Flexibility a strength in times of uncertainty

Multi-asset funds have come into their own in recent years as they offer diversification across a wide spectrum of asset classes and, in many cases, some hedging against risk and/or an overlay of tactical strategies designed to squeeze the last drop of return from difficult markets.

This broad diversification allows multiasset funds to achieve better risk-adjusted returns, and typically they aim to produce a return in line with historic equity returns but with reduced volatility.

The classifications of multi-asset funds lack clarity, however, as they are determined according to the proportion of equities in the fund, and can have widely differing levels of volatility. We have used the Morningstar EUR Moderate Allocation category of funds which are mandated to invest in a range of asset types for a €-based investor, with an equity component between 35 per cent and 65 per cent. Research by Allianz Global Investors shows that funds in this moderate sector have a particularly wide range of volatility profiles with an annualised standard deviation that ranges from 6 to 18.5.

Even identifying a multi-asset fund is not straightforward, as they go under a myriad of labels, and there can be confusion with the absolute return sector although absolute return funds tend to use cash as their benchmark, rather than a market-related index.

Our table is headed by Degroof’s Global Isis Medium Balanced fund, the category’s largest Jacky Goossens, director and member of the executive committee at Degroof, says the fund’s primary appeal to investors is that it offers diversification at the lowest cost possible, and it is indeed also the cheapest fund in the table with a TER of 0.86 per cent.

Diversification

Degroof’s Global Isis Medium Balanced fund holds 55 per cent in equities, 45 per cent in bomds and 5 per cent in cash

One of four ‘risk profile’ funds Degroof runs, the Medium Balanced fund holds 55 per cent in equities, 45 per cent in bonds and 5 per cent in cash with no allocation to alternatives.

Mr Goossens says he makes tactical calls based on valuation but never takes positions that are ‘100 per cent in one direction’. The extent to which a fund managertakes tactical positions is a major differentiator in this sector. Some take a fairly steady, benchmarked approach, and may impose a nearly static asset allocation while others are unconstrained, giving the manager greater freedom to pursue opportunities as they arise, which will often involve the use of derivatives.

For example, the third largest fund in our table, BNY Mellon Global Real Return fund, is based on a consistent, stable core of returnseeking assets, but uses offsetting derivatives to actively manage and reduce risk, such as a ‘put spread collar’ on the S&P which both protects against downside risk and reduces the cost, and a position in volatility on the VIX.

Targeted at Euribor+4 per cent, the fund aims for volatility of 10-12 per cent – somewhere between bonds and equities.

Investment horizons

BNP Paribas Investment Partners’ Diversified World Balanced fund also works to a longterm horizon, but using quant models. Emiel van den Heiligenberg, CIO Global Balanced Solutions, says that irrespective of BNP’s short-term view on an asset class, positions are adjusted to a long-term value approach. “Short-term tactical asset allocation positions are made but are dwarfed by the long-term value strategy,” he says. Mr van den Heiligenberg also makes the more general point that “it is a difficult market in which to take tactical bets. Most of my colleagues are taking limited tactical risk at the moment because markets have been well correlated.” However, he believes correlations are likely to come down in 2013 as a result of political policies and the regulatory environment.

Another critical difference between funds is that sometimes there is a single manager in charge of the whole piece who adjusts asset allocations as macro economic circumstances change. Others, typically those with a predetermined asset allocation which is rebalanced at regular intervals, parcel out different asset classes to fund managers who have expertise in that particular space, and slotted back together to make the fund, but there may be little holistic oversight over the portfolio as a whole.

This can lead to overlaps and unexpected risk. “An understanding of all the risks in a portfolio is essential for a multi-asset approach,” says Will Edge, investment specialist at Russell Investments.

“If for example you want to reduce your exposure to China you might decide to accomplish that by just reducing the discrete holding in China, but you may have exposure in other parts of the portfolio, such as companies not located there but whose revenues depend on China, or within commodities, for example,” he explains.

“An holistic approach is incredibly important in terms of managing total risk and where risks overlap. If the portfolio is managed in discrete parts and put together without complete oversight, it is hard to manage a single objective for the total fund. Take currency risk for example. There should be a good understanding of the level of unhedged currency exposure external managers are applying to the portfolio to effectively manage currency’s contribution to total risk.”

Mr Edge also warns there can be a tendency for managers who lack strength in an asset class not to allocate to that area at all or to allocate on a passive basis, without a full understanding about how to manage the risk/return profile of the portfolio. Direct commodity exposure and other alternatives are typical missed opportunities as they have a low correlation to developed equity markets.

Currently, most fund managers believe there is most value in risk assets such as equities but are divided in their views towards the US and Europe. Degroof’s Mr Goossens, for example, prefers to be invested in equities anywhere other than US, which he thinks are expensive, while he is relatively optimistic about Europe.

“The US has outperformed European stocks by 25-30 per cent since 2009,” he says. “Everyone has been so negative about Europe and pondered the end of the euro but that is not what we think will happen.” Templeton’s Global Balanced Fund is benchmarked against the MSCI World whichis 50 per cent invested in the US but it, too, is underweight the region with just 30 per cent in US stocks – a position which made for a tough time in the first part of the year. Subsequently, the fund’s sizable holdings in Europe made up the lost ground however as the Eurostox outperformed the S&P by 20 per cent from May to December.

Peter Wilmshurst, portfolio manager at Templeton Global Equity Group, in Melbourne, runs the fund’s 65 per cent equity portion and is still relatively optimistic about Europe, on the basis that “it is stillundervalued and European households bar the Greek and Spanish have maintained their spending power and are resilient. We believe Europe is well on the way to recovery – trade balances are improving, deficits are reducing and since the progress made in the middle of last year, tail risk has dialled back.”

However, Mr Wilmshurst believes that certain multinational companies based in Europe in the consumer staples and luxury goods sectors are significantly overvalued and has been scaling out of them. Their inflated share prices reflect the fact that investors see them as a way to hold Europe with reduced risk, while at the same time accessing consumer growth in emerging markets.

Uncertain future

Certainly, despite the Wall Street rally at the beginning of the year, painful decisions on US spending cuts have merely been delayed and speculation about the superpower’s credit rating has not gone away. Further political standoff seem inevitable, with Congress and the White House likely to start battling over the $16.4tn (€12.3tn) debt in February.

If the budgetary uncertainty can be resolved in the next few months, growth should pick up in the second half of 2013, but the consensus is it will not top 2 percent. Yet there are silver linings. Corporations have cut costs and amassed $1.7tn in cash.

Indeed 2012 as the best year for car sales in the last five, and The Institute for Supply Management’s index of manufacturing activity rose in December. Unemployment remains high at over 7 per cent but there has been a steady rise in jobs. It is precisely for such a time of macro economic uncertainty that multi-asset funds come into their own. Under the most benign of possible scenarios, José Antonio Blanco, manager of UBS SXS Balanced Fund, expects moderate growth in the US and most emerging markets. He believes Chinese domestic consumption is rising as a result of its nascent social security system, and Asia generally is better placed than Latin America or European emerging economies, which could be destabilised by the forthcoming Italian and German elections.

“The market will remain volatile, providing opportunities to buy on dips and reduce on rallies,” adds Mr Blanco. “That’s the beauty of portfolios that are able to move around. Multi asset funds are a very attractive strategy in this context, as they are not constrained to a particular asset class or market but can exploit opportunities as they develop, while others fade.”

Although credit is stretched, Mr Blanco thinks it also offers value for managers prepared to switch around – last year US investment grade debt did best but he believes this year European debt and emerging market corporate debt will be most attractive, along with local debt in the emerging market debt space.

Newton portfolio manager James Harries, who manages the BNY Mellon Global Real Return Fund, similarly believes the business cycle will be shorter and more volatile than in the past, and that earnings expectations are too elevated. Newton is a thematic house and one of its more recent concepts is that the Chinese market is unbalanced and so Mr Harries has steered away from building materials, coal, cement, the Australian dollar and the Canadian dollar.

The fund is 47 per cent in equities, 27 per cent in bonds, 14 per cent in cash, 6 per cent in gold mining shares and 4 per cent in gold exchange traded commodities, sharing with several other managers in the sector the perception that gold is a useful off-setting hedge in a negative real return world.

The importance of the individual

Multi-asset funds are very different beasts, so looking closely at a manager’s style and operations is critical. “Our advice on multi asset funds is to look carefully at what is inside each fund,” says Alan Higgins, chief investment officer, UK at Coutts. “We are not convinced that all managers take volatility into account. There are big differences in investment grade and high yield bonds for example.” He says they also look for a low total expense ratio which may be reduced by using exchange traded funds and by holding bonds directly, so avoiding the payment of fees to a third party.

“Balanced funds can be a way of outsourcing portfolio management, but with the caveat that thorough work must be done initially to select the right kind of manager for the client’s risk appetite,” explains Mr Higgins.

“There are low risk managers such as Troy and CF Miton, but others have much higher risk. It is too simplistic to just look at the equity holding,” he adds, referring to traditional fund sector classifications. “One needs also to consider the equity beta for other structures such as high yield.”

Current low return but volatile markets should theoretically provide a backdrop against which multi-asset funds should perform relatively well.“In what is now a very different investment landscape, with more muted returns in volatile markets and with the potential for rising interest rates and inflation, the multi asset approach is better placed to generate returns for investors,” says Will Edge, investment specialist at Russell Investments.

“The better control that the oversight of the total portfolio gives a manager, means a multi asset portfolio can be managed to a range of client objectives, such as recurring income or consistency of growth, in addition to a more traditional risk-targeted approach,” he explains. Another way of managing client money is to look at a client’s individual objectives, such as saving for a child’s university needs, or for retirement, and investing different portions of their wealth in different corresponding portfolios, rather than awarding all goals the same tolerance for risk, says Mr Edge.

“Advisers who talk to clients about their individual investment goals can improve their rapport and their referrals. It’s a more progressive way of working with individual clients.”

VIEW FROM MORNINGSTAR

The fight to outperform

Dynamic asset allocation is a notoriously difficult task for active managers, only a few of whom actually outperform an appropriate composite benchmark over the long term. For example, although funds in the Moderate Allocation category returned an average of 8.25 per cent in 2012, the category’s composite benchmark (50 per cent Barclays Euro Aggregate + 50 per cent FTSE World TR, in euro terms) returned 12.23 per cent Nevertheless, managers within this category have a wide range of performance drivers at their disposal. In addition to allocating between equities, bonds and cash, sector calls and bottom-up stock selection can be used to add value into the equity pocket. Within bonds, managers can rely on traditional fixed-income plays such as bets on duration, yield curve and the allocation between government debt and higher-yielding securities.

In 2012, funds with higher equity stakes tended to do better than their peers, as was the case for Fidelity Euro Balanced, which returned 23.87 per cent. The fund maintains a fixed allocation

of 59 per cent to equities, higher than most in the category. Successful stock picks within the equity pocket also contributed strongly to the fund’s outperformance. By contrast, Sauren Global Balanced returned only 8.16 per cent. The two managers running this fund of funds since 1999 select around 40-50 underlying investment vehicles, and rebalance their portfolio regularly to  maintain equity exposure at 50 per cent. Although the fund benefitted in 2012 from strong performances of several funds in the portfolio, others disappointed, which limited the fund’s progression last year.

Mara Dobrescu, senior fund analyst, Morningstar France