A year on from the credit crunch it is time to evaluate where portfolios are standing. At first glance it certainly appears to be a gloomy picture. We believe tighter credit conditions, increased defaults on loans and mortgages by consumers and bank write-downs will continue to create a challenging environment in the year ahead.

Through the latter part of 2006 and the beginning of 2007, the UK press was full of reports about the good returns enjoyed by what were termed ‘the barbarians at the gate’ – private equity managers. By taking advantage of freely available and modestly priced lending over the past few years, deals became increasingly leveraged and the market witnessed a wealth of large public-to-private transactions.

The global fixed income markets have seldom offered more attractive opportunities than investors will find in today’s environment. Since the summer of 2007, trading activity has been far from normal in many fixed income sectors as concerns about the US housing market and economy set off a widespread flight from almost every form of credit risk.

In last month’s column, we spoke about diversifying your portfolio to protect it from recent high levels of volatility in the market. This month we focus on one of the most liquid and inefficient markets which can be central to that diversification strategy – currency.

When constructing a portfolio, two main challenges present themselves – picking the right asset classes and then picking the best managers to run those assets. Choosing an asset allocation strategy can help protect you from downside risk as well as helping to ensure that you maximise the benefit from potential upside. Interestingly, diversification is one of the few elements in a portfolio that is also free.

The traditional way of analysing managers has been to measure their tracking error by looking at the volatility of the difference between a portfolio return and its benchmark index return. This works with managers who take a thematic approach to their fund. But a fund which is a pure stock picker and looks for a good company will be quite diversified by industry. In this case, their tracking error may be quite low and lead us to (wrongly) assume that they aren’t taking much active risk.

Having experienced a positive market environment for both the economy and equities for some years now, the climate is starting to change. Among the biggest changes is that earnings growth is ­decelerating and financial companies are suffering the consequences. There are ­indications of a re-pricing of risk, while volatility has returned to its old levels, much more in line with long-term averages. And since not all stocks will do well, investors will seek out stock pickers who can make a difference.

Recent market movements have had an unsettling effect on some money market funds, and investors found they were carrying more risk than they had assumed. To avoid nasty surprises, you need to ask the right questions of your funds at the outset. These include: is the fund a stable NAV fund? And what of its ­independent rating? Since the term money market fund has been applied to a variety of product, where MMFs are ­concerned, ­information is key, and the key to a sound investment is knowledge.

From exotic to the norm

The march of derivative usage from niche strategies into mainstream asset management now seems inexorable. With the convergence between the absolute return focused hedge fund community and the mainstream asset management market, this increase in derivative use is mirrored by a growing sophistication in the markets that they serve.

New sophisticated techniques

While not immediately apparent, the mutual fund industry has been undergoing a quiet transformation as the full impact of the Ucits III regulations are felt. Once the privy of the large institutional investor base and hedge fund industry, sophisticated investment management techniques are now being employed in mutual funds.

Expected returns versus actual returns

Portfolios are built on what are believed to be carefully thought out and well-researched ideas. However, investment performance often falls short of expectation and investors are disappointed with the actual returns achieved. Is this because we invest too little too late? Have we become too attached to individual stocks? Are our portfolios not diversified enough?

This gap between expectation and reality is not limited to a few individuals who may perhaps be inexperienced or fall prey to faulty information but is often widespread. This is demonstrated by the formation of ‘bubbles’ in the market – most famously in recent times in the technology sector on the back of the rise of the dot com. Investors both amateur and professional were affected by the subsequent drop – no-one is immune from less than objective decision-making.

Direct route headaches

They say that home is where the heart is. To most of us as individual investors, our homes also make up a large part of our assets. Property has long been a recognised investment vehicle and its characteristics are familiar to us.

However, as an investment opportunity, its attractions have in the past diminished somewhat because, until now, the only way to reach this market has been directly i.e. through buying bricks and mortar. Direct property investment can be a difficult option for investors as it is fairly illiquid, requires significant upfront capital and can provide ongoing management headaches.

Back to basics

The world of equity funds is becoming increasingly diverse and offers a bewildering array of strategies. How should one best navigate this and find the most suitable fund? By not forgetting the basics! A solid starting point is ascertained by defining a risk budget. Once determined you will find that you create a narrower and more manageable universe which still offers many interesting approaches to finding outperformance in equity markets. You can thus evaluate potential returns relative to the risk budget by using measures such as the Sharpe ratio.

Some active managers add value by implementing high conviction ideas. This means finding someone who thoroughly knows their stocks, the stories behind them and the ‘right’ price for each stock. A relatively concentrated portfolio of around 40-60 ideas can allow for this degree of focus and allows utilisation of the best research ideas. From a risk perspective, the investor can perhaps seek some comfort from the idea that a stock story must be very strong before it makes it into or indeed is sold out of a relatively small portfolio.

A continued upward trend?

In the face of the recent market correction in developed markets, investors may well be considering tempering their attitude towards risk and diversifying away from holding investments at the higher end of the risk spectrum. But should we be so hasty? If we stick with a range of equities from different geographies and sectors are there still opportunities to be found which may deliver upside potential?

As we all know, emerging markets have delivered very attractive returns in the last few years. The MSCI Emerging Markets Free (EMF) Index returned over 30 per cent in both 2005 and 2006, compared to 10 and 20 per cent respectively for the MSCI World¹. Do the prospects for 2007 look as good?