The best way to build your nest egg

Anyone considering what to put in their pension is faced with a truly overwhelming choice of funds and asset classes.

Most personal pension providers offer upwards of 50 different funds, and if you have chosen a self-invested personal pension (SIPP) wrapper you can also invest in a wide range of other asset classes, such as shares, investment trusts, exchange traded funds, property and commodities.

These days, investors also have access to instruments that previous generations could barely have dreamed of, such as capital-guaranteed structured notes, funds of hedge funds and private equity investment companies.

The first questions a financial adviser will always ask are designed to assess the level of risk you are comfortable with, which will depend on your total wealth, health, years to retirement and other financial commitments.

Those who want to manage their own portfolios will have to examine their attitude to risk themselves, being honest about how much money they would be prepared to lose and what motivates them financially.

Choose the right approach

The traditional approach to designing a portfolio is to split your cash between a variety of asset classes to make a portfolio that matches your attitude to risk.

'Low-risk' investments start with cash and investment-grade government bonds, and move up the risk scale to corporate bonds and blue-chip shares.

At the riskier end of the spectrum are assets such as high-yield bonds, small company shares and alternative assets such as commodities, hedge funds, and private equity, which operate in less perfect markets and therefore offer greater scope for the manager to add value and generate an attractive return.

Ironically, a mistake inexperienced investors often make is to classify themselves as low risk and then invest in low- return cash or money market funds, unaware this will have a devastating impact on their pension fund's growth.

Most portfolio construction is based on the theory of diversification, that as one asset's price falls, another will rise to compensate.

In the financial crisis of 2008, however, the correlation between asset prices began to converge and prices fell together. Consequently, experts increasingly dispute the value of diversification, although it is still generally used as a starting point.

The best advisers are now calling for a more nuanced approach to asset selection, examining assets at a more granular level so accurate predictions can be made about their behaviour under different economic circumstances.

That might mean, for example, breaking down the BRIC funds into their constituent parts, and seeing Brazil and Russia as principally commodity producers - very different from India and China, which are commodity consumers.

Arguably, the desirability of a true international portfolio in modern markets, where most growth comes from emerging nations, makes a multi-asset portfolio the obvious choice, with a professional moving your money between assets as opportunities arise.

There are two ways this can be achieved - either as a balanced multi-asset fund that invests directly in a range of asset classes, or as a manager of manager arrangement, where your fund manager constructs a portfolio by buying into a range of underlying funds, and the skill you are buying is his ability to select the best ones.

Global multi-manager portfolios that are in the top 10 over one year include Investec Managed Growth and Henderson Global Strategic Capital.

The managed pension fund universe is further split between the balanced managed sector, where funds must comprise no more than 85% in equities plus an element of fixed interest to reduce volatility, and the cautious managed sector where funds can only hold a maximum of 60% equities, with at least 30% in cash and fixed income.

Examples of respected funds in the balanced managed sector include CF Miton Special Situations, CF Miton Strategic Portfolio, AXA Framlington Managed Balanced fund and Baillie Gifford Managed Balanced fund.

In the cautious managed sector good examples include Henderson Multi-Manager Income & Growth, AXA Global Distribution, and HLL/Invesco Perpetual Distribution Pension.

For more aggressive funds, the active managed sector allows up to 100% to be invested in equities and includes Jupiter Merlin Growth, M&G Managed Growth and CF Ruffer Equity & General.

Another way to achieve international spread is through global investment trusts, which are often touted as an efficient way for small investors to obtain equity exposure.

Quoted on the stockmarket, these trusts invest in shares of other companies and have low annual management charges - often about a third of the equivalent unit trusts.

Two of the largest, Foreign & Colonial and Witan, are both steady performers and have risen 15.5% and 14.5% respectively in the last year.

"There are so many different funds and options, investors can be paralysed by choice," says Andy Brown, head of asset allocation at Prudential.

He generally recommends two or three managed or multi-manager funds so that there would also be some diversification by manager style.

"The additional charging of a multi-manager fund will be worthwhile," he claims, "because although an individual may be able to buy the underlying funds more cheaply, genuine expertise is required to know when to go in and out of funds."

Correctly timing the market

Another trend that has quietly come back into fashion among institutional investors is trying to 'time' the market - that is, attempting to pick certain investments at a point in their cycle before they start rising.

Many top-end consultants have come full circle and are now advising their high-net-worth clients into 'dynamic' and 'tactical' asset allocation funds that switch between assets opportunistically, such as the Aviva Investors Absolute Tactical Asset Allocation fund and Schroder ISF Global Tactical Asset Allocation.

A lot of research has been conducted on unconstrained mandates, which allow the manager greater freedom to stray from the benchmark, suggesting such funds deliver better returns.

The range of approaches is endless, but another established strategy for investors with fairly large pensions is to have a core portfolio in a low-cost passive fund, such as an exchange traded fund, perhaps with global exposure, such as the iShares MSCI World Index fund, and then to add four or five racier satellite funds or assets to deliver outperformance.

These satellites might be active portfolios where you expect to make high returns, such as emerging markets or funds of hedge funds, where you feel a manager has the skill to exploit discrepancies in an imperfect market, but they could equally be passive plays on markets where you think there is a long-term secular bull trend and emerging economies would be an example of this, too.

Making poor decisions in choosing funds can be expensive. According to Financial Express, the best holding in an unfettered life assurance pension fund over the past five years is BlackRock Gold & General fund, which made investors a return of 183%, while the worst is Legg Mason Japan Equity, which has lost 65%.

The huge difference in this case is largely a function of the respective regions. Nevertheless, the best pension balanced managed fund over the same period is Friends Provident Newton Balanced, up 58%, while the worst is Framlington Corp Pension Fund, down 12%. It is important to note that the differential can be great within the same category.

Certain pension providers have limitations. Ben Willis, head of research at Whitechurch, which runs an interesting income distribution portfolio for post-retirement portfolios, says he sees clients who have had a SIPP wrapper with a bank, where there has been no ongoing service or changes made to the portfolio.

"Banks use a lot of in-house funds and the question for investors is whether they are getting best of breed," Willis says.

"Banks also have a tendency to invest directly in equities, because individual share-broking is their traditional specialism. This is not suitable for cautious investors."

He has also seen portfolios where as much as 40% was in structured products, but personally prefers to cap such exposure to 5% of a portfolio, owing to counterparty risk.

Your portfolio should be reviewed regularly. If a portfolio is left unchanged for years then rising markets will normally boost the equity holding and increase investment risk.

As you approach retirement, your pension should gradually switch to less volatile assets, but not the whole portfolio and not too soon.

In the two years before retirement, you may want to ensure you have sufficient liquidity in the portfolio to take your entitlement to tax-free cash of up to 25% of the fund's value.

However, if you move into income drawdown on retirement, the capital value of the pension must not be eroded or maintaining your level of income will be difficult.

It is important to maintain some exposure to equities as well as income-producing assets such as government and corporate bond funds.

Currently there could be a lot of value in dividend-paying blue-chip shares as many of these big companies were left behind in the last rally.

"Whether it is a post- or pre-retirement portfolio it is important that the portfolio is aligned to the individual's attitude to investment risk, time horizon and income requirements," says Sarah Lord, wealth planning director at Killik & Co.

A useful questionnaire to determine your risk appetite can be completed online at Legal & General's website (http//

This article was originally published in Money Observer - Moneywise's sister publication - in November 2010