1. The first task for the investment adviser is to establish the objectives, attitude to risk and tax status of the client. The second is to consider which combination of investments is likely best to match the identified requirements.
In this respect, investments are best viewed at the generic level. That is to say, the adviser will consider the various categories of investment fund (for example, UK Equity Income funds and Corporate Bonds funds), rather than the ‘tax-wrappers’ in which funds can be held (for example, Unit Trusts and ISAs) or the managers of the funds.
2. One of the most widely used principles of portfolio construction is core and satellite – i.e. to base the portfolio around one or more long-term ‘Core’ holdings (such as Managed funds, Funds of Funds or Distribution funds), which are widely diversified across a range of underlying investments and therefore provide a stable foundation on which to build other holdings. Those other holdings would fall under the broad categories of Growth, Income or Deposits (including National Savings).
3. Current stock market conditions and future prospects. The two main investment categories are shares and fixed interest securities (such as Government Bonds) and although most portfolios should usually contain holdings in both, there are times when one category suggests better prospects than the other. For example, when interest rates are rising, fixed interest values may be affected adversely.
4. The portfolio should usually include holdings in overseas funds. In the words of the Sandler Report, produced for the Treasury in 2003; “The clear academic consensus is that risk reduction through international diversification outweighs currency risk”.
5. The portfolio will be constructed so as to create a combination of investments, which meet the requirements in terms of risk and return, income and growth, and which addresses the necessity for funds to be encashed in the future.
Key to this process is the need to spread the investments to cover types of asset (not only shares and fixed interest but also property and other holdings), which will react differently from each other to changes in economic or political circumstances.
Because some types of investment are riskier than others (for example, Japanese shares are more volatile than UK shares) the overall balance of risk will be achieved by adjusting the amounts devoted to each type of investment.
6. When a suitable combination of different types of investment has been decided, consideration can be given to the most appropriate tax-wrapper. This will depend largely on the tax position of the client and the utilisation of annual investment entitlements, but it will also take into account any shorter-term cash needs and the possibility that longer-term investments might be directed to pension plans.
7. The final stage in the process is the selection of funds in each of the required investment categories. In this respect the adviser will be considering the spectrum of the several thousand funds available and analysing not only the performance figures but also factors such as size of funds, date funds were launched, number of underlying holdings, length of managers’ tenure, income yields, charges and risk characteristics of the funds.
8. The resulting portfolio will then be consolidated into a formal report, which will be subject to on going up dating and review to ensure that it continues to meet its objectives.
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