Silver the bedrock for tactical asset portfolio

Our tactical passive portfolio has performed well since its inception in August 2012, on the back of rising silver prices as investors sought a safe haven ahead of the US fiscal cliff showdown, rising confidence in European equities and the Aberdeen New Thai Investment Trust:fs, one of our active picks, continuing its successful run.

Another active pick, the £13 billion Standard Life Global Absolute Return Strategies fund (GARS), has solid long-term performance and did well in 2012, partly because it took a position that reaped the benefit of US dollar strength versus the euro.

However, it is quite sophisticated, and since taking over this portfolio from Peter Temple - who has now retired - I've discovered that financial advisers don't fully understand the fund. It's never a good idea to invest in something you don't understand it, so I asked Andrew Ford, an investment specialist on the GARS investment team, to shed light on the fund's current strategy and the impact of recent staff departures.

Off-setting strategies

GARS is essentially a "best ideas" fund and there are currently 29 ideas in play. They are typically expected to pay off over a longer time frame (of around three years), as the markets they aim to beat are less efficient over longer investment horizons. The team likes to identify potential risks and find off-setting strategies and methods of implementation that address them.

GARS is, for example, long the US dollar and short the Canadian dollar on the rationale that Canada, with its highly geared domestic consumers and an overheated housing market, is not the safe haven investors think it is. Team head Euan Munro visited Canada recently and reported tell-tale signs of a housing bubble, such as A-grade properties being built on C-grade plots of land.

"Canada is exposed to the global slowdown due to its reliance on commodities, whereas the US is more insular," says Ford. "We are favourably inclined to the US. We are encouraged by the recovery in the housing market, with house prices having risen for six straight months now, which is indicative of a functioning credit market. We believe unemployment will continue to fall once the uncertainty regarding the fiscal cliff has dissipated."

The GARS team estimates that the resolution of US tax problems will take 1.5% off US growth rates next year and that the associated uncertainty has reduced the capital expenditure normally seen at this stage of the business cycle. It believes there is, in particular, pent-up demand for technology, due to a growing awareness among company managers that it is often more cost-effective to invest in efficiency-enhancing technology than employ additional labour.

The team has therefore taken a long Nasdaq and short Russell 2000 position. The arguments against small-cap stocks in the Russell 2000 index are that recovery is already priced in and that quarterly results are likely to disappoint against consensus expectations of near 20% growth in earnings per share. Also, large companies often have more cost-cutting potential and tend to be more export oriented, so they have benefited from the weaker dollar.

GARS has a long position in Russian equities, via a basket of nine global depositary receipts that track the Russian index, which has high exposure to oil and gas. The team believes Russian valuations are cheap, at around 4.5 times earnings, and that President Vladimir Putin is keen to at least make the right noises regarding corporate governance improvements.

Exposure to non-Middle Eastern oil is a key part of the investment strategy behind this position, an attractive trait given that the portfolio has exposure to equities - in the US, for example.

It is often said that the fund rigorously canvasses right across the company for ideas. GARS really matters to the Standard Life group as a whole. It was set up in 2005 to address underfunding in the insurance group's staff pension scheme, which still invests some £2.6 billion in the fund, a massive sum relative to the group's market capitalisation of £6.5 billion.

Significantly, three of the multi-asset team - David Miller, David Jubb and Richard Batty - left GARS for Invesco Perpetual in September 2012. Analysts were quick to say this would have little impact, as Munro and Guy Stern are still taking the decisions. However, the situation is not as simple as that.

The team members who left have been replaced by three senior internal transfers, plus Adam Rudd from JPMorgan in New York, who had already been approached to add derivatives expertise to the team. What gives me comfort is that there has been no change to the risk team, a key part of the GARS process headed by the uber-thorough Brian Fleming.

ETF choices

I'm also inclined to stay with our silver holding, via ETFS Physical Silver, although it is a little large for an optimally-balanced portfolio. It was the preferred substitute for gold during Diwali and was buoyed by Indian government regulation on purchasing gold and tax deductions. Analysts expect that silver has further to run, and Thomson Reuters predicts an increase in the price of silver of 38% next year to possibly $50 an ounce as sluggish global economies increase demand for safe havens.

European stocks, represented by iShares DJ EuroStoxx Growth, have also had a fantastic run because they have been massively oversold by historical standards. The fundamentals may be poor, but there is room for revaluation.

One area where the portfolio has a hole, however, is government bonds. The International Monetary Fund has been warning of a 25% risk that some eurozone countries will suffer deflation before 2014. Deflation is typically a feature of severe economic decline and soaring unemployment that far outweighs any benefit to consumers from falling prices because lower prices and wages further depress a nation's tax receipts.

Chris Jeffery, senior strategist at BNP Paribas Investment Partners, says in view of the "meaningful probability" of deflation in continental Europe, holding a few remaining AAA-rated countries has the additional attraction of scarcity value.

"European inflation has been held up by energy prices and taxes," he says. "Core inflation excluding VAT in Europe is close to 1%, but there is plenty of spare capacity in European economies in terms of what Karl Marx called the reserve army of the unemployed. Once tax and energy come out of the inflation figures, inflation could drop, while negative inflation is possible in two to three years."

Jeffery adds: "German yields are low. But people have been predicting the end of bond markets for three years, and in Japan for the past 20 years. It is hard to see the preconditions falling into place for a sell-off to begin."

Conscious of trading costs, we are leaving the portfolio as it stands. But followers of the portfolio who are cautious might consider investing in German bonds such as the iShares Barclays Germany Treasury Bond ETF.

On a final positive note, an £85 dividend from the New City High Yield Fund:fs holding has boosted the cash position to £8,586.

You can follow this portfolio on our sister website, moneyobserver.com. All instruments are available on Interactive Investor.