Investment portfolios were often based on traditional and historical structures of which seemingly few had changed over the decades. The range of assets was very straightforward as judged primarily by the stockbroking models used by both the stockbrokers and discretionary managers at that time. A balanced portfolio would often be 80 per cent in equities, with some gilts added, along with possibly a corporate or property bond – and not forgetting that unit trust popped in to cover the rest of the globe. Why such a structure? Well the clue is in the name. We were brokers of stock in those days.
Practise
To this you could add the normal trading practises of around 20 purchases and 20 sales a year. This, of course, would normally fulfil your expectation to have provided around 40 commissions over the year and thus in all likelihood entitle you to a bonus. Cynical? No, I used to sign the cheques.
As for the intermediary world, this usually seemed to follow a similar asset allocation as laid out so perfectly by the old dogma of the insurance company ‘stochastic’ models of asset allocation (or was that sarcastic?), which provided a rigid structure for the adviser just to pop in their favourite funds du jour.
Thus such a structure ensured that any market correction would affect all across the board, but of course who could be criticised? After all they had all followed the hallowed dogma.
Around the turn of the new century, some participants disgruntled with this approach broke away and looked to bring in, if not new ideas, then at least previously little-considered concepts in the retail world. And so Markovitz’s ‘new portfolio theory’, although not new, would have a radical effect on the structure of many portfolios and, in due course, many businesses.
This introduced far greater diversity of assets into the allocation. The aim was not just for diversification of risk but also to try and manage volatility. From this we saw the burgeoning of the multi-asset portfolios, not just as a range of fund of funds, but rather using a far more considered approach to portfolio construction as opposed to simple asset allocation dogma and last year’s top-performing funds.
Once the concept of broader multi-asset portfolios seemed to receive greater acceptance, it was then time for the advent of the specialist fund managers. These would often be smaller houses – not the big brand name fund houses, but those capable of bringing greater focus to investment areas previously bundled together into larger sections of asset classes like emerging markets.
A particular area that had been frequently ignored was that of currency investment and risk. Currencies were not seen so much as an asset class in themselves but rather as a more volatile and dangerous risk to what could otherwise have been a well-diversified global portfolio. One dramatic movement in sterling and all the good work had gone to waste. Here then was where we saw the introduction of currency hedging starting to enter the mainstream as multi-managers’ portfolios could bring this institutional discipline through to the retail market.
Illustration
For ‘multi-manager’ you could read ‘multiple active managers’. The range of multi-managers could be best illustrated by a series of Venn diagrams of all the similar fund managers they all used in varying proportions. The only exception seemed to be when just their own in-house funds were applied.
To challenge this cosy oligarchy came the institutional managers with their open secret of using passive funds – very common in the US but barely touched in the UK, as, of course, none of them paid any commission.
They were introduced to improve lower-cost trading within the multi-managers when managing inflows and outflows. However, quickly thereafter some went further and established entirely passive portfolios, albeit still with an active asset allocation process applied.
This then put the asset allocation process at the heart of the portfolios, leaving the blend of active and passives, or entirely passive portfolios to compete directly with one another; was it all about cost or all about performance? Of course not – it was all about the asset allocation.
Then as volumes grew it became perfectly logical for some houses to bypass the passive providers altogether and in effect create their own baskets of direct holdings. This would enable providers to lower costs while maintaining the asset allocations for the client portfolios.
From here then followed the logical step of finding more cost-effective ways to implement the asset allocations. Thus rather than necessarily having to buy the ETFs or the underlying equities, now derivatives could be applied to achieve the same exposure at a lower cost; whether through buying dividend strips or futures contracts for particular indices, a more precise asset allocation could then be executed at a lower cost. This improves the value to the client and makes implementation of the asset allocation decisions more precise, while minimising the amount of capital actually being deployed. These ‘smart’ passive approaches continue to develop and help to fine-tune the implementation of the asset allocation models.
Derivatives
Of course the application of derivatives has been shown to be highly effective already, however the rigour, control and discipline to manage them effectively is not to be underplayed. While these can be highly effective tools in the right hands, they can equally be extremely destructive if not properly managed.
What we have seen over the past decade, therefore, is not just introduction of the latest investment fad for the managers to show off their capabilities, but rather in fact the deployment of institutional disciplines through to the retail market. Increasingly careful application of derivatives will provide a concise and cost-effective execution of asset allocation. They are and will increasingly be vital tools in multi-manager investment management, but they are the tools and not the answer themselves. They are just another method of managing your tactical asset allocation cost-effectively, concisely and carefully, but they themselves are not the asset allocation discipline.
Justin Urquhart Stewart is marketing director of Seven Investment Management
Key points
- Investment portfolios were often based on traditional and historical structures of which seemingly few had changed over the decades.
- Once broader multi-asset portfolios were accepted, it was time for the advent of specialist fund managers.
- What we have seen over the past decade is the deployment of institutional disciplines through to the retail market.
