UK Portfolio – Part 3 – Equity Asset Allocation

This part of the process in revamping my UK friend's investment portfolio consisted of deciding which asset classes to include in the equity portion of the portfolio and which percentage each asset class should have. I must admit upfront that the assignment of target percentages in this step required some kludging and a bit of hocus-pocus. I feel it's the least defensible and any comments or suggestions on how to improve would be most welcome. Rather than search for a perfect answer, I think/hope that what I've done is good enough. After all, as Scotland's immortal poet Robert Burns (or Rabbie but definitely never Robbie!!, if you don't want to be considered an eejit by any Scot you may encounter) wrote in Tam O Shanter, “nae man can tether time or tide” and one must get on with it.

The table extract from my spreadsheet shows what I ended up with in terms of asset classes. One axis has the geographical breakdown and the other various types of holdings within them. All these are based on the wealth of accumulated finance research that shows these various groupings tend to move differently and so provide the benefit of diversification, namely increasing returns and lowering volatility. In the end there are only eight separate holdings, adhering to the objective of keeping to ten or less. I had wanted to include some international and US small cap and value holdings but they are not available to a UK investor and so ended up with European only. On the property (real estate) column I debated whether to include UK and/or US and ended up with only the global holding, partly to keep the number of holdings low and partly not to duplicate assets because the friend owns a house here and thus already has a large UK property investment.

My biggest uncertainty lies with the appropriateness of the percentages allocated to each asset class. Finance theory indicates that one should hold assets in the proportions that they occupy within the total global market. That would lead one to the proportions shown in Efficient Market Canada's article on Building a Globally Efficient ETF Portfolio or in see this presentation by Alejandro Echegorri citing Brinson Partners data. However, when I looked at sources of top professionals like the Index Fund Advisors, no one seems to keep to the market percentages in constructing portfolios. The IFA portfolio most comparable to the one of this UK friend (that's one with a 55% equity allocation) has a 39% US equity allocation compared to the 22% that US equity occupies in the total investable world capital market. In his book All About Asset Allocation, Richard Ferri recommends anywhere from 25 to 40% US equity allocation. There always seems to be a home market over-weighting. Most people seem to do that, including me in my own Canadian equity over-weight portfolio, but is that actually logical?

In the end, I just took round numbers, no less than 5% in each category, keeping the core total market asset classes large and the others small on the general pattern of the portfolios I have seen, like those mentioned above (imitation is the sincerest form of flattery, no?). Part of the reason for rounding up to 5% is also to make a reasonable size investment so that future re-balancing doesn't end up dealing with tiny amounts that would get chewed up by trading costs.