Investors turn to multi-asset funds

Dissatisfaction with the performance of traditional managed funds and the resulting criticism may see the rise of multi-asset solutions, according to Dominic McCormick.

It is not surprising that many investors are dissatisfied with the performance of traditional diversified (balanced and growth) funds and their model portfolio brethren over the last decade.

Part of this dissatisfaction is probably unfair, given the very difficult environment we have faced for much of that decade, including an ongoing, once-in-a-generation global financial crisis. 

However, I believe some of this dissatisfaction and resulting criticism is fully justified, as traditional multi-manager and single-manager diversified funds and most model portfolios have proved too inflexible, too wedded to flawed financial theory and too slow to recognise, let alone adjust to, the dynamics of a challenging new macro environment.

Fortunately, a quiet revolution is slowly taking hold in the management of diversified funds with the creation of a new category of more flexible, ‘multi-asset’ funds.

Led by some of the more innovative institutional funds locally and globally, but gradually encroaching on the retail investment industry, it represents an abandonment of the constraints of modern portfolio theory and strategic asset allocation and a focus on – some would say return to – diversified investment options with true flexibility and, importantly, an emphasis on absolute or real (cash/inflation) investment objectives that actually matter to everyday investors.

This means ‘making’ money versus cash and/or inflation, preserving capital over the medium-to-long term and moving away from the unhealthy obsession with peer comparisons and business risks.

However, this is not just a simple return to the more active balanced funds of the 1980s when the BT Retirement Fund and several others were prepared to make large asset allocation moves between equities and cash/bonds.

Sure, much more flexible/dynamic asset allocation is one key element of the new multi-asset approach, but it has many more dimensions than this. (When both bonds and equities enjoyed sustained bull markets from the early 1990s the limitations of the earlier approach in some investment scenarios were highlighted).

Rather, the new multi-asset approach seeks to utilise the much broader range of tools available in the modern investment world to produce robust, well-diversified portfolios.

What, then, are the defining features of this multi-asset revolution?

• The proper incorporation of, and adherence to, investment objectives that actually matter to clients – ie absolute/real ones (cash-plus or inflation-plus) over the medium to long term, and also attempting to preserve capital in the meantime. These objectives are integral to the way money is managed, and not just in there for marketing/competitor reasons.
• Abandonment of the straightjacket of strategic asset allocation and adoption of much more flexible and dynamic asset allocation, driven from a forward-looking, valuation perspective.
• Much more focus on sub-asset and sector selection, irrespective of benchmark/index weightings; ie a sector/asset earns its way into the portfolio because of its future return/risk characteristics, not due to its past performance or current market capitalisation.
• When using active managers, there is a focus on looking for those with an absolute/non-benchmark mindset and the resulting flexibility to fully utilise valuable insights.
• A willingness to use low-cost passive vehicles (including exchange trading funds) for expressing a short/medium-term asset/sector view, or for core exposures to attractively valued asset classes – but not for a ‘set and forget’ approach many are now advocating).
• Greater use of selected alternative assets and strategies in the portfolios, particularly to reduce risk.
• Greater consideration of adverse future scenarios and the extreme risks in financial markets, and the inclusion of certain tail risk hedges in portfolios when they can be purchased cheaply and efficiently.

Not all of the new multi-asset funds embrace all of these elements.

Some believe that certain of these elements are not necessary or even appropriate to deliver on these real/absolute objectives. Some even believe gearing should be selectively employed.

However, they all tend to be consistent in the view that this new approach is necessary because we live in a world where just relying on market beta alone is too unreliable, and even if one is eventually rewarded for taking this market risk, many investors cannot handle the rollercoaster ride involved.

It is also a long overdue recognition that the path of returns – and not just average returns – over time matters most for clients in the real world, especially, but not only, for those in the pension phase in retirement.

Putting much of a client's assets into equity markets when they are expensive and vulnerable to a big drawdown, or drawing down a client’s money during a bear market, are recipes for poor investor returns and ultimate disappointment.

Conversely, at the other end of the spectrum, currently rigidly loading up on the perceived safety of low yielding bonds as occurs in most capital-stable funds/model mixes, as suggested by lifecycle approaches for retirees, is likely another recipe for disappointment.

A more diversified and smoother path of returns is achievable.

Of course, the new multi-asset approaches are not about eliminating volatility or avoiding any negative returns, but they do aim to avoid or limit the very large drawdowns that can destroy client portfolios because they are almost impossible to recover from.

It also aims to prevent investors being slowly decimated in long-term bear markets that go on for years because they are heavily exposed to equity risk and little else.

Part of the solution for retirees, I believe, is to shore up better the cash/liquidity needs of the next few years (three-to-five) by specifically allocating sufficient amounts to cash, term deposits and other low-risk fixed income as the ‘liquidity’ or ‘preservation bucket’ of client portfolios.

This enables clients to be more objective about, and patient with, the diversified/growth-oriented ‘bucket’ and be prepared to wear some (but not excessive) volatility.

A feature of the new multi-asset funds is they typically offer only a couple or even just one option or ‘risk profile’.

This makes sense given the features described above and is a welcome move away from the confusing multitude of only slightly different diversified options and model portfolios some groups offer (sometimes as many as seven or eight). 

Some fund managers are approaching this ‘revolution’ by slowly revamping some of their old diversified options, while others are launching totally new products and even separate investment teams.

Both approaches come with some significant issues.

Those gradually changing their existing diversified products are understandably implementing a process of evolution rather than revolution, with the result they may only achieve partial benefits of the new approach.

On the other hand, those groups launching totally new products are faced with the challenge of explaining where each product sits. If this approach is ‘new and better’, the average financial planner and investor might ask, “Why is my money stuck in the old-style diversified fund?”

Some of these new diversified funds are multi-manager and some single-manager. And they include well-known brand name managers such as AMP, MLC, Perpetual and Schroder.

Even some overseas managers are coming into Australia to specifically tackle the multi-asset market. Of course, while these funds are new as retail offerings, the approach is not new in the investment world. 

Endowment funds globally have long adopted some of these elements, as have some of the more innovative institutional funds and super funds. In Australia, the Future Fund is a clear example.

Some say that the ‘absolute return’ term sometimes used to describe such diversified funds is just a meaningless marketing term. I disagree.

While the term has been misused and misunderstood, in my mind absolute return is primarily about a non-benchmark mindset and linking the actual investment strategy with the absolute return-oriented objectives.

It does not promise to always achieve positive monthly, quarterly or even yearly returns, but is about achieving reasonable absolute returns over the medium- to long-term period of the objectives (typically three-to-five years-plus) and avoiding large, sometimes ‘permanent’, drawdowns.

Because some of these new multi-asset funds cannot be easily put into a box, some research houses have placed this new type of multi-asset fund into the ‘alternative’ investment category, to be used as a non-core, small part of a client portfolio.

We believe this view will be increasingly seen as primitive thinking, and that this new style of fund will eventually deserve a core role representing at least half and, in some cases, even all, of clients' portfolios.

While an ability to invest in hedge funds and other alternative assets and strategies in meaningful ways is one component of this approach, it is just one element, and not all the new multi-asset funds will use alternatives significantly anyway.

What is the point of having true flexibility if it is not utilised across the majority of an investor’s portfolio?

Clearly, one cannot say that this new approach is always better than more conventional diversified approaches. Indeed, in raging bull markets for equities, multi-asset funds will almost certainly lag their more traditional peers.

However, I am confident that they can be more than competitive over the long term and, particularly, can do better in most (but not necessarily all) difficult periods for equity markets.

But why bother with what is a more complicated approach to diversified portfolios now?

Clearly, it is harder to fully explain to investors and harder to implement for fund managers.

Increasingly, however, investors and financial advisers trying to build or access truly robust portfolios will have little choice. In the current challenging environment, applying the appropriate tools, expertise and flexibility is necessary.

And remember, the whole idea of fund managers implementing these is that much of this complexity does not need to be fully seen nor understood by investors, as long as they judge the manager to have the appropriate skills and resources.

Meanwhile, some investors and financial advisers are reacting to the challenging environment by resorting to more passive investment solutions which actually introduce more equity risk than conventional diversified funds.

When excessive exposure to equity risk has been a major problem, many financial advisers have opted for solutions that give their clients more of that same risk, no doubt partly blinded by a narrow focus on cost alone.

They had better get used to explaining volatility and large drawdowns to their clients.

Clearly, it will be extremely difficult for financial advisers or investors to develop and implement these more innovative multi-asset portfolios for their clients themselves.

Most lack the appropriate skills and focus and, even if they have these, there are some aspects of the new approaches that simply cannot be implemented easily by financial advisers, including timely asset allocation changes, use of derivatives for currency and market hedges, or access to some fund structures and offshore managers that are not available on platforms they use.

But isn't using such multi-asset funds as the core of a portfolio taking away some of the financial adviser’s job?

To an extent this is true, although there are still plenty of elements of the financial adviser’s job outside investments.

Indeed, this is a broader industry trend that is already well developed. Increasingly, dealer groups and owners of dealer groups are realising that letting the majority of financial planners loose on extensive approved product lists with little control is a recipe for disaster.

Model portfolios have been a step in the right direction, but with little of the flexibility or tools of the more developed multi-asset diversified portfolios.

Therefore, while financial planning groups are increasingly embracing the outsourced investment model, some are resorting to passive portfolios while others are moving to the other end of the spectrum and using truly active multi-asset funds. Both have advantages from a business perspective.

However, in the same way that some financial advisers are using a passive core and adding satellite investments, I believe using a diversified multi-asset core also works well from a business perspective.

It makes administration easier. It also ensures diversification.

However, unlike the passive core approach which requires faith that the markets will deliver appropriate risk premiums over time, and that clients will handle the volatility that this will entail, the multi-asset approach is more diversified across various risks, although it does require confidence in the skills of the multi-asset manager selected and their ability to select attractive underlying investments over time. 

The advantages of the more flexible multi-asset fund are likely to help renew interest in diversified funds generally during a time of significant criticism of the fund management industry.

Indeed, those financial adviser groups who believe they are taking little or no ‘business risk’ by ignoring this trend or using a core passive investment approach may become increasingly exposed to delivering client returns and risks that deviate markedly from what more progressive investors and financial advisers are achieving with such funds.

If you are convinced that traditional markets are readying for new multi-year bull markets and the difficulties of the last decade are largely over, then the long-only, equity-focused approach at the heart of the traditional or passive diversified approaches will do well.

Even then, the challenge will be to keep investors invested over time given the volatility of this approach.

However, if you are of the view that global economic deleveraging and other macro challenges will continue to create a world of high volatility and provide no certainty that historical equity risk premiums will be delivered, then the new multi-asset approaches are much better placed to deliver for investors.

This certainly doesn't mean it will be easy for fund managers operating them, but at least they are playing to the appropriate rules of the game and with the right goals in mind.

There is a lot of intellectual firepower in the investment industry. Finally, it is being deployed in ways that are focused on truly meeting clients’ real objectives, rather than just creating products with an appealing story attached.

Dominic McCormick is the chief investment officer of Select Asset Management.