Multi-asset funds provide room for manoeuvre

The market has taken the US Federal Reserve’s decision to commence tapering in its stride, but there is still a good deal of uncertainty for investors to contend with. In such a fluid market, multi-asset funds are useful as their managers can react swiftly, moving between assets as conditions change and opportunities arise.

Several diverse scenarios could materialise in the months ahead. The economy may slow more than expected, or stockmarkets might move into bubble territory, where the Fed would be forced to tighten liquidity without raising rates. Investors concerned about inflationary pressures might jettison their bond holdings, increasing yields, which would be a concern owing to high levels of debt in the system.

Managing the recovery

 “The dangers of not tapering would have been that asset prices would become too elevated relative to the underlying economy,” says Jan Dehn, head of research at Ashmore. “This would have created a dangerous bubble that, if it burst, would have undermined confidence in policymakers and, particularly, in the integrity of the recovery, which remains far more fragile than the behaviour of stockmarkets would suggest.”

 On the other hand, quantitative easing and easy monetary policy remain imperative supports for an economy that remains saddled with spare capacity, high levels of debt, and low inflation, explains Mr Dehn. This is why the Fed coupled its announcement of tapering with enhanced, albeit qualitative, forward guidance couched in inflation and unemployment terms, he says.

 “The intention is clearly to scale back QE going forward, but the process will be very gradual and it may well be delayed, slowed down, or even temporarily reversed,” adds Mr Dehn. “Asset prices, interest rates, and the economic cycle will have to remain very well behaved for QE to be scaled back in a smooth way. We think this is unlikely. Investors should be prepared for policy reversals and associated rate volatility, particularly in the long end. In our view, the main shocks to the global economy will continue to come from developed countries.”

How the timing of the taper will influence future rate hikes will be critical. “The Fed has tried to separate these, to reduce market concern that interest rate hikes may be coming soon,” says Tony Coffey, who manages the Franklin Templeton Global Fundamental Strategies Fund.

“While the Fed’s new chair Janet Yellen has a dovish reputation, overall the composition of the Fed committee is slightly more hawkish than it has been in the past and so the taper and rate hikes may occur sooner than anticipated. Looking ahead we feel that equity markets and risk assets in general should continue to do well. However, on the fixed income side, with the Fed tapering in mind, we have seen a back up in interest rates from historically low levels and this will put pressure on fixed income.”

The challenge in stockmarkets is that earnings multiples are outstripping real growth in earnings. “PEs are increasing at a faster rate than earnings growth but we can’t expect them to expand indefinitely and this could prove a drag on equities,” adds Mr Coffey.

“There is potential for equity markets to respond negatively to aggressive tapering by the Fed because much of the strong performance of risk assets has been a function of accommodative monetary policy and the market does not expect the same level of accommodative policy in future.”

One market where there is greater optimism about earnings expectations in 2014  is the UK, particularly as it has recently suffered a period of underperformance. Bank of England governor Mark Carney’s regime was expected to weaken the pound but instead there has been improved economic data and a better outlook for the UK economy. A stronger pound has also encouraged capital flows to the UK, where the corporate sector has cash on its balance sheets which will be picked up in merger and bid activity. UK companies are often bid targets as the UK regime is less fastidious about selling assets overseas and capital flows to the UK continue to be attracted by its record on rule of law and property rights.

Picking winners

The mixed fund sector spans everything from absolute return style funds to 100 per cent indexing, but in the current climate, funds with a stockpicking bias arguably have the advantage. Andrew Cole, director of the strategic policy group at Baring Asset Management, says that although Barings is a committed believer in the top down approach, right now stockpickers are enjoying a tailwind and it is appropriate to use your risk budget for stockpicking.

“Stockpickers like upward trending markets where they are not hampered by liquidity constraints or mid and small cap stocks,” says Mr Cole. “Big macro years when the economy dominates, such as 2008 and 2011, are problematic for stockpickers. For people to be rewarded for picking stocks the best scenario is a stable economy – not booms and recessions but stability in the business cycle, and in a sense that is beginning to happen now as companies are being run for themselves rather than for survival.”

Stockpickers who have done well first correctly identified those companies that would survive the storm by looking at their balance sheet strength, says Mr Cole, and are now looking at those that have maintained their margins, and are going back to good business managers who are managing for growth rather than survival.

“We expect a continued benign economic backdrop to markets and continued improvement in the global economy,” he says. “We don’t see big risks from rising interest rates or indeed from inflation and we continue to worry less and less about the impact of monetary policy.”

Many asset managers offer a range of three or four funds of differing risk profiles. For example Degroof, which manages the second largest fund in the sector, offers four risk-rated  funds which are each 40 per cent indexed for broad diversification with a 60 per cent tactical/active allocation based on a value approach.

Jacky Goosens, director at Bank Degroof, is wary of high yield bonds. “Many high yield companies are taking on debt with weaker covenants because investors are looking for yield and are therefore happy to have 2-3 per cent spreads,” he says.

Andrew Cole, Barings

Looking to Japan

Like many other funds in this sector, Degroof currently holds overweight positions in emerging market equity and local currency debt, and also in Spanish and Italian bonds. Many managers are also currently overweight Japan, as a story entering an important phase of Abenomics in the recovery process. The Baring Multi-asset fund, which targets an equity-like return of cash plus 4 per cent, and is 70 per cent allocated to equities, currently holds around 10-11 per cent in Japan.

“Over the next few months we will see whether the windfall gains to the export sector do get redistributed across the wider economy,” says Mr Cole. “The effect on the broader part of the Japanese economy is a key determinant as to whether Abe’s attempts to reflate will work. We think it will but will be paying close attention to Japanese data. It is one of the few areas in the world where the electorate, the government and the central bank are all aligned. There are not many economies where everyone is facing in the same direction. In the long term, they will not be able to outmanoeuvre the debt steamroller, but the plan gives them another 10-20 years.”

One possible cause of derailment could be Japan’s dispute with China over the Senkaku Islands in the East China Sea, known as the Diaoyu Islands by China, which has dragged on for months and could escalate this year. While economically, China is more open than ever before, critics point out that politically and socially it is more repressive than ever, and this year – June 4 – marks the 25 year anniversary of the Tiananmen Square massacre, an event still never mentioned in public.

Meanwhile, China hopes to tackle its domestic problems, such as rising labour costs, by boosting productivity. Although it has the world’s largest e-commerce market and a vibrant social media, the country has been slow to apply business technology in an effective way. Technology is now becoming a priority for the first time in many enterprises, and is helping to reduce headcount and  transform the supply chain, which could result in the loss of thousands of jobs in sectors such as retail and high street banking.

Bargain hunting

Multi-asset funds have the freedom to scour the entire market for unloved assets, and to take big off-benchmark bets in selected asset classes. “In terms of markets for 2014, a huge contrarian stance would be for bonds to deliver any kind of positive return and we believe they could hold up better than the consensus believes,” says Alan Higgins, UK CIO at Coutts.

“In the US, while Fed chairman Ben Bernanke notes that the underlying economy in the US is strong, we share his focus on ultra low inflation and the absence of credit growth which mean that rates will be low for longer,” he says.

“With rates likely to remain at zero for another year, then only a slight hiccup in growth or equities will result in short covering in bonds because the alternative would be ultra low returns on cash. In the US the five-year forward rate is already 4.5 per cent, so our suspicion is that bonds could surprise with a positive return in 2014. Government bonds and selected high grade credit provides a liquid income stream and there is still great demand for income.”

Mr Higgins also believes that some types of securitised credit were caught up in the indiscriminate selling panic of 2008, such as straight forward prime residential ABS (asset backed securities) and CLOs (collateralised loan portfolios) where there is visibility into the underlying asset and realised default levels have proven significantly lower than priced into the market.  

Equity exposure

Coutts offers both active and passive styles in its range of multi-asset funds and clients often take a blended approach. Alan Higgins, UK CIO, says it is critical for investors to look inside these funds as multi asset funds in the cautious category can allocate anything from 20 to 60 per cent in equity holdings, and in the current environment, many are pushing 60 per cent, while some balanced funds currently hold up to 80 to 85 per cent in equities.

This practice of pushing the envelope is, says Mr Higgins, “a reflection of the IMA/Lipper regime and the ranking system. Managers often look to stretch their equity risk in this environment.”

Investors should therefore look behind the labels. “If you are allocating to funds with high exposure to equities or other related risk assets you are looking for that manager to correctly call the next major turn in the market and essentially switch out of equities at the right time.”

Mr Higgins admits that timing the market is not easy, but points out that a small selection of multi asset funds had a particularly good 2008 to 2009 transition which paid off, some of which Coutts is currently working with. Investors need to look at the evidence – at how the portfolio is invested and the most likely outcome for the portfolio and the manager’s track record – but this is secondary to current positioning because history does not necessarily repeat itself, he explains.

“In particular, investors should be aware that high yield tends to be more correlated with equity than fixed interest, and there may also be significant equity beta embedded in strategic bond funds mainly via high beta credit and high yield,” says Mr Higgins. “For a cautious investor a portfolio of circa 60 per cent equities/40 per cent high yield bonds and strategic bond funds will likely have too much equity beta.”

Included on the Coutts platform is the Newton Real Return and the Baring Multi Asset fund. Mr Higgins says they “fit the bill” as they are in the balanced category but with more moderate overall equity risk exposure.

“While we are positive on equities we won’t over-risk a cautious portfolio as we recognise investors are looking for cautious profile and our approach is to manage portfolios consistently, essentially offering multi-asset funds centred on 25 per cent, 50 per cent and 75 per cent in equities,” he says.

View from Morningstar: Funds battle to beat benchmark

The Euro Moderate Allocation category comprises funds with an intermediate risk profile, defined by an equity stake ranging from 35 per cent to 65 per cent of assets. As such, those funds are designed to allow investors to benefit as equity markets rise yet with lower volatility, while gaining exposure to other asset classes.

Yet in practice, dynamic asset allocation is a notoriously difficult task for active managers, and only a few manage to outperform a relevant composite benchmark over the long term. 2013 was no exception, and the category’s composite benchmark had a gain of 10.5 per cent, far better than the 5.7 per cent recorded on average by the typical fund in this category.

In 2013, funds with higher equity stakes have tended to do better than their peers, as world equity markets were on the rise for most of the year. The Fidelity Multi Asset Strategic Fund managed to outperform its peers although its equity investments are much lower than most of its competitors as they are capped at 45 per cent. The fund is run by Trevor Greetham, who brings a wealth of experience, while desired asset allocation is achieved by investing primarily in Fidelity funds.

Sauren Global Balanced also managed to outperform the average, returning 7 per cent. The two experienced 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. In practice, this portion is often overweight on European equities, and around one third of it is dedicated to small caps.

Thomas Lancereau, director of fund research, Morningstar France