December, 2016 Print
Simon Fox, Senior Investment Specialist, Aberdeen Solutions.
Simon Fox of Aberdeen Solutions examines the various ways in which managers aim to deliver consistent and repeatable returns from a multi-asset portfolio
A lot of recent analysis has focused on the performance of Diversified Growth Funds (DGFs). Does this new breed of multi-asset strategy really deliver relative to an old fashioned balanced fund? Hasn’t a simple blend of equities and bonds performed just as well for much lower fees? In many cases, the answer is yes – traditional portfolios have performed strongly since the global financial crisis and market volatility across the board has been extremely low.
Our concerns with this analysis are twofold – firstly that it is backward looking (and, more than ever, past performance is not a reliable indicator of future results – given the current market environment). But, and perhaps more so, we believe that this misses the point of why consultants and investors have been attracted by the DGF approach. In a world where traditional asset classes are looking challenged, DGFs are attractive because they can offer something “more” – be it access to idiosyncratic manager skill, market timing capability, or simply a broader array of return drivers. In every case, the “more” that a DGF offers will be attractive if it helps to improve the consistency of returns, reduces downside risk and increases the likelihood that an individual member can grow his DC pot, or a DB scheme can pay its pensioners.
The different types of “more”
As we set out above, there are essentially three ways that a manager aims to deliver more consistent, repeatable returns from a multi-asset portfolio:
- One option is to replace some of the market risk in the portfolio with idiosyncratic “alpha trades”. Typically managers use a lot of derivatives with this type of approach – both to hedge out market exposures, but also to capture specific trade ideas. In many respects this can be seen as a hedge fund-lite approach.
- A second approach is to do more market timing. Most multi-asset funds do a degree of market timing as an inherent part of their strategy (indeed we believe that we can add value from flexibly allocating across asset classes), but if this is the real “more” that a manager is targeting, they need to be willing to make quite significant adjustments to the portfolio. There is also a philisophical difference between simply “adding alpha” relative to a strategic asset allocation and actively asset allocating to achieve a more consistent absolute return profile.
- Finally there is the option to better diversify the portfolio. There are more asset classes and investment opportunities for us to allocate to today than there were even five or 10 years ago. Infrastructure (both social and renewable), property, high yield bonds, emerging market bonds, loans, insurance-linked securities, aircraft leasing and peer-to-peer lending can all be used in multi-asset funds. Diversification can reduce the portfolio’s reliance on equities to generate growth; it can also help reduce the risk of the portfolio by lowering volatility and downside risk. The world’s largest investors no longer rely on just traditional equities and bonds – diversified growth funds don’t have to either.
When it comes to choosing (or reviewing) a DGF manager, we believe that investors need to identify the “more” that the manager is promising. Two key questions can follow – is the manager’s approach aligned with the role that the investor is looking to fill; and, secondly, is the manager adding value through the “more” that they are offering.
Manager approach versus investor goals
An investor’s primary goal is to increase their likelihood of good investment performance – good long-term returns with few nasty surprises along the way. Done well, DGFs that incorporate a high degree of manager skill – both through hedge fund-lite alpha trades or aggressive (or idiosyncratic) market timing – can be highly diversifying alongside a traditional equity or bond portfolio. In its purest form, alpha aims to provide compelling returns with a low correlation to traditional markets.
However the dependence on manager skill can also make these strategies more challenging from a governance perspective. The alpha itself is likely to be cyclical (as all investment strategies are), but in a drawdown, distinguishing cyclical underperformance from bad active management can be really difficult. Negative alpha can also be an unwelcome surprise – it might not always be obvious why it is happening. Manager diversification can help here, but that, in and of itself, adds more complexity for investors. All in all, we see these more “idiosyncratic” strategies as hedge fund alternatives, rather than core multi-asset funds.
For smaller investors – or individuals – a DGF often needs to add value as a governance solution, providing a simpler route to better performance. For these clients, a single DGF may represent a large part of their allocation. In a DC scheme, a single DGF might represent the only investment for someone looking to grow their pension pot (this is certainly the case with the default for Aberdeen’s own pension scheme). In these cases, a more diversified approach may provide a more understandable pattern of performance, and reduce the dependence on managers always “getting it right”.
In essence, we believe that manager skill should be a component of a broadly diversified portfolio – it shouldn’t be the main driver. Investors that already have allocations to equities, bonds, higher-returning fixed income strategies and real assets may benefit from DGFs that can provide material alpha. For other investors, we believe that simple asset class diversification is a better first step. It can also be the more transparent one.
Judging the “more’s” value add
Understanding the additional value add that a manager is looking to bring is important for assessing whether the manager is delivering as they should. At a headline level, the distinction between hedge fund alpha, traditional market timing and broader diversification is important. In practice investors may need to go a layer deeper too.
Some market timers focus on fundamental research, others on momentum and flows. It’s important to remember that different strategies will be in favour at different times. To the degree that investors shouldn’t praise managers when their style is in vogue, nor should they necessarily criticise when it isn’t.
Alpha strategies can also come with their own inherent biases – including focusing on specific time horizons, particular asset classes, or different derivative structures. With a number of funds in the market offering “clones” of longer-running strategies, maybe it is easier to identify those that are genuinely adding value through alpha – but even here, the outperformance of one versus another may be no more than luck.
For those of us that stake our value on diversification, hopefully the value add is clearer. Are we genuinely offering access to a broader range of return drivers, reducing reliance on the equity risk premium, and generating a lower risk return profile? Can we demonstrate efficiency in the way that we access different asset classes? Do the evolutions to our asset mix ensure that our portfolio is better positioned for the future?
So are DGFs better than 60/40?
We could quibble that there isn’t really such a thing as a definitive 60/40 portfolio – does it include emerging market equities; is the fixed income domestic or global, nominal or inflation-linked; is the currency hedged or unhedged? The structure of the 60/40 portfolio would have had material implications for performance over the last few years – and not least since the recent fall-off in sterling. If investors want a particular 60/40 portfolio to be their benchmark, then most multi-asset managers will be willing to manage a portfolio relative to that. In practice, DGFs have been in favour because they don’t start from a simple 60/40 construct.
All this said, some consultancies count DGFs in their hundreds – our assumption is that not all of these have a “more” that adds value – particularly net of fees. But just because 60/40 portfolios have performed well recently, investors shouldn’t assume that DGFs can’t offer a better solution. Indeed the reasons for many investors to turn to DGFs – uncertainty over equity returns; concerns over fixed income yields – are more worrying now than they were a few years ago. DGFs need to demonstrate what “more” they can offer – we believe that genuine diversification is the clearest value add there is.
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