Assets aligned

Given the volatile way in which stock markets have started the year, it is understandable that investors might be looking for ways to spread risk as widely as possible.

In this environment, multi-asset funds have a significant and, I would suggest, core role to play for investors, with the tactical flexibility to switch between assets a particular advantage. Fine-tuning a portfolio, in our case equities, bonds and cash, may sound like a simple task, but the target is never a static one.

Adapting to conditions

In practical terms, asset allocation decisions should result in just the right mix that enables a portfolio to adapt to the prevailing market environment. But when it goes wrong, investors can find themselves stuck with poorly performing assets, with a consequent dilutive impact on their portfolios.

Asset allocation works at its best when one asset class is demonstrably better value than another. And even then, one may need patience before a strategy is successful. Under more normal circumstances, where the valuation arguments are more finely balanced, I believe that asset allocation tends to achieve its own natural equilibrium, with the size of the equity component driven by the number and quality of ideas we find. I favour simple valuation methods, which provide a good starting point for identifying those companies worth a closer look.

Elastic markets

A key question investors are currently facing is the future of bonds. Many people use bonds as a ballast to balance out share price volatility, a role they have played to good effect over the last decade. A common mistake is expecting this bond price appreciation to continue during periods of risk aversion, insuring against potential equity losses in future. Higher interest rates are on the horizon and, if the Bank of England decides to move earlier than currently expected, we could see some potentially large capital losses for bonds.

Equities may not be cheap any more, but very little is. We live in a world of rampant money printing and this cash has to go somewhere. The UK stock market did not fully share in the share price rises seen elsewhere during the second half of 2013, due in part to the international nature of the index components.

Thus, more stability in emerging markets and some recovery from Europe both remain on our wish list. Greater confidence in equity earnings could also prompt cash to shift decisively out of bonds or cash into equities, which would provide further support for share prices.

Given these factors, on balance, we continue to favour equities over bonds. But we continue to play close attention to the elastic relationship between these two asset classes. In the short term there can be a divergence in performance, but whichever direction they travel neither can go far without the other.