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Our investment strategy: a step-to-step guide to building our portfolios

So far in our Investment Strategy series, we’ve covered the key tenets that form our philosophy, what we actually offer our customers, and the governance structure we have in place to ensure quality throughout. Every step of the process is vital, though perhaps none more so than the one we’re going to discuss here. 

As a wealth manager, Moneyfarm’s success will ultimately be measured by the quality of the investments we make on behalf of our clients. It’s a multistage process involving a number of cogs in the Moneyfarm machine, from the identification of opportunities to the risk management that goes with it. 

Here, we’ll break down some of the key steps in our investment process. This is not an exhaustive list by any means – you can read more about our investment strategy by downloading the full document here

Strategic Asset Allocation

The core function of the Strategic Asset Allocation (SAA) stage is to find portfolios for each risk level that, over the long term, maximise the utility of each risk profile. In this context, “maximising the utility” essentially means providing the highest possible returns. The SAA begins and ultimately ends with this aim. 

 

The SAA process can be best summarised in a few main blocks: 

  1. Firstly, we estimate the long-term distribution of the returns. This means estimating the expected returns of each asset class, along with their volatility and correlations. 
  2. Aware of the inherent uncertainty in those inputs, we set up boundaries of concentration of each asset class in each risk level.
  3. We run a robust optimisation program to manage the model risks and to create portfolios that should perform better in risky scenarios. 
  4. Both the inputs and the outputs are then reviewed and validated by our Investment Committee. 

The forecasting and the assumptions we make are based on thorough analysis of data and a decidedly long term view. You can read the full breakdown of the SAA process in our comprehensive investment strategy document here

Tactical Asset Allocation

A well-constructed portfolio can go a long way toward helping our clients achieve their goals. However, the Strategic Asset Allocation is only the beginning. Even if our 10-year forecasts prove to be accurate, the journey there is unlikely to be smooth. With that in mind, we constantly evaluate market conditions and look to add value by introducing tactical tilts to the portfolios.

We typically rebalance our portfolios 3-5 times per year. Our tactical decisions are driven by two core considerations: 

 

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  • Seek target risk: keep the risk of the portfolio aligned to the target. 
  • Increase returns by identifying and exploiting opportunities over a shorter (12 month) time horizon. 

 

We focus on a broad range of macroeconomic and asset class data to achieve these two goals. Given our focus on risk management, we evaluate the sources of risk within each portfolio to ensure that they are consistent with our investment views. The process we follow is, ultimately, a combination of quantitative analysis and investment debate.

We approach our Tactical Asset Allocation from the same core principles as the Strategic Asset Allocation – by building a probability distribution of the expected returns for the main asset classes. Through a combination of machine learning, debate, data analysis and experience, our Tactical Asset Allocation process keeps our portfolio fit for purpose. 

Instrument selection

Once we’ve finalised the weighting of our portfolios, we can turn to instrument selection. Currently, we build our portfolios using Exchange Traded Funds (ETFs) and Exchange Trade Commodities (ETCs). Both are tools for low-cost exposure to a broad range of financial markets in a liquid and transparent way. 

Of course, we follow a rigorous evaluation process to ensure that we focus on only the most suitable instruments for our investors. In what has become a competitive ETF market, the process of selecting only high-quality instruments has to be robust. To achieve an ETF score – a starting point for our analysis – we focus on four core metrics: 

 

  • Quality: metrics related to the replication ability of the ETFs. Big tracking errors can lead to a difference between the preferred exposure of the portfolio and the real performance 
  • Liquidity and credit risk: we look for ETFs that can easily be made liquid without incurring higher costs than expected. Also, the number of issues in the index and their liquidability is a key factor we consider in our index and ETF selection.
  • Operational factors: these include the quality of the ETF provider and the replication strategy of the ETFs. In general, we prefer to hold ETFs that are constructed using physical replication. 
  • Cost: both the bid-ask spread and the management fees are important here. The lower the costs, the higher the potential returns and the faster we’re able to help our investors reach their goals. 

 

Risk management

The final stage in the investment process is the measures we take to monitor and minimise risk. Understanding and evaluating the sources of risk in portfolios helps to ensure that our portfolios reflect our investment views. Risk management can sometimes result in lower short term absolute returns but, over time, we believe that it’s a critical component in ensuring a better outcome in line with our clients’ goals.

The main sources of risk in our portfolios are: market risk, credit risk, liquidity risk and volatility risks. Having a clear picture on the risk exposures of our portfolios is crucial to avoid taking on any unintended risk. Once we know these, we can stress the risk factors to compute and decompose value at risk, volatility, stress tests and so on. 

Working with funds instead of single stocks has a lot of advantages, but requires some additional computation to understand the risk exposure. When we think in terms of exposure, we are not interested in knowing the quote of the ETF in the portfolio. We are interested in the risk factors.

This is another complex part of the investment process and the details are far greater than we can fully explain here. For the full breakdown of how we assess, manage, mitigate and exploit risk, take a look at the full investment strategy document here

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