When you first sign up to Nutmeg, we build you a portfolio based on the information you give us – including your timeframe, your attitude to risk and your personal finance profile – as well as our in-depth analysis of the financial markets. Every month we rebalance your portfolio – free of transaction charges – in response to prevailing economic conditions.
To build and manage your portfolio, we practise what is called asset allocation. In this article we take you behind the scenes of the asset allocation process. We explain how we do it and why we think it’s the best way to run investment portfolios.
When you choose to invest, one of the most fundamental decisions is which type of assets to invest in. Investing is about much more than just shares in companies (equities). Other asset classes include government bonds (including the UK equivalent, gilts, and the US version, treasuries); corporate bonds; money market funds; property and infrastructure; emerging markets; natural resources; and commodities such as gold, copper and silver.
Academic studies have shown that up to 90% of the ‘variability’ of investment returns – that is the extent to which your returns differ from the average investor’s – is due to asset allocation1. Investing in the right asset class, in the right proportions, at the right time is, therefore, a vitally important decision. In our view, intelligent asset allocation is a better investment approach than trying to pick one of the few fund managers who will outperform their benchmark or an individual company which will outperform its competitors.
When we diversify your portfolio across multiple asset classes, it helps improve the chances of returns and reduce the overall risk. Or to put it another way, we don’t put all your eggs in one basket.
This is not a static, one-off process. We continually review the asset allocation for all our customers to decide if we need to make adjustments.
How the asset allocation process works
A lot of preparation goes into our monthly asset allocation meetings. However, the basic approach follows three main steps:
1. The economic backdrop
What’s going on?
2. Asset class choices
How are our asset classes performing? Should we change them in the light of the economic backdrop?
3. Choosing the best investments
What’s the best way to invest to achieve the right asset class distribution?
Let’s take each in turn.
1. Economic backdrop
Each meeting begins by discussing the big picture: what is happening in the world and how will it influence markets over the coming weeks, months and years? The range of factors to consider is vast. What are the latest job numbers? What’s driving performance across different markets? Where is money currently flowing? How are small companies faring compared to larger firms?
We look at everything from earning statements to quantitative easing, currency movements to the weather. And instead of relying on rigid computer models, we carry out our own rigorous analysis of the relevant data.
2. Asset class choices
We then look at how our current portfolios are performing. Which asset classes have performed well? Which are underperforming? Which represent good value? And, in the light of our analysis of the economic backdrop, what do we expect to happen next?
We also consider the risk of each asset class. How volatile is its price? What could go wrong? By combining the allocations to different asset classes in a mathematical way we can work out how risky the portfolio has been in the past. We can also simulate the extent of losses during extreme financial market ‘stress’. In this way, we can decide which allocations are the most appropriate given the market environment and your financial goals.
We then make a decision about which asset classes to buy and which to sell.
3. Choosing the best investments
We then have to choose the most appropriate way to invest in each asset class.
At Nutmeg we invest predominantly in exchange-traded funds (ETFs), which provide an easy way to gain exposure to different asset classes – from developed equity to infrastructure to emerging market bonds – instead of having to buy individual shares and bonds. A recent study by Vanguard found that fewer than one in five ‘active’ fund managers managed to beat their benchmark over a five-year period. ETFs are ‘passive’ instruments which aim to deliver the performance of the market at the lowest possible cost.
You can read more about how and why we choose ETFs in our ETF guide. In short, however, we consider factors such as cost (we aim to keep costs as low as possible), trading volume (we want to be able to buy and sell easily) and tracking difference (how well it matches the market).
The universe of ETFs in which we can invest is growing regularly. View the full list of ETFs.
We constantly compare ETFs to make sure we’re making the best decision. For example, if we want to invest in the FTSE 100, should we buy the Vanguard, HSBC or iShares ETF?
After we’ve made our investment decisions, the final stage is to buy and sell on behalf of our customers. By trading in bulk, we can often obtain favourable prices, matching sellers and buyers internally to reduce transaction costs (the difference between buying and selling prices). We have found that rebalancing monthly is the most efficient compromise between trading too often and too infrequently – although in exceptional market circumstances, we can, of course, intervene whenever we like.
We believe that our active approach to asset allocation is what makes Nutmeg special. We build and manage your investment portfolio, so you can sit back and relax – safe in the knowledge that we’re constantly responding to world events and adapting your portfolio to best fit your objectives.
Risk warning: As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past or future performance indicators are not a reliable indicator of future performance.
1. Determinants of Portfolio Performance – Brinson, Singer and Beebower, 1991; Does Asset Allocation Explain 40%, 90% or 100% of Performance? – Ibbotson and Kaplan, 2000