This trend has been accelerated by broadening opportunities involving a wider variety of index funds available across asset classes, sectors and regions.
Ultimately it is effective asset allocation rather than stock selection that will drive risk and therefore the returns of a multi-asset portfolio. The old debate of “active versus passive” therefore seems increasingly irrelevant. What actually matters most is choosing the right funds, with the right investment style, to meet the needs of a particular multi-asset strategy. With this in mind, there are many advantages to investing almost exclusively in passive funds, especially when you are trying to consistently meet specific risk targets.
Cost-effective
In a world where fund management costs are increasingly under scrutiny, investors’ demand for cost-effective multi-asset solutions has never been higher. The move towards fee-based advice that has come out of the retail distribution review has the potential to create a significant advice gap in the UK, with many people who need help planning their financial futures perhaps being priced-out due to their inability or unwillingness to bear the cost.
This is a difficult problem that requires some innovative thinking to solve. The challenge for advisers and product providers is to continue providing a high-quality service, but to do so at a lower cost. Finding this solution is especially important because those people who are potentially being priced out of the advice market are the high net-worth clients of tomorrow.
Any solution must remove some of the key costs from the advice process. This can be achieved by moving more towards index funds; these of course have dramatically lower costs than their active equivalents. Also, bringing them together in a diversified multi-asset portfolio greatly simplifies the adviser’s research, due diligence and transactional workload.
The other key point is risk. Any solution to bridging this advice gap must adhere to the FCA’s principles of ‘knowing your customer’. Advice must be bespoke, and of course the products must be appropriate for the investment goals and especially the risk tolerance of the individual client. A genuinely risk-targeted fund – not just a fund that is ‘risk rated’ – could help to provide a solution to the problem and index funds will play a vital role.
Index funds play an important role in building an efficient multi-asset portfolio. It is important to note, however, that just because a multi-asset fund makes extensive use of ‘passive’ funds does not necessarily mean it has to be managed passively itself.
In building a global multi-asset portfolio the key determinant of risk, and therefore returns, is going to be asset allocation rather than stock selection. If anything, the ability to be active in asset allocation is more important now than it has ever been. Investment markets are beset by many uncertainties, with the global economic malaise that was triggered by the debt crisis continuing to have far-reaching effects.
So although conclusions about the characteristics and volatility of different regions and asset classes can be drawn from historical analysis, it is also important to recognise that the future is always uncertain. Being able to react to a changing environment and actively adjust asset allocation will be crucial for multi-asset funds to deliver attractive returns.
Risk rating services allow advisers to align their risk assessment process with the fund selection process. This can be valuable, but there are still very few multi-asset funds that are actually managed with these risk ratings in mind. Many have taken existing strategies and mapped them to risk profilers, but unless the fund manager is explicitly targeting risk, the profile may change significantly over time. As such, these funds are not aiming to remain suitable for the investor’s risk profile.
However, simply being ‘risk rated’ is not the only option: funds can also be ‘risk-targeted’. Risk-targeted funds aim to maintain risk within a particular range, so advisers and investors alike can align investments to their clients’ needs from the outset. This risk range could typically be volatility-based rather than, for example having a specific relative performance target.
Targeting risk can help the adviser recommend suitable investments to its clients whilst ensuring they have the right mindset, and appropriate expectations. Risk-targeted multi-asset portfolios aim to maximise return given the investor’s risk profile. These risk-targeted funds have been designed to be a core holding for those who may otherwise get priced out of the advice process, so the costs of these risk-targeted solutions take on greater importance than in other multi-asset funds.
There is little doubt that the growth of passive strategies within multi-asset funds is also at least partly driven by the disappointment some have experienced with actively-managed exposures. That is not to say that active managers cannot outperform or that multi-asset fund managers cannot find strategies/managers that can outperform, however due diligence can often be an expensive and often resource-intensive and this is becoming increasingly difficult in the post-RDR world where costs are under increasing scrutiny.
Investing solely in passive underlying strategies in a multi-asset fund is not always ideal as it restricts the universe of asset classes in which one can invest. Examples include direct property, which cannot be efficiently accessed through an index fund. After all, you can not go out and buy a small interest in every building the same way you can go and buy an interest in every company in an equity index.
In such cases the multi-asset fund managers have a choice: to include some actively-managed exposure in certain asset classes and accept the higher costs, or simply ignore them altogether. Both approaches have their pros and cons, but ultimately it comes down to the active funds that are available.
If the active fund is of sufficient quality, and importantly a low price can be negotiated, then it could even make sense for the most cost-conscious of fund managers to include it in their overall portfolio.
Solutions
I believe risk-targeted funds are the next generation of multi-asset investment solutions, and it is no surprise that they have seen significant inflows and there has been a plethora of new launches.
With increased competition among product providers, these are exciting times for investors who should ultimately benefit in the form of stronger risk-adjusted returns and products that meet their needs.
Risk-targeted multi-asset funds provide a solution that allows advisers to bridge the advice gap and bring cost-effective advice to a large group of clients who might otherwise have been priced out of the market.
Additionally, if these funds are able to succeed in being consistent with specific risk profiles the adviser and their client will both have peace of mind that, as long as the client’s attitude to risk does not change, the funds will remain suitable.
Justin Onuekwusi is a fund manager for Legal & General Investment Management
Key points
- Investors in and fund managers of multi-asset funds are being drawn towards passively managed strategies.
- The move towards fee-based advice that has come out of the retail distribution review has the potential to create a significant advice gap in the UK.
- There is little doubt that the growth of passive strategies within multi-asset funds is also at least partly driven by the disappointment some have experienced with actively-managed exposures.
