should be multi-asset and diversified with some passives in the core, low-cost ideally. But that doesn't really take into consideration what's been going on in the markets. We've had developed market equities rally significantly over the last five years, bond markets had a fantastic run for longer. How do you marry that with portfolio theory?
Port: Well, I think you do need to look at the whole basket. You need to look at every individual component and see what they are doing for your portfolio and really look at how you are constructing the whole thing, but the macro environment is really important as you suggest. Last year Gilts outperformed the FTSE All-Share by 13% which on a 30-year basis that's incredible result. So, I think investors in particular need to be very wary of bonds. Bonds are looking very pricey.
Equities maybe a bit pricier as well, but bonds in particular are looking very pricey in this environment and if you are looking for a five to 10-year portfolio, you have to be very wary and cautious in how you manage those diversifiers in your portfolio. It's not just about equities, it's not just about bonds, but some of the other assets as well look expensive.
Wall: So, looking at bonds then, you still need to include bonds in a portfolio because they do offer that diversification and they can offer the only ‘fixed’ income, whereas equities’ income can fluctuate, but where should you be looking for those bonds, because as you mentioned some of them look very expensive?
Port: Yes. I think short-dated, the short maturity corporate bonds are less than five years to mature. I think they still got a reasonable yield, certainly going to do better than cash and even in a rising rate environment those bonds are still going to deliver you a reasonable return whereas longer-dated government bonds, like the 20 or 30-year bonds, you could have some losses of 10, 15, maybe even 20% on those bonds over the next few years.
So, you can get some returns out of bonds and they are still a good diversifier in a portfolio.
Wall: And should we be worried about the fact that interest rates are going to rise in the near, short-term or long-term future?
Port: Well, if you look at every cycle over the last 30, 40 years, actually equities have done reasonably well through an interest rate cycle. Every cycle is different but generally when rates are going up it means the economy is doing really well. What we haven't actually seen in most economies is improving sales growth. We have seen really massive expansion in margins of most companies which has really driven profits but we haven't seen as top-line sales growth start to get momentum.
Once we see the economies growing momentum in sales growth that will give central bankers encouragement that they can actually start to raise rates. So, a normalisation in rates shouldn't necessarily be bad for equities in the first instance.
Wall: So, normally in a portfolio in the core of that portfolio you would have some developed market equity exposure, maybe an ETF from the FTSE 100, maybe one of the S&P 500. Those two markets have done significantly well, the S&P in particular. Does that affect you holding them in the core of your portfolio?
Port: Well, certainly you should look at valuations, but valuations aren't a perfect guide for the next two years even three years. They may be a good guide for the next 10 years and of course over that period valuations can come down as earnings improve. So, they are not a perfect guide to the next one or two years. So, you shouldn't always purely base your strategy on valuations.
Yes, the U.S. does look expensive by historical reasons, but Europe looks reasonably valued and Japan looks reasonably valued as well. So, you don't have to just focus on U.S. Developed markets still are the place to invest for us. I still think emerging markets are going to underperform for some years yet even though they are quite cheap at the moment. So, valuations aren't the only guide and I think there is a lot of momentum in these markets still.
Wall: So, we have covered the core. Let's have a little bit think about the satellite funds or holdings. You mentioned earlier alternatives, thinking about things that aren't equities and bonds to include in a portfolio. What should we be looking at now?
Port: Well, I think you need to be careful what you have got, whether it's a real alternative or whether it's giving you diversification. I think the problem for investors at the moment is there isn't much true diversification out there. Really you're getting the same factors whatever product you are using, you get similar factors. I think property actually looks quite overvalued in terms of real estate.
Wall: Well it was a fantastic 2014 for commercial property.
Port: Absolutely. I think you need to be careful of what is a bond proxy. REITs, real estate investment trusts, have performed very well, but they are very, very highly related to bonds and when bond yield start rising again, you will see those sectors underperform.
Commodities I still think are under pressure. So, actually you generally come back to equities and equities look relatively cheap against other asset classes, in particular, bonds. So, it's not just equities in isolation look expensive, they actually look cheap relative to other asset classes.
Wall: So, perhaps if you are not okay about emerging markets you could be looking up to re-scale to small European companies, is that the sort of thing?
Port: Yeah, I think Scandinavian economies look very interesting, smaller markets, but actually did very well, very strong performance. You've seen Italy in particular do quite a bit better in the stock market and the DAX, the good old German stock market, had an incredible year so far, up 20%, quality companies and still reasonable valuation.
So, you don't have to just invest broadly. You can look at individual countries where there are some good opportunities.
Wall: Shaun, thank you very much.
Port: Pleasure.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
