News and Views

Background

Clients are classified across different risk categories depending on their desire and ability to take on risk.  These range from Conservative through to Adventurous.  WHIreland has five recommended portfolios for investors across each of these risk categories.  In each risk bracket, performance is benchmarked against the appropriate Private Client WMA Index, a theoretical index used to measure returns.  We also compare performance to data from ARC, a group that offers a risk-based approach to investing through surveying industry participants who provide information on client portfolios. Whilst the WMA indices provide a structure for asset allocation and portfolio management, the ARC indices help to manage overall portfolio risk.

Benchmark Changes

On 1 March 2017, the indices against which our portfolios are benchmarked, switched from the FTSE WMA Private Investor Index Series to the MSCI WMA Private Investor Index Series as the WMA formally ended its partnership with FTSE.  Following these changes, we have reconsidered whether the current risk profile bandings remain adequate. The following summarises the changes which have taken place in the WMA Balanced Index following the move to MSCI:

Component Weighting Old New
UK Equities 32.5% FTSE All-Share Index MSCI United Kingdom Investable Market Index (IMI)
International Equities 30% FTSE All-World ex UK Index MSCI All Country World ex-UK Index
Bonds 17.5% FTSE Gilts All-Stocks Index 5% Gilts (Markit iBoxx £ Gilts Index)

10% Corporate Debt (Markit iBoxx £ Corporates Index)

2.5% Index Linked (Markit iBoxx UK Gilt Inflation-Linked Index)

Alternatives 10% FTSE Custom Hedge Index (Split equally between FTSE All-

Share + FTSE UK Conventional Gilts up to 5 Years index)

Split equally between MSCI World Diversified Multiple Factor

Index + cash

Commercial Property 5% FTSE Custom All UK Property Index MSCI UK Investable Market Index (IMI) Liquid Real Estate Index
Cash 5% 7-day LIBOR Index Cash Equivalent (LIBOR-1% with floor of 0%)

 

Investment Implications

The new indices reflect a focus on liquidity.  Both UK components are dominated by the same large stocks so we do not envisage much difference between the two in terms of performance.  Over the long term, international equities may see some divergence given the higher weighting towards North America within the MSCI index. Exposure to corporate and index linked bonds means that indices will achieve better diversification and may be more representative of actual portfolios but in recent history they have had greater correlation to equity markets.  Alternatives will generate a higher level of international equity exposure because of the breakdown of the new MSCI component, the World Diversified Factor Index.  Historically, the alternatives component has mimicked hedge fund performance.  Commercial Property will provide a greater level of equity exposure with the focus on listed property instead of ‘bricks and mortar’ funds.

Test One: Beta is a measure of volatility which shows the scale of movement in relation to a benchmark index, in this case the FTSE All Share.  We use it as a tool to measure portfolio risk in relation to equity markets.  A beta of 50% means that the portfolio would be expected to move 0.5% for every 1.0% movement in the benchmark index.  The table summarises the changes in estimated portfolio beta since our previous update in 2014.  It shows the measure in 2017, before and after the move to MSCI.  Although the underlying asset classes have changed, we need to establish whether the portfolio betas as a whole have been impacted.

WHIreland Risk Target Range WMA Index Relative Risk: β (2014) Relative Risk: β (2017) Pre MSCI Relative Risk: β (2017) Post MSCI
0-40% Conservative 41% 35% 48%
40-60% Income 60% 53% 61%
60-80% Balanced 72% 61% 65%
80-110% Growth 80% 72% 75%

Since 2014, the WMA committee has reduced equity exposure on balance across the indices, adding to alternatives.  This factor, along with a general reduction in betas in overseas markets, explains the initial reduction in the portfolio betas.  Following the move to MSCI, we have seen betas pick up again, with the move particularly pronounced in the Conservative and Income indices because of the changes to fixed income and alternatives.  The betas are based on data from a specific timeframe and over different periods may provide different results.  Over some periods of history, corporate and index linked bonds have actually provided zero or negative correlation to equity markets which would reduce the portfolio betas.

Test Two: Portfolio Return And Volatility (sigma)have been considered.  The higher the volatility figure, the greater the expected portfolio movement over a year.  We have provided annualised returns for the 5 year period as this is the longest period for which data are available for all comparable benchmarks.  Sharpe Ratios (The Sharpe Ratio is a measure used to calculate risk-adjusted return, and this ratio has become the industry standard for such calculations.  The Sharpe Ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk) have also been calculated for the benchmarks.  This is a measure of risk adjusted performance; the higher the number the better.  Looking at the overall risk and return of the benchmarks, one can see that there is little to choose from across all categories between the FTSE and MSCI WMA Benchmarks (which have been backdated).  Whilst there has been a modest change in the source of risk for each benchmark, the actual outcome has been similar.  The ARC numbers show lower return and volatility numbers in comparison to the WMA indices.  This reflects the difference between the WMA indices, which are theoretical benchmarks, and ARC, a sample of portfolios within the industry.  This may reflect the practicalities of managing client money where specific client requirements overlay asset allocation structure.  The Sharpe Ratios are comparable across the spectrum; for a given level of risk, each index is achieving an appropriate return.

Annualised Risk Reward to end March 2017

  5 Years    
  Return Volatility Sharpe
MSCI WMA Conservative 7.5 5.2 1.4
FTSE WMA Conservative 7.2 4.7 1.4
ARC Cautious 4.0 3.0 1.2
       
MSCI WMA Income 8.4 6.1 1.3
FTSE WMA Income 8.4 5.7 1.4
ARC Balanced 6.0 4.9 1.1
       
MSCI WMA Balanced 9.6 7.1 1.3
FTSE WMA Balanced 9.8 6.7 1.4
ARC Steady Growth 7.4 6.2 1.1
       
MSCI WMA Growth 10.5 8.1 1.2
FTSE WMA Growth 10.6 7.8 1.3
ARC Equity Risk 8.6 7.5 1.1

Conclusion and Recommendations

We would conclude that the move to MSCI does not warrant any changes to the risk based classification approach adopted by WHIreland.  Whilst betas may have changed modestly in recent years, we see this as part of what can be expected to occur in dynamic markets.  The overall index returns and volatility for the MSCI WMA and FTSE WMA are seen to be close and do not warrant any changes to the process.  We will continue to review these metrics.