While next year could deliver good returns, market risks remain and investors should consider hedging their portfolios with safe havens such as gold or alternatives, according to the team behind the Seven Investment Management (7IM) model portfolio service.

As part of an ongoing series in which FE Trustnet explores the model and managed portfolios on offer to UK financial advisers, we spoke with 7IM senior investment manager Peter Sleep about the team’s process, current positioning, recent performance and outlook.

The firm runs five risk-based products ranging from cautious to adventurous, with a separate strategy run for income investors.

The models are managed with similar asset allocation models and using the same process as the multimanager range but invests solely in passive investments in an effort to keep fees to a minimum.

Table of products and fee structure

Source: Seven Investment Management

“We charge 25 basis points plus VAT which totals 30 basis points and then there is the underlying investments. That is all there is to it,” Sleep said.

The team start each year with their external consultants who run historic analysis on all asset classes that 7IM deems investable.

“We look at the return and risk of every asset class starting with cash all the way through to frontier market equities, which are just about investable if you are careful,” he noted.

“They come up with an expected return and volatility for every asset class and then look at the long-term history going back to 1926 of the correlation coefficient –how much these asset classes move with each other and how much diversification they add.

“They put all the data into a simulation and see what the best combination of assets that produces the highest return with the lowest risk is.”

This produces an efficient frontier which the portfolios aim to sit on, with the riskier portfolios likely to make money over the long-term.

“What we end up with is our neutral position and then every quarter we have a review meeting and we take our own views into account and tweak these positions trying to move along the efficient frontier and make sensible tactical asset allocations,” Sleep added.

Key Overweights

One area the team have quite a punchy position in is gold, which Sleep said is a popular position among his in-house colleagues, though he remains more wary.

“The idea is we are risk-off and in a crisis there are few things that do well,” he noted.

“There is nothing that does reliably well but there are a few steps you can take against that horrible event be it a Trump bump, North Korea, a nuclear explosion – whatever it is.

“We are slightly risk-off because we want to insulate ourselves from what we call those terror risks – those one-off one in 10-year events whether it is the invasion of Kuwait or Iraq or 9/11 or the global financial crisis.”

Gold is traditionally used ahead of other precious metals as it is more reliable, with less industrial uses than silver and platinum, which is used in car catalysts, meaning prices tend to be more economically sensitive.

“Gold is there to give you that cushion. Your portfolio will still be down 10 per cent but if the market is down 15 per cent then it has worked,” Sleep said.

Currently gold looks attractive as, despite its recent resurgence having bottomed out at the start of 2016 on the back of a fear of a slowdown in demand from China, it remains some way off its peak.

Performance of gold spot over 10yrs

Source: FE Analytics

Currently, the balanced model has a 7 per cent weighting to the commodity, which has a relatively low opportunity cost at the moment with cash and bonds yielding very little.

“The opportunity cost is receiving 1 or 2 per cent in cash – so it’s not great – and is the 25 basis points that iShares charge,” he said.

In an upcoming article we will also look at the alternatives Sleep has added to the portfolios this year giving the models an overweight position to the asset class.

Key Underweights

One area the team is underweight is US equities, with 8 per cent of the balanced portfolio in the asset class.

“We tend to be a value house, so when we went through our process we looked at value and didn’t anticipate how strong the US equity market would be,” Sleep said.

Indeed, as the below chart shows, despite many commentators concerns over valuations, the US market has grinded to new record highs throughout the last decade.

Performance of S&P 500 over 10yrs

Source: FE Analytics

“We looked at cyclically adjusted price-to-earnings [CAPE] multiples and all that good data and projected what we thought could happen this year,” Sleep noted.

“The US is the most expensive market, the leadership in it is very narrow and the CAPE excluding the period of 1998-2000 it at all-time highs. It is the least attractive market.”

As well as this, political issues surrounding president Donald Trump and his challenges in renegotiating the North American Free Trade Agreement, potential trade sanctions on China and confrontation with North Korea do not suggest a benign backdrop for the US.

He said the team ran analysis based on two upside scenarios, one balanced outcome and one down situation and decided to go into Europe and Japan instead of the US.

“There is value to be found in the US but you need something to push that forward and we thought there was more going on that was positive in Europe and Japan,” the manager said.

Sleep added that while this has been the wrong approach to take for the last couple of years, now is the wrong time to go overweight US equities.

“I think we would probably be whipsawed quite hard as there is a correction due – although nobody knows when that is going to happen and I’ve not read my horoscope today so I can’t tell you either,” he said.

Performance

Since its launch in March 2012, the balanced portfolio has returned 54.41 per cent while its
IA Mixed Investment 20-60% Shares benchmark has returned 40.37 per cent.

This return would place the portfolio in the top quartile of the sector since its inception though the model would be among the most volatile funds in the sector, with a bottom quartile maximum drawdown – the most an investor could have lost if buying and selling at the worst times.

Performance of balanced fund vs IA Mixed Investment 20-60% Shares sector since launch

Source: FE Analytics

However, it has one of the highest Sharpe ratios – a measure of risk-adjusted returns – as well as Sortino ratio – which also measures risk-adjusted returns but with a focus on capturing upside volatility.

The portfolio had a particularly strong year in 2016, returning 16.28 per cent – 5.96 percentage points ahead of the sector.

“There were two things that really helped last year. One was the uncertainty after Brexit as a lot of our competitors hedged and that struck us as being a little bit dumb because we thought sterling might fall and sure enough it did,” he said.

As such, the portfolio held a number of foreign assets that went up in value both on an absolute basis and through the currency which was unhedged.

This has been more of a headwind year-to-date as sterling has rallied throughout 2017, though it remains some way off pre-Brexit levels.

“The other thing that helped us in 2016 was that even though we are underweight bonds we still own them,” he said.

“It is very difficult when you are using passive instruments as you can’t really take a short duration position in bonds so we were full on duration and therefore benefited from the fall in bond yields last year.”

Outlook

Next year looks to be another good one for investors, according to Sleep, who said the chances are that equity markets remain stable.

“We do a probability-weighted scenario analysis and, on the whole, we see a 55 per cent chance of upside through capex-led growth with some muted wage inflation,” he said.

Growth fuelled by capex (capital expenditure) would be good for markets as it would send a sign that companies are beginning to reinvest in themselves, wage inflation could hit margins.

“It will be a double-edged sword, but on the whole we think it is going to be positive,” the manager noted.

However, there are risks to the market with the first being an upwards surprise in inflation which would initially spook the bond markets, causing prices to fall and yields to rise.

“If bond markets sell off then you might find that you have an equity market fall as companies’ cost of capital increases,” he said.

The other is the potential slowdown in China, which impacted markets at the start of 2016 but has calmed down since.

Performance of MSCI AC World vs MSCI China over 5yrs

Source: FE Analytics

“What will start to happen is you will have some surveys come in which will be down on this year because they have been so good and then any analyst with a ruler will just extrapolate down and say we are heading for a recession and the market can sell off – that is the concern,” Sleep said.

“We know that growth is going to down from 7 per cent to perhaps 5 per cent but that is all it will take before we have some pundit saying there is going to be a growth recession.”

There are also unknown risks like 9/11 and the global financial crisis that could shake markets, meaning that while next year has more potential to be positive for investors, there are pitfalls that investors need to be aware of.