Multi-asset funds shift their approach

As many traditional multi-asset funds disappointed during the GFC, recent times have seen many managers diversify. Deanne Fuller examines the sector.

Many traditional multi-asset class funds disappointed during the global financial crisis (GFC).

They experienced significant drawdowns bought about by being structurally required to hold as much as 70 per cent in equities (35 per cent in Australian equities and 35 per cent in global equities for a typical growth fund) at a time when equity markets were in free fall.

Strategic asset allocation benchmarks are designed around long-term historical return, risk (volatility) and correlations expectations.

During the GFC, markets behaved nothing like those long-term averages, leading to perverse performance outcomes.

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Investors who thought they were ‘diversified’ were surprised that that was not the case, with bonds and other diversifying assets offering little protection.

Since then, we have seen a number of managers (Ibbotson, Mercer, MLC and Russell) widen their asset allocation ranges and opt for a more dynamic approach to asset allocation.

Dynamic asset allocation aims to only take positions over the medium term when markets are extremely over/under valued.

We see this approach to be particularly beneficial when used as a risk management tool (used to protect on the downside when markets are extremely overvalued), rather than specifically trying to generate alpha from the process (market timing bets).

Dynamic asset allocation processes tend to still operate in a constrained environment: + / - 5-10 per cent from strategic asset allocation benchmarks. 

Dynamic asset allocation, whilst useful in providing some additional flexibility, does not go far enough for a select group of managers.

They argue that markets have entered a period of heightened volatility and the need for flexibility in asset allocation is essential in delivering portfolio risk and return objectives.

This includes the ability to ‘go anywhere’, meaning the fund may be completely divested from a particular asset class in periods of severe market stress. It also allows for more opportunistic investing in new asset classes as and when opportunities arise. 

These funds aim to limit the extent and severity of drawdowns and deliver a ‘real’ rate of return above cash or inflation. What sets these funds apart from the traditional multi-asset class funds is the absence of the structural impediments usually associated with strategic asset allocation. 

It is not unusual to see a 0–70 per cent asset allocation range around Australian equities for example.

Multi-asset class real return funds should not to be confused with ‘hedge funds’, because although they are less constrained than traditional multi-asset class funds, they are not ‘unconstrained’ in the truest sense.

These funds generally do not use gearing (MLC Long Term Absolute Return Trust is the exception) and will not employ ‘shorting’ at the asset class level.

In a similar vein, multi-asset income funds allow for flexible asset allocations in order to deliver a more reliable income stream to investors.

These funds are designed for those investors who have a need for stable and consistent yield, for example retirees.

Many fixed income funds currently researched by Lonsec are confined to investing in fixed income securities and are not structured to produce a targeted yield.

Instead they are focused on performance against an index or a peer-relative performance.

Multi-asset income funds are designed to be liquid, invest across a range of income-producing assets, and provide a regular, stable income – a level of capital growth to keep pace with inflation and to provide some downside protection.

These new style of funds, while still in their infancy, seek to overcome some of the issues raised post-GFC and are considered to be an exciting development within the space.

That said, Lonsec recognises that no one investment style will outperform in all market conditions. Multi-asset real return funds are likely to underperform their more traditional counterparts in strong bull equity markets, but as a trade-off, will potentially provide a much smoother ride for investors.

Traditional strategic asset allocation does have its limitations, but provided the underlying assumptions (risk, return, correlations) are revisited regularly, and risk is considered in its broadest sense (ie, minimising draw-downs, managing liquidity), the traditional strategic asset allocation approach can still be an appropriate way to invest for those who have long term investment horizons.

Diversified Funds

While many fund managers offer solid diversified products, it has proven difficult for one manager to be the ‘best of breed’ across all underlying asset classes at any point in time.

Schroders is a notable exception, having consistently rated solidly across all major asset classes over an extended period of time.

A structural limitation of many diversified funds is that they tend to be restricted to a single style within each asset class.

The majority of managers will typically have only one capability within each asset class, which will display an inherent style bias (value, growth, etc) consistent with the house philosophy.

This can lead to significant underperformance or outperformance depending on market conditions. 

Furthermore, it is not easy for a diversified manager to terminate its own investment managers over performance issues or the loss of key investment staff.

Multi-manager funds were originally established to overcome some of the structural limitations associated with diversified funds.

In recent years, some of the larger diversified managers (Blackrock, Colonial First State, Schroder, UBS) have sought to diversify their style of exposures within asset classes, by blending a number of internal capabilities.

This has led to somewhat of a blurring of the distinction between multi-manager and diversified funds.

Outflows continue to affect the sub-sector, with most managers experiencing significant outflows in 2011.

When faced with declining funds under management (FUM), it becomes difficult for managers to commit resources, evolve products, and add asset classes, particularly those that may offer good diversification benefits but may be less liquid in nature.

Despite these headwinds, diversified funds continue to play an important role for some investors, particularly those with small account balances.

Notably, diversified funds provide a convenient access point to a range of asset classes, with asset allocation determined by experienced professionals.

Managers that Lonsec regards highly in terms of capital market expertise include Goldman Sachs, Schroder, and Perpetual.

With underlying exposures managed in-house, diversified portfolio managers tend to be closer to the decision-makers at the asset class level, enabling a greater understanding of the particular nuances of an underlying fund.

Multi-manager

Multi-managers share some of the benefits of diversified funds in that they are diversified across asset class; convenient; managed by experienced asset allocation professionals; and provide efficient implementation and rebalancing as well as monitoring.

They go further by providing access to underlying funds that may not otherwise be accessible to Australian retail investors, and invest in best-of-breed managers within each asset class.

Multi-managers tend to be better resourced than diversified funds, largely due to manager research requiring large teams or the assistance of asset consultants.

Objectivity is enhanced, with multi-managers able to more readily redeem from underlying sector specialists if required.

In contrast to diversified funds, multi-manager funds have generally evolved more rapidly in terms of incorporating new strategies and dynamic asset allocation approaches.

Multi-managers have, however, often been criticised for over-diversification and generating index-like returns, diversifying the wrong risk, and being too peer conscious.

FUM has grown in this sub-sector, with most managers recording inflows. For the most part, this FUM growth has been at the expense of diversified funds.

Managers with strong manager research capabilities include Advance, AMP, ipac, Mercer and Russell. For the most part, multi-managers are objective about how they select their underlying managers.

That said, there are a number of managers who continue to increase their allocations to internal and related parties, potentially comprising the objectivity of the portfolio construction process – particularly when it comes to the removal of underperforming managers.

AMP and Colonial First State hold the largest allocations to internal managers, although MLC is also increasing its exposures to related parties as it expands its NabInvest business.

Multi-asset income and real return funds Lonsec believes multi-asset income funds will play an important role as investors continue their search for stable yield.

For investors who want a real return target, and greater potential certainty in performance outcomes, multi-asset real return funds may be attractive.

While most investors have an overall investment objective to target a medium- to long-term return above inflation, few investors specifically manage to achieve this objective. Lonsec sees these funds as playing an important role in filling that gap.

People and resources

Reassuringly, the level of industry experience within the multi-asset class sector is high and generally increasing with an average of close to 15 years experience in both multi-manager and diversified investment teams.

The range of average team industry experience is impressive at 10-24 years.

Pleasingly, the level of industry experience has continued to rise over recent years across most managers, indicating that where investment team turnover has occurred, managers have tended to fill vacancies with equally experienced candidates. 

In terms of size, multi-manager teams (average size of 10) tend to be far larger than their diversified counterparts (average team size of three), due to the labour intensiveness required in undertaking manager research.

Multi-asset real return and multi-asset income investment teams tend to be the investment professionals who are managing the more traditional multi-manager or diversified funds within a funds management business. 

In Lonsec’s view, on-the-ground coverage, both in Australia and in other regions, is important when researching and selecting managers.

As expected, those managers who undertake all their own manager research tend to have large teams (eg, Russell, MLC) whereas those who use third party research tend to have smaller teams (e.g. typically less than six). 

Turnover

Whilst some minor staff movements within the Multi-Asset Class universe were evident throughout 2011, on the whole, the sector remained relatively stable.

The most notable staff changes occurred at manager level, where a degree of corporate uncertainty was evident, in particular INGIM Optimix and AXA/ipac.

Deanne Fuller is an investment analyst at Lonsec.