When discussing a client’s financial planning needs, and specifically what portfolio to establish, an adviser is required to navigate through the client’s specific needs and goals. This is with an ultimate view to provide a portfolio from within the specific discipline and processes that will meet the client’s expectations, while importantly avoiding as much risk as possible.

While focusing on the growth of a portfolio is primarily what an adviser is often engaged to do, especially with historic low bank rates as we face now, a better and more client centric approach is to ensure the clients goals (fiscal or not) are incorporated into their financial plan.

Traditionally, this has been done by aligning these clients’ needs and goals to a risk profile. In turn, this risk profile is aligned with a Strategic Asset Allocation (SAA) where a mix of asset class sectors been applied.

For example, a balanced portfolio has 60% growth assets (shares etc) and 40% income assets (bonds and cash etc). Another layer on this is where fund managers see the market as it sits and apply tilts that underweight or overweight certain assets; this is called the Dynamic Asset Allocation (DAA). Again, for example, a Model Portfolio, for a Balanced Investor, has 57% growth assets and 43% income assets; in effect, a 3% variance.

This process has allowed financial planners and investment advisers to construct a portfolio that sits within their allowed variances of the SAA, while still trying to construct a portfolio with sub-asset classes to meet their goals. This also requires the adviser to be in tune with their client.

While many of these features can be achieved via the portfolio construction and the review / rebalance process, there is a ground swell of movement where such funds can build in the rebalancing function for the client. While these solutions may not make up the entire client portfolio, they certainly may be incorporated into the wider asset management structure.

What is also appealing for some investors, in some cases, are Absolute Return funds. Absolute Return is the return that an asset achieves over a certain period, expressed as a percentage that an asset achieves over a given period. Absolute Return differs from Relative Return because it is concerned with the return of an asset and does not compare it to any other measure or benchmark. Therefore, the saying “you can’t eat relative returns” rings true.

In practice, an Absolute Return fund invests into asset classes its sees appropriate for the time. While it may have an SAA, its DAA may vary totally and as such, it may be a highly traded fund.

Therefore Goals-based funds tend to have a lot more focus on protecting downside risk. This is particularly important for retirees because we all saw what happened in the Global Financial Crisis with more traditional balanced funds. They followed the market straight down . With the growth of KiwiSaver account balances to a point where they provide meaningful income levels for their clients, I see that Goal-based products will provide a natural transition out of the multi-sector funds once income is started to be drawn. This will form a part of the advice process and KiwiSaver Scheme and fund selection process.

The word ‘conservative’, particularly when it comes to conservative investment portfolios, usually suggests stable, slow-to-change and steady-as- she-goes, but in these changing times, there are early warning signs that a ‘conservative investment portfolio’ may no longer be the haven that it once was.

Most people who don’t have a huge appetite for risk, often because their earnings potential is declining due to age or because they need the income from their investments, will traditionally opt for a conservative investment portfolio. A conservative portfolio may be 75% bonds and cash, and just 25% of so-called riskier growth assets or shares – but the world is a different place from what it was five or ten years ago.

We are living in times of unprecedented and historic low-interest rates, not just here in New Zealand – where the Reserve Bank of New Zealand just recently left its official cash rate unchanged at 1.75% – but also in many of the world’s major economies. For example, the Bank of England last year cut interest rates to .25% for the first time in its 322-year history (it has since gone up to .50%).

Interest rates likely to rise

Essentially this means that cash investments are currently returning next to nothing, which puts pressure on people who rely on their investments for income. Meanwhile, inflationary pressures are increasing here in New Zealand and abroad – recent moderations in inflationary growth, due to a fall in energy prices, are unlikely to be long-term as low unemployment continues to exert upward pressure on wages and, as a consequence, prices.

The New Zealand Reserve Bank also needs to keep money flowing through our economy which, as it strengthens, may lead to rising interest rates to balance inflation.
On top of this, economists are also warning that we can expect to see higher interest rates due to positive growth outlooks, possibly early or mid-2018 here in New Zealand, while the Federal Reserve in the United States has already increased interest rates twice this year. At the moment, New Zealand’s banks are struggling to find cash to lend because the low-interest rate environment is deterring local investors from cash investments. As a result, local banks are having to source funds overseas, where rising interest rates are in turn making those funds more expensive. Ultimately, this will likely cause our banks to increase interest rates locally to attract ‘cheaper’ money. The upshot is that interest rates are likely to rise and, while this is good for cash investment returns, it’s not so good for the other half of your income portfolio, bonds.

Secondary market risks loom for bonds

Traditionally part of a portfolio to offer liquidity and flexibility, bonds can be defined as a ‘debt investment’, because when you buy bonds, you are essentially loaning money to an entity like a corporate or government e.g. government bonds.

Bonds can comprise around 40% to 75% of some conservative portfolios. When cash starts to outperform bonds, however, the latter ends up getting stuck on third base, resulting in a secondary market risk for investors with a large bond presence in their portfolios.