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How to construct an all-weather ETF portfolio

The outlook for markets is highly uncertain. This set of investments balances growth with protection in a crisis, says Cris Sholto Heaton

The long-standing rule of thumb for an investor who wants to balance the opportunity for growth with protection against the worst falls in the market is a 60/40 split between riskier assets and safer ones. This isn’t a panacea for all crises and there have been times when other combinations would have delivered a better trade-off between risk and return – but it’s worked well on average over many decades and it’s simple and intuitive, hence its continued popularity.

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For much of that time, that 60/40 split for a typical individual investor would have meant 60% in domestic shares and 40% in domestic bonds. But the rapid growth of exchange traded funds (ETFs) and index funds over the past decade has made it possible for any investor to build a much more diverse portfolio. You can hold all of the major asset classes – cash, conventional bonds, inflation-linked bonds, precious metals, real estate and shares. You can diversify internationally and you can fine-tune holdings within each asset class to reflect what you think offers the best opportunities. And you can do all of this very easily and cheaply, probably with fewer than ten funds.

A baptism of fire

At MoneyWeek, we’ve set out diversified portfolios using these principles that reflect our overall views on global markets several times over the years in articles and newsletters. The ETF portfolio that we’ve tracked most closely over time is one that I last updated about three years ago. At the time, the safer assets were cash (10%), UK conventional government bonds (10%), UK inflation-linked government bonds (5%), US inflation-linked government bonds (10%) and gold (5%). The riskier assets were UK and Europe large-cap shares (15%), UK mid-cap shares (10%), US shares (5%), Japan shares (10%), emerging market shares (10%) and property shares (10%).  

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The coronavirus crisis marks the first real test of this asset allocation. So it’s reassuring to see that this portfolio would have done relatively well in such an unprecedented situation – results would depend slightly on exactly when you choose to rebalance the portfolio back to its target weights (we suggest once per year), but it would probably be up around 9% over three years (including dividends), compared to a fall of around 4% in the FTSE 100. Perhaps more significantly, so far this year it would be down by around 1%, against a fall of about 15% in the FTSE 100. When the crisis peaked on 23 March, the FTSE 100 was down by around 33%, while the model portfolio would have been down by around 13%.

That’s not because the portfolio got anything brilliantly right (indeed, a couple of things were definitely wrong in hindsight), but because diversifying internationally and across a range of assets helped insulate it from any single event going wrong. A portfolio like this deliberately doesn’t make big bets on any particular outcome – instead, it tries to reflect a balanced view of what is likely to lie ahead. Most of the assets are chosen to do well with adequate growth and modest inflation. However, there are assets that should do particularly well in times of higher inflation (gold, inflation-linked bonds, real estate). Others would be especially helpful in severe deflation (cash, conventional government bonds). If a more extreme environment becomes much more likely – eg, growing risks of high inflation or severe deflation – you would adjust the amount allocated to certain assets to reflect the changing threats.  

Give me inflation – but not yet

Many things have changed in the world since we first set out this portfolio, but up until this spring surprisingly little had altered the economic outlook or the prospects for markets. We still believed that inflation was the likely outcome of the policies that governments were following, but there was no sign of it gaining traction.

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The coronavirus pandemic has now upended the world to a far greater extent and made the future much more uncertain. It seems unlikely that we will emerge from this and return to the same economic environment that we had before – we are likely to end up moving one way or another towards deflationary depression or high inflation (possibly paired with stagnant growth – stagflation).

It seems deflation must reign in the short term – too much demand has been destroyed by the global shutdown and the resulting surge in unemployment. That argues against loading up on inflation protection right now. However, in the medium term governments will try everything to restart their economies through both monetary and fiscal policy, with government budget deficits underwritten by central banks buying bonds. We have to assume that they will keep doing this until they get results – they fear a depression much more than inflation.

So there is finally an obvious path by which inflation will take off – and so I suspect a portfolio like this might look significantly different in five years’ time. But it’s not a done deal and it’s certainly not happening tomorrow – and thus the changes I’d make at this stage are still limited.

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